TRAUMATIC financial and macroeconomic shocks across the global economy have re-focussed attention on the role of money, banks and financial institutions in the economic system.
In the early years of the noughties, macroeconomists, including Ben Bernanke, now the chairman of the Federal Reserve System, opined on the happy arrival of The Great Moderation: a viewpoint that suggested economists had found a successful approach to conquering major fluctuations in the business cycle, and could ensure that there were no excessive gyrations in national income and output.
This approach emphasised the supremacy of market behaviour and suggested that policy makers should concentrate their attention on liberating the economy further through de-regulatory policies, along with an emphasis on controlling inflation through the actions of an independent central bank.
The role of money was de-emphasised. Money was believed to play a neutral role in the economy – in other words, it had no great effect on the real workings of the economy.
Lurking in the background of this cosy consensus about the Great Moderation was the view that economic man was a highly rational phenomenon, not prone to irrational speculative behaviour in asset markets.
Such a view further inferred that asset market bubbles could not arise because they were irrational phenomena! The implications of this type of thinking minimised the role of money, banks and financial institutions in the economic system. The limitations of the Great Moderation were exposed by the arrival of the Great Financial Crisis, which exploded in the United States with the collapse of Wall Street's investment banks in 2008.
The crisis arose because the widespread availability of credit in a low interest rate environment had encouraged financial institutions and the investment banks to lend heavily into the growing US property market.
When interest rates tightened and the riskiness of the sub-prime property loans became apparent, the house of cards collapsed. Money and credit that had appeared to be abundant were no longer available.
In the international economy, the bankruptcy of Lehman Bros and the near failure of the other US investment banks produced financial contagion as attention focused on the very loose banking systems in countries such as Iceland, Ireland and Spain.
Money, banking and finance – which had been largely discarded by the economics profession as interesting areas of research – came back into vogue. Once again, the links between money, finance and the real economy have emerged as key links to kick-start recessionary economies back into life.
There are essentially two phases of this type of monetary operation. First of all, there is the necessity for central banks to provide new liquidity to the banking system. The Federal Reserve, and more recently the European Central Bank, have both engaged in this type of operation to provide massive liquidity to shore up the banking system.
This liquidity has provided considerable stability to the system by restoring confidence to depositors, and thereby reducing the risks of bank runs and capital flight.
The second phase of this operation is to enable the banks, replenished with new liquidity, to expand credit to entrepreneurs so as to re-animate economic activity. Such is the theory; the reality appears to be different as the banks have become reserve hoarders rather than credit creators.
There appears to be a type of financial indigestion emerging at the very heart of the banking system, with high-powered money provided by central banks buttressing up the reserves of the banks but not acting as the catalyst for the further expansion of credit.
Faced with over-leveraged balance sheets, concerns about their own capital adequacy, a desire not to make the same mistakes as in the past, and substantial new regulatory controls, the banks have become excessively prudent.
For an earlier re-run of this type of banking behaviour, it is pertinent to examine the history of the Japanese economy since the property market crash of the 1990s.
The Bank of Japan provided considerable liquidity to its banking system that had been badly affected by the property market crash there. However, this liquidity was hoarded by the banks rather than lent into the real economy.
One school of economic thought maintains there is no problem here, because of its belief that the banking system automatically provides the credit that the real economy requires. This line of reasoning implies that bankers are just passive providers of credit, acquiescing quickly to the demands of the productive and services sectors for new credit.
However, in the banking world of the great recession, there is a new emphasis on the role of bankers acting as lenders. This is, of course, necessary, given the excesses of bankers in the asset market bubbles of the early years of the noughties. That said, there needs to be a distinction drawn between screening and blocking credit. In order to screen properly, the banker needs to be well informed of the business world that he/she inhabits. If not well informed, a banker's tendency may be to block credit lines to businesses seeking new loans or the extension of existing lines of credit.
I found an interesting example of this in some research that I carried out on the French banking system in the 1950s. At the time, Eugene Schueller, the owner of L'Oreal, found it very difficult to borrow money from the banks because their analysts believed that he was operating in a very risky 'new' area – namely that of women's fashion!
In addition, they found that Mr Schueller, now regarded as one of the founders of modern marketing, was spending too much money on "flashy advertising".
Unable to borrow sufficient money from the banks, Mr Schueller had to rely on financing a great part of his activities through retained profits – a policy that resulted in his daughter, Liliane Bettencourt, becoming the owner of a very sizeable equity shareholding in L'Oreal, and one of the wealthiest people in Europe.
Proper screening of credit requires educated and well-informed bankers who are cognisant of the broad potential of different areas of the economy. Unfortunately, many of them, as recent experience has shown, had very limited mind-sets, extending credit only to the property sector.
The key to sorting out the financial indigestion in the banking system will be to lend more imaginatively into growth sectors of the economy capable of providing long-term employment.
Money and banks are always of considerable importance in providing the financial infrastructure for growth. Entrepreneurs are the people that transform this finance into real growth.
Economies where dynamic entrepreneurs cannot avail of new credit are doomed to stagnation.
Antoin E Murphy is a co-author with Donal Donovan of 'The Fall of the Celtic Tiger: Ireland and the European Debt Crisis', which will be published by Oxford University Press in May.