Do you know what a bezzle is? Here is a book which explains the sophisticated financial system. 

The economic columnist I most admire is John Kay, who writes regularly for the Financial Times. He taught at various universities, was director of the independent think tank, Institute for Fiscal Studies, and has held a host of other interesting and important jobs. His columns are always well informed, amusingly light while being deep, show excellent judgement and often have stunning illustrations of fundamental ideas. In the intellectually vibrant economic discussion of Britain and, indeed, the North Atlantic he is an outstanding contributor both as a thinker and as someone who connects to the popular audience.

Kay has also written a number of books, but perhaps none is as significant as his latest Other People’s Money: The Real Business of Finance, which is probably the best book available on how the financial system currently works.

Essentially the system trades IOUs. To take a simple example, you deposit your IOUs (perhaps a bank deposit or cash) with a finance company, which gives you another IOU in return – perhaps it promises to pay you cash (‘interest’) at regular intervals and, after a certain time or on demand, return your deposit.

To think about such things start off with peer to peer (P2P) lending with an investor directly funding a mortgage, say, to a property owner (a traditional activity in New Zealand). But you have to choose and monitor the deal while taking the risk on just one property. Instead you put your funds in a bank which does the choosing and monitoring and reduces risk because the deposit is diversified across many investments. (Quite properly, the bank or whatever takes a margin for doing this specialised task; you pay them from some of the return on the investment.)

Your financial investment is not 100 percent safe – as the crashing of finance companies a few years back illustrates; while the institution in which you make the deposit may be fraudulent, never intending you to be able to redeem your IOU. (A lot of regulatory effort is made to minimise such catastrophes for savers, but fundamentally, it is ‘caveat emptor’ – let the investor beware.)

If New Zealand’s financial system is this vanilla one, the dominant international one is more Neopolitan with layers on layers of IOUs of different hues. Think of it as an enormous (cyber)-room in which people frenetically trade increasingly complicated IOUs among themselves. The paper gets churned around but it does not actually do anything (a simplification but fair enough for exposition). Yet at regular intervals the paper-traders take huge salaries and bonuses. Where do their fees come from?

The trick is that some of the IOUs left in the room have no value. Except we do not usually know which ones until they are about to be redeemed. Until that point the depositors of the IOUs which underpin the duds think they are valuable. John Kenneth Galbraith described the phenomenon as the ‘bezzle’ (after embezzle; sometimes the ‘f-bezzle’ – i.e. financial-bezzle). It temporarily boosts the economy because some think they are richer than they are. The deceit cannot go on forever, and people eventually find their IOUs are worthless. (Well some are, many are redeemed by the taxpayer.) Their value has been taken off in the salaries and bonuses of the dealers.

Other People’s Money elaborates this story with detail and wit. It compares the trading to tailgating on the motorway—a high-risk strategy that works most of the time but occasionally ends in a devastating crash (not only for the tailgater).

You know how when reading a book you sometimes want to underline a phrase or sentence for recall or to share (I resist); I wanted to do so even as often as to every paragraph. To summarise my view of the work: a student in a business faculty who has not read and mastered it does not deserve a degree. The rest of us need to read it if we want to comment on the international financial system.

Not that Kay has all the answers, although implementing his recommendations would be progress. Of course they are resisted by the dealers playing with other people's money, taking their margin in exchange for dud IOUs.

In at least two ways it matters to New Zealanders with their vanilla financial system. First, when the dud IOUs cannot be redeemed the whole world economy suffers. Second,  the two great centres of financial activities – London and New York – are issuing dud IOUs to investors outside Britain and the US. So some New Zealanders are being directly impacted – probably those who would appear in the likes of the Panama Papers.

There is however a deeper problem. All of us assume that on the whole we can do our own thing and, subject to a series of caveats, that is in the interests of society. There are a handful of industries we proscribe because they are not in the public interest – such as suppling narcotics. One has an uneasy feeling that the much larger industry of Neopolitan finance belongs in the same basket. John Kay does not say this, although he wants to further regulate and restrict the business. But one closes his book wondering.

Comments (4)

by Fentex on June 07, 2016
Fentex

The rest of us need to read it if we want to comment on the international financial system.

I'm going to take you up on this (and not just because what you've recounted in this column sounds like it agrees with my thoughts) but because I'm curious about how much I will agree with your evaluation.

I've been using Amazon since it's inception to buy books and I've generally found one can deduce quality from reviews quite accurately (poor opinions and lax standards in a reviewer being inferable from their writing) and I've developed a hobby of comparing reviews to what I read.

by Andre Terzaghi on June 09, 2016
Andre Terzaghi

One of the things I find attractive about a Financial Transactions Tax is that it could act as a brake on shuffling IOUs around. If the government clips the ticket every time the IOUs get repackaged, then the "profit" available becomes much smaller and we get less of that activity. It should similarly put a brake on high frequency trading. Since those are purely parasitic activities, reducing them has to be a good thing, right?

Or have I got the wrong end of the stick?

by Fentex on June 10, 2016
Fentex

Or have I got the wrong end of the stick?

I think that plan merely creates an extra opportunity to arbitrage transactions within more obtuse mechanisms.

by Brian Easton on June 13, 2016
Brian Easton

Many economists generally favour a Financial Transactions Tax for the reasons that Andre indicates, providing it is introduced on a comprehensive basis. (here). However they do not favour one introduced on a partial basis -- say just in New Zealand --- for the reasons Fentex indicates. 

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