New Times,
New Thinking.

  1. Culture
  2. Books
27 November 2015

What is “narrow banking“ – and could it put finance right?

Other People’s Money and Between Debt and the Devil approach finance from different angles, but arrive at a single policy.

By Felix Martin

How much finance do we really need? The unprecedented explosion in the size of the UK’s financial industry and levels of debt in the economy over the past three and a half decades have long posed that question. The 2008 crash made it all the more urgent. Yet mainstream economics has proved unable to come up with a compelling framework with which to explain the appropriate role of finance in our economy. Until now, that is. These two books go an impressively long way towards filling the gap.

John Kay and Adair Turner are two of Britain’s most profound and articulate economic thinkers. With that, however, the similarities end. Turner is the consummate insider. A former director of the Confederation of British Industry, ex-chairman of the Financial Services Authority and a member of the House of Lords, he has for years been the pointman of the powers that be on any thorny economic policy problem requiring the forensic application of vast brainpower, clear exposition and political nous.

Kay, for his part, is a professional outsider. A uniquely versatile entrepreneur in both business and ideas, he has disrupted virtually every big economic policy debate in Britain for the past four decades, founding think tanks and companies along the way. He is also – as he demonstrates in his celebrated weekly column in the Financial Times, and as Other People’s Money confirms – an unparalleled communicator of economics to a non-specialist audience.

Consequently, the simultaneous publication of Other People’s Money and Between Debt and the Devil is a double blessing. Both books are scintillating individual contributions to the debate not just on the future of finance but how we should run our economy. But I would strongly recommend anyone interested in these topics to read both – because Kay’s and Turner’s contrasting backgrounds and temperaments bring two very different perspectives to the table.

Kay takes a microeconomist’s approach. He tackles the phenomenon of financialisation by focusing relentlessly on what people who work in financial institutions actually do – and whether it meets the needs of consumers. His conclusion is that, to an alarmingly large extent, it does not.

Select and enter your email address Your weekly guide to the best writing on ideas, politics, books and culture every Saturday. The best way to sign up for The Saturday Read is via The New Statesman's quick and essential guide to the news and politics of the day. The best way to sign up for Morning Call is via
  • Administration / Office
  • Arts and Culture
  • Board Member
  • Business / Corporate Services
  • Client / Customer Services
  • Communications
  • Construction, Works, Engineering
  • Education, Curriculum and Teaching
  • Environment, Conservation and NRM
  • Facility / Grounds Management and Maintenance
  • Finance Management
  • Health - Medical and Nursing Management
  • HR, Training and Organisational Development
  • Information and Communications Technology
  • Information Services, Statistics, Records, Archives
  • Infrastructure Management - Transport, Utilities
  • Legal Officers and Practitioners
  • Librarians and Library Management
  • Management
  • Marketing
  • OH&S, Risk Management
  • Operations Management
  • Planning, Policy, Strategy
  • Printing, Design, Publishing, Web
  • Projects, Programs and Advisors
  • Property, Assets and Fleet Management
  • Public Relations and Media
  • Purchasing and Procurement
  • Quality Management
  • Science and Technical Research and Development
  • Security and Law Enforcement
  • Service Delivery
  • Sport and Recreation
  • Travel, Accommodation, Tourism
  • Wellbeing, Community / Social Services
Visit our privacy Policy for more information about our services, how Progressive Media Investments may use, process and share your personal data, including information on your rights in respect of your personal data and how you can unsubscribe from future marketing communications.

The problem is not finance per se. The core functions of finance are not only valuable, Kay argues, but essential in a modern economy: to facilitate payments; to match those who have savings with those who need capital for productive investment; and to enable households to manage their financial affairs and to insure themselves against risk.

The problem is that practically everything that accounts for the phenomenal growth of finance over the past 35 years has little to do with these core functions. The gargantuan dimensions of modern finance are mostly the result of financial institutions trading with one another – not of their providing a broader range or more useful services to the businesses or individuals who invest or deposit their money with them.

The origin of this pointless (from the view of the consumer) hypertrophy, Kay argues, is a deep-rooted confusion in Anglo-Saxon financial culture between the central concepts of insurance and wagering. Insurance involves the mutualisation of risks and is a socially useful service that society should happily pay financiers to deliver. Wagering, on the other hand, is not a socially useful activity, but a zero-sum game that adds no economic value. Insurance is a core function of finance. Wagering is not. Yet policymakers have allowed a vast industry of wagering to thrive under the misconception that it represents useful insurance.

The key to salvaging the situation, Kay says, is to apply the universal logic of economic regulation: “Finance is a business like any other, and should be judged by reference to the same principles – the same tools of analysis, the same metrics of value – that we apply to other industries, such as railways, or retailing, or electricity supply.” That is a compellingly simple principle and indeed, in Kay’s expert hands it yields a raft of convincing suggestions. Yet, strangely enough, one of the central purposes of Adair Turner’s book is to argue that it is invalid.

“Money,” Turner states early on in Between Debt and the Devil, “is different from other commodities, goods, or services, and neither the economic nor the political arguments in favour of free markets apply to money.” He reaches this startlingly contrasting conclusion because he approaches finance from the opposite direction to Kay.

Seen from the microeconomic perspective that Kay takes, money appears as a thing – a commodity like any other – that is passed from savers to banks to borrowers. Seen from the macroeconomic perspective of the economy as a whole, however, it is shown rather to be a system of credits and debts created and managed by banks. And as at present constituted, Turner argues, this system is intrinsically unstable.

Money creation in modern banking systems depends on the accumulation of debt: it is through the act of making loans that banks create the money we use. There is no doubt that this is a remarkable set-up, and one that historically has greatly facilitated entrepreneurship, invention and trade. In its modern incarnation, however, it also suffers from two flaws.

The first is that there is no natural limit to the quantity of credit and debt that it generates. It is not the case, as the models in economics textbooks claim, that households and businesses need to save up money before banks can lend it on to borrowers. Banks can make loans and thereby create money without any prior act of saving taking place. The idea that the growth of finance is constrained by the rate at which people save is therefore a comforting illusion.

Not the only one, either. Ask most people what banks do, and they will probably tell you that they take in the savings of individuals and lend them out to businesses. Yet, as Turner explains, lending to non-financial companies accounted for a meagre 14 per cent of UK banks’ loan books in 2012. Critics of the banks might think they have an explanation: banks just lend to hapless households to fund “debt-fuelled consumption”. Yet consumer credit made up an even smaller 7 per cent of banks’ loans. What accounts for the other four-fifths of banks’ loans – what banks really do – is mortgages. The overwhelming bulk of British banks’ retail business is lending us money to buy each other’s houses. The outcome is unhealthy. Creating ever more debt to finance real estate does not make the economy any more productive. What it mostly does is pump up house prices. In short, in the current banking system we end up with “too much of the wrong kind of debt”.

This is a diagnosis a degree more pessi­mistic than Kay’s. It is not just that financialisation has erected a tottering skyscraper of “socially useless” gambling on the healthy core business of banking: the foundations are rotten as well.

Which perspective is right, Kay’s or Turner’s? If only banking were shorn of its rent-seeking activities and treated like a normal industry, would all be well? Or are even the core functions of finance intrinsically flawed? In fact, you don’t have to choose. Both approaches yield analyses rich with valuable insights. Perhaps more surprisingly, the approaches converge on an identical, central policy recommendation: banking needs deep structural reform.

Writing ever-fatter rulebooks will not work; what is needed is a different institutional structure. Banks should be restricted to providing current accounts and processing payments. Savings, investments and mortgage finance should be assigned to specialised institutions. The catch-all term for this solution is “narrow banking”. Turner sees it as an unlikely ideal; Kay argues convincingly that it is perfectly workable.

When two such independently minded thinkers, approaching from two such disparate angles, argue as convincingly as Kay and Turner do in this marvellous pair of books that a single policy is the royal road to putting finance right, it is time for policymakers to listen – and act.

Felix Martin is the author of “Money: the Unauthorised Biography” (Vintage)

Other People’s Money by John Kay is out now from Profile Books (368pp, £16.99)

Between Debt and the Devil by Adair Turner is published by Princeton University Press (320pp, £19.95)

Content from our partners
We need an urgent review of UK pensions
The future of private credit
Peatlands are nature's unsung climate warriors

This article appears in the 25 Nov 2015 issue of the New Statesman, Terror vs the State