Why not allow Internet disintermediation in Central Banking operations?

Many, including myself believe that the Internet has changed the world significantly. Few, including myself again believe that Internet and associated Information and Communication Technologies (ICTs) can even do more, in newer and newer areas too, to meaningfully solve many of the otherwise challenging problems of our world. And impacts of Internet and ICTs can therefore be much larger.

One such area surely lies in disintermediating the operations of the Central Bank. 

As a researcher on the Internet and on broader ICTs who also happen to be an avid follower of global economy, including the latest financial mess in which the world is in lately because of credit crunch in the US; lately I often wondered on the radical idea of using the reach of the Internet and associated ICTs to have a better control of the objectives of any Central Bank – primarily through disintermediating the primary banking operations.

One would agree that it surely sounds like a stupid, prematured, out-of-the blue idea, at best a rant. But that’s what great technologies and their impacts can potentially be.

Coming back to Internet, and broader ICTs; these have been termed as General Purpose Technologies (GPTs). And thereby its impacts have been compared with power delivery systems (of different forms waterwheel, steam, electricity, internal combustion to new-age batteries powering handheld devices) and transport innovations (railways, motor vehicles, ships, etc. Adopting of GPTs eventually leads to higher growth in productivity, and thereby results in improved economic growths. Internet and many ICTs (so do all GPTs) also share the characteristics of disruptive technologies, which eventually may lead to a change in the industrial order. And all these are well known, and thereby well established facts.

Now coming back to the role of any Central Banker, it essentially acts as the Banker of the banks. Following mainstream media, the definition that emerges of a Central Bank is (1) it creates money and thereby ensures adequate credit and liquidity is available in the economy, (2) It is the lender of last resort to commercial banks, (3) its objective is to balance between inflation targeting and economic growth by fixing different key interest rates, (4) regulate commercial banks, etc. And it owns the entire responsible for the monetary policies of an economy as an independent authority of an economy.

Interestingly, just like GPTs herald in growth in productivity and economic activities, right Central Banking operations also result in the same. However faulty Central Banking policies result in economic depressions to great financial mess, both of which often get mentioned on global news and media because of prevailing economic conditions, primarily in the US.

A lot of reference is now being made about the speech of Bernanke, Chairman of the Federal Reserves, in the event of commemorating the 90th birth anniversary of the great economist, Milton Friedman. The apparent argument focused on what caused the Great Depression in the US, or on the bigger argument on role of the Central Bank in avoiding economic recessions to economic depressions. Friedman had his opinion on it and Bernanke had his PhD thesis on it. And both believed that the Central Bank was to be blamed for the Great Depression. What we don’t know due to the ‘attention-deficit-disorder medium for an attention-deficit-disordered age’  is whether that diagnosis holds true for all economic slow-downs, recessions or depressions,  or that diagnosis holds true for a class of those events, like the Great Depression, due to the various prevailing economic reasons.  Categorizing all economic problems in same class may be too much of a generalization!

And the way the Fed. has been acting, since the signs of sub-prime crisis started affecting other parts of the economy, vindicates that Bernanke believed that monetary policies can act as a remedy for almost all economic slow-downs. One would wonder what would have been his prognosis had he pursued his thesis on the current inflationary problems that Zimbabwe faced!

The actions of the Fed. since then have received mixed responses. However what can’t be denied that irrespective of the urgency of many of these debatable actions, it’s the intermediaries who always benefit from this fractional reserve banking policies that Central Banks follow. ‘Heads they win, tails we lose’ has been the business model of commercial banks and a majority of financial intermediate entities.

There can’t be any denying of the fact that intermediate entities like banks served and still serve a great mechanism of canalizing savings into credit, and into various investment products for different types of needs.

But time now has probably come to ask a fundamental question: can we think about a future world without financial intermediates like commercial banks or brokerage houses, at least to take care of the basic operations of canalizing savings, credits and investments? The hypothesis does not suggest that the world will do without them altogether, however in present age, most citizens can’t live without them. The exception comprises the ‘have nots’ of the society from developing or even economically worse categories of nations. And there are also financial intermediates who ‘really’ add value rather than relying on their ‘spread’ of fund alone to generate profits.

Let’s take the argument with couple of examples of current relevance:

In the context of the US, the largest economy of the world, as it stands now, in-spite of interest costs being lowered over the last six-seven months, and adequate liquidity being injected to these intermediate entities; the end-borrowers have not yet benefited much. The reasons can be many, the primary one being that banks are still to recover from the credit hangovers, and the housing crisis may still have further downside. And it’s a therefore a case of market failure. And thereafter we see Fed. bailing out investment bank Bear Stearns with tax-payers money.

So essentially the commercial banks borrow at 2.75% or similar rates, but lends at 5.5% or even at higher rates. The difference or the spread is to cover the risks associated, the costs of servicing, and also contributes to the banks profit. In earlier days, it was impossible for the Central Bank to reach out to millions and billions; however with technology it no longer is impossible.

Most of us, individuals, don’t play with our money in esoteric financial derivatives. A majority of us bite that much only what we can chew and therefore never default on our loans repayments. So for the vast majority, the commercial banking business covers nil risk and assures them of hefty profits.

Question therefore is, why can’t we take the same credit from the Central Bank directly at lower costs bypassing these commercial banks? All documentations can be checked, credit worthiness verified, and suitable interest rates can be charged with additional processing costs put to the customer’s account. The same things can be applied in the matter of collecting savings also. So in both, it’s a win-win model for the customer and the Central Banker. And the profits (or even losses at exceptional periods) of the Central Bank belong to the tax-payers because at the end of the day, it’s for the citizens.

It’s another matter that the Federal Reserves now have a balance sheet that’s economists’ nightmare. And while it focused on protecting the balance sheet of Wall Street banks and financial intermediate entities, it also spoiled the balance sheet of the majority of the working Americans.

True, one immediately senses hundreds of objections, many valid. How can a regulator also act as another entity itself? Isn’t it what the Fed. is doing right now (or the Northern Rock nationalization)? Without competition, service levels will deteriorate. Can we really say that these commercial banks (or the loan-sharks) really deliver great services? And even if yes, that can still be taken care of and competition can be created through other means.

True – it’s a simplistic version. There will be critical challenges. However, those can surely be overcome.

The point is simple. It’s the Central Bank that’s behind monetary policy, and the only authority to create credit or determine key costs of credit/savings. And the whole of society needs them. Why do we still need financial intermediates to channel that credit or savings when technology can act as the greatest enabler in connecting the service generator (the Central Bank) and end-service consumer (you and me).

Many industries no longer exist as they have been made redundant through disruptive developments. And in many other industries, classes of disintermediates have been replaced by one single powerful reintermediates (Google, Amazon, Wal-Mart).

In the financial world, we have seen disintermediation and online impact in the last mile of the supply chain, like online banking with a commercial bank – an intermediate agent, or one can access the trading terminal of a broker to trade in exchanges. However in both, the broker or the commercial bank does not add any value but still pocket some money. Today, with technologies, we can surely maintain direct online banking relationship with the Central Bank, or trade directly in an equity market. It’s the agents in between who as such don’t add any economic values engage into malpractices or unsustainable practices.

If the Fed. can lend JP Morgan nearly 29 billion dollars against 30 billion dollars of mortgages at attractive interest rate, all U.S. citizens having little higher home-equity than those mortgages can also claim similar terms from the Fed, losses in both cases taken up in the accounts of the Fed. It’s no longer the question of exception, as starting with ‘Greenspan Puts to these measures’, they have already become norms.

The process would also enable developing countries like India, the world’s largest democracy, to be able to reach out to the millions of ‘have nots’. If Grameen Bank could do it and still make profit, it shows that the ‘have nots’ as a class of credit takers may not be riskier than the Wall Street firms. The have nots need right credit (microfinance) at right time at right costs, they don’t need to be force-fed costly mortgages by loan-sharks. Indian government would therefore do well if it restraints from populist loan wavering of farmers and focuses on reaching out to the farmers through banks (better through Central Bank using ICTs), as majority of Indian farmers take loan from money-lenders at much higher interest rates. With Internet and direct policy-interventions of the Central Bank, government can directly reach out to these underprivileged sections with cash rather than different ineffective subsidies, where for every 100 units government currently spends, hardly 11 units reach them through the leaky delivery channels with different intermediates.

Increasingly, the line of difference between money-lenders of India and profit-driven financial intermediates of Wall Street are vanishing. However the difference is, Indian Central Bank don’t yet practice the example of bailing out its money-lenders.

It’s a question of government will.  Central Bank, as the creator of fiat money, must not be catering to the select few through its credit window, who in turn run havoc with global economy and individuals’ lives and properties in search of higher and higher profits. Central Banks must not be viewed as a coterie for the rich and the powerful, rather they should be answerable to the people, more than even the government as in democracies government change often and therefore can afford taking populist measures. Central banks can’t take populist measures today to build more pains for the future.

Unfair access and costs of credit money has also been a driver of the ever rising inequality the world witnesses now, from China to Russia to India to the US.  The present form of capitalism also increasingly looks unsustainable where the whole banking system works for the interest of the banks and not for the broader interest of the society. Both the problems can be effectively countered when the Central Bank opens up its window to all citizens uniformly.

Central Banks must ensure that costs of credit must be uniform to all depending on risk and return. Citizens in the US can’t be blamed if they demand same treatment as JP Morgan got while taking over Bear Stearns. In India, an industrialist from the real estate segment with $1 billion dollar asset can take $2 billion loan and acquire farmer’s land whereas the farmers are denied $1000 credit for their land assets of $10000 or even more. And same $10000 asset becomes $100, 000 with the transfer of ownership.  Even if the farmer gets the loan, he pays much higher interest rates. These are not exceptions, Mr. Paulson (or Mr. Chidambaram) – but these are norms in present capitalist society due to the untenable financial intermediates.

Let all commercial banks and financial intermediates that depend on playing with costs of capital from borrowers and savers be dead. Along with them, we will see the expiry of lot of the financial derivatives of the world. Let the Central Bank do business directly with all citizens. If it can’t with present technology, it does not have any authority to be the Central Bank – it then only remains the Banker of the Wall Street.

As we can directly buy tickets online from airlines bypassing the travel agents, as we can directly buy books from publishers at a discount bypassing the shops charging a premium, so we can individually do banking with the Central Bank bypassing the inefficient intermediate entities. We also see economic benefits in visiting a large intermediate entity like the Wal-Mart or the Amazon; however those benefits are not there with commercial banks, unless they resort to unhealthy credits or products.

Still sounds impossible? No doubt it is. However many would be optimist, and believe a change like this can eventually come. It may not necessarily usher in the US, but somewhere else with less influential lobbies, to be experimented and perfected over the years for a better future. And that’s what GPTs are for.

Long live the Central bank. Let the commercial banks die

Ranjit is an Associate Professor at Indian Institute of Foreign Trade, and is the author of the book Wondering Man, Money & Go(l)d Opinion is personal.

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