Nations Get what their Financial-Industrial Systems Deliver: A Comparative Analysis of Three Different Groups of Financial-Industrial Systems

“To sum up … the radical fault of our system lies in the fact that our financial institutions are out of touch with our industries, with the natural consequence that these industries, or most of them, are defective in their organisation and equipment.”

H. S. Foxwell, ‘The Financing of Industry and Trade’, in ‘The Economic Journal’, Dec 1917, p522 (also quoted in Yao-Su Hu, “Industrial Banking and the Special Credit Institutions,” Policy Studies Institute Booklet No 632, October 1984).

There are three different kinds of financial-industrial systems operating among the developed and developing nations of the modern world. It is useful when considering economic growth potentials to classify countries according to their different procedures for funding investment, because these procedures result in different growth potentials.

1 The Low-Growth, “natural development” Anglo-Saxons

The “natural-growth” economies are characterised by the absence of any external source of saving for corporate investment. Commercial and industrial companies have to rely on internal funding of investment. New equipment funding is low, and after allowing for equipment withdrawals and obsolescence it is very low. Investment can only occur in those companies which can turn over a profit. Since equipment investment, and the embodied technological progress it entails, is the key to economic growth, low investment results in low growth. As Ben Cant has commented:

“To the majority of people in both countries (that is, Britain and the United States) it is of the essence of Anglo-Saxon democracy that economic viability can be taken for granted”.

Ben R Cant, “Britain’s economic problem in international historical perspective,” (1972), discussion document, Centre for Business Research in association with Manchester Business School.

However true that may have been in 1972 or previously, it is valid no longer.

The economic viability of the UK and USA can no longer be taken for granted.

Other countries with more effective financial-industrial systems have been, and are, hollowing out UK and American domestic industries.

The banks in Anglo-Saxon economies have no commitment to industrial development, and bankers in these countries stand aside from the process of economic development. American and British bankers regard themselves as citizens of the world, and have no particular commitment to the industry or to the people of their own country. Bankers drain the savings of the nation from the regions and convert that saving mainly into high-cost consumer credit, to sovereign lending, to high interest rate short-term and overdraft loans to businesses, and to speculative gambling on securities and bonds and interbank lending.

The politicians, economists, businessmen and bankers in these nations do not understand the role of banks in promoting economic development, and it shows.

The principal examples of these highly developed, low industrial growth economies are such countries as Australia, Canada, New Zealand, the United Kingdom, and The United States of America. These are the low-growth nations of the Anglo-Saxon tradition, where industrial development happened early and naturally, and where there is a strong tradition of low government involvement in setting the circumstances that promote development.

The key aspect of any financial-industrial system is intermediation – that is, the conversion of short-term saving in the banks to long-term loans to industry. A lot of intermediation happens in building societies and banks for mortgage activity, but the British banking system at present has no priority whatsoever to provide intermediation to industrial companies, which in recent decades has been at between two to five per cent of total available bank funds, and that’s usually only enough for funding part of trading and working capital, not plant and equipment investment. The major purpose of the German banking system is financial intermediation for industrial loans, and German banks were founded to fulfil that purpose, which works reasonably well, converting between 25% to 50% of German national savings, plus a bit of credit creation, into productive factory investment. Dr Yao-Su Hu contrasted the origin of the British and German positions in his pamphlet “National Attitudes and the Financing of Industry”, PEP, 1976, in which he observed:

“In England, the industrial enterprises had been established and financed by private individuals, largely out of their own large fortunes and those of friends and relatives in the local region; this was possible because there were large pockets of individual wealth amassed from trade, shipping and the colonies. In Germany, here was no such class of people, hence Adolf Weber’s saying that German Banks had been founded for people who needed money and British Banks for people who had money.”

Dr Yao-Su Hu, ‘National Attitudes and the Financing of Industry,’ PEP booklet, 1976.

Things for UK industry have changed since the 1970s – they have got a lot worse. Some British industrial companies, due to the further withdrawal of bank support from industry, now have zero overdrafts at the request of their bank.

The average repayment rate on term lending to UK industry is now about 65% and not the 40% it was during the 1970s.

Weber’s view that the British financial system was created to serve those who had money while the German system was created for those who needed money is a well-founded conclusion based on historical observation. Britain’s banks were established by the trading profits of individuals and from the beginning gambled upon trade, on “when the ships come home” and only for a glorious century and a quarter or so (perhaps from about 1750 to the heyday of the British bank amalgamation activities in the 1870s) did local banks provide significant amounts of investment funding for local industry, as occurs in Germany from the mid-1850s to this day.

The ex-colonies of the United Kingdom have often adopted the same legal framework and the same industrial-funding traditions as the UK. The above list does not include developing countries which also adhere to that tradition. It would not be surprising if the ineffectual tradition of funding industrial development entirely from internal profits was limiting much of the development potential in these parts of the less developed world where the Union Jack was lowered several decades ago.

2 The Industrial Banking Economies

As the brilliant Dr Yao-Su Hu puts it:

“Industrial banking may be defined in terms of a set of both functions and attitudes. Put simply, it stands for banking for industry. Industrial banking may be defined as a combination of:

· “The provision of long-term finance (long and medium term debt, or debt plus equity) to enterprises and entrepreneurs in the industrial and commercial sectors, in the form and combination that is most suited to their needs, as distinct from and in addition to the provision of short-term loans of a self-liquidating nature which has always been the province of commercial or merchant banking;

· A sense of purpose, a perceived role or mission, an institutional culture or set of attitudes, which is reflected in a readiness to promote, encourage and support industry;

· A willingness to accept a measure of responsibility for the performance of industry [eg…German banks…rescue of AEG-Telefunken; contrasted with Britain, where the rescue of Rolls-Royce and British Leyland fell on the government];

· An ability to understand the problems of industry, due to close relations with industry and the in-house deployment of people with industrial experience and technical expertise, and therefore to accept what would be considered ‘very risky’ business by financiers who are ignorant of industrial realities.”

Yao-Su Hu, “Industrial Banking and the Special Credit Institutions,” Policy Studies Institute Booklet No 632, October 1984, p17-8.

The “industrial banking” economies are characterised by the presence of a centuries-long tradition of providing long-term bank funds for corporate investment. Industrial companies do not have to rely solely on internal funding of investment, but can also borrow long-term funds from industrial, regional and local banks that also scrutinise investment projects and provide helpful advice. Equipment funding is at a medium level. Corporate investment is funded by profits and loans. Since equipment investment, and the embodied technological progress it entails, is the key to economic growth, a medium level of investment results in middling growth.

These principal examples of these highly developed, medium growth economies are such EU countries as Belgium, Denmark, France, Germany, Holland, Italy, Norway, Spain and Sweden. It is obvious from this listing that the main investment banking economies are these of Western mainland Europe. The bankers in these EU economies are committed to assisting the process of economic development, which they see as a patriotic duty, as well as good business. European bankers are full partners in the process of economic development, and are committed to the success of the industry of their own country. The politicians, economists, businessmen and bankers in these nations show some understanding of economic growth procedures and of the need for long-term low-cost bank loans for industrial investment.

Germany is a good example of the industrial banking tradition. The central purpose of German banking is the promotion of industry, especially SMEs.

Germany’s public bank system is particularly active and effective in this role: as Wikipedia comments

“The typical public bank acts as a business development bank” and

“The first savings banks in Germany were founded at the dusk of the 18th century in its major trading cities. One of the first institutions with the business model of modern savings banks was the Ersparungsclasse der Hamburgischen Allgemeinen Versorgungsanstalt in Hamburg in 1778. Founders were rich merchants, clerks and academics. They intended to develop solutions for people with low income to save small sums of money and to support business start-ups.

In 1801 the first savings bank with a municipal guarantor was founded in Göttingen to fight poverty.”

Source of these two quotations: http://en.wikipedia.org/wiki/German_public_bank.

No British bank has ever been established to support business start-ups or to fight poverty. For more than a century British banks have majored on fashionable speculation, losing money on hire purchase in the 1960s, sovereign debt in the 1970s, and on inter-bank lending on securitised housing loans in the USA (one of the major triggers of the credit crunch) in the first decade of the 20th century. British banks have now, and have had for many years, the largest margin in the developed world between their interest cost of funds and their loan interest to bank customers, over-charging their borrowing customers, as they often have done (and as bankers have often told me they have to do) usually with the covert approval of Government, to rebuild their capital base after each disastrous episode of bank speculation. British merchant banks say they invest, but they don’t – the major risk in their activity is speculation on pre-existing assets, which they call “investment” but which does not add one iota to economic growth, but which uses public savings plus circulating credit to bet on trends in order to increase bankers’ share of national income and to provide very large bankers’ bonuses for the favoured few. The major activity of the British banking system is charging high interest loans to all their borrowing customers. In my extensive experience of British bankers, they fight vigorously against any attempt to educate them about economics or industry, and do not know much about either.

General de Gaulle nationalised the three major French banks in 1946 to ensure their compliance with the French desire for economic development through the Commissariat du Plan. That Commissariat acted in concert with the Credit National, which had been created in 1919, partly to fund French SMEs. That worked for the most part, although French bankers hated it.

The principal spur to the economic development of the continental nations was the example of the successful industrialisation in the United Kingdom.

Industrial banking seems to have developed first in Belgium, as Dr Yao-Su Hu has argued. These countries have used their banking systems to develop more rapidly than had occurred in the slow-growth naturally-developing British economy. Germany, for instance, caught up with over one and a half centuries of British natural economic development [1750-1910] within forty years [1870-1910]. The ex-colonies of these Western European countries have hardly ever adopted the traditions of their imperial teacher, so few developing countries share similar attitudes to development.

3 The Investment Credit (“Shimomuran”) Economies

The “investment credit” economies are characterised by the introduction, at some point during the last 60 or so years, of government credit creation at the central bank, canalised through a co-operative banking system, to public or private corporate investment. These credits are supplied through the banking system as long-term loans for corporate investment. Industrial companies do not only rely upon internal funding of investment, but also can borrow long-term funds from regional, local and industrial banks, who receive a large flow of these funds from the government and from the savings of the nation. Equipment funding is at a very high level. Corporate investment is funded by profits, loans arising from savings, and loans arising from central bank credit creation. Since equipment investment, and the embodied technological progress it entails, is the key to economic growth, very high investment results in similarly high growth.

The government and banks in these economies are committed to assisting the process of economic development, which they see as a patriotic duty, as well as good political and economic business. Bankers in these nations are full partners in the process of economic development, and are committed to the success of the industries of their own country. Financial intermediation – the transformation of short-term saving from all sources into long-term commercial and industrial loans – is above 75% of the bank activity of these countries.

The politicians, economists, businessmen and bankers in these nations all show a more full understanding of the role of banks in economic development, as the results testify. The principal examples of these rapidly developing (or in the case of Japan, developed) high growth economies are China (from the late 1970s) Japan (from 1946) South Korea (from the mid-1950s) and Taiwan.

It is obvious from this listing that the investment credit economies are currently all in Asia, but it should be remembered that the first investment credit economy was the United States of America, where the Fed created investment credit during the years from 1938 to 1944 to ensure the availability of investment finance to fund the investments required to produce the munitions and other materials necessary for winning the Second World War.

The principal spur to the economic development of South Korea, Taiwan and China itself was the example of the very rapid industrialisation in Japan. These countries, through political decisions, created financial-industrial systems aimed at providing very high levels of investment credit. Once again, with the exception of Japan, some of these countries were colonised by Japan (or in the case of China, partly colonised) and now seem to have adopted some of the investment-funding traditions of their imperial teacher.

4 A Comparative Analysis

There are therefore three different kinds of financial-industrial system, which could be characterised as:

-The “natural development” economies – with a financial-industrial system in which industry “stands on its own feet” and can only invest its retained profits: such a system is usual in the low-growth Anglo-Saxon economies -The “industrial banking” economies – where industry can invest its profits plus some long-term bank borrowing; that system is characterised by the existence of industrial banks, which act as financial intermediaries to convert short-term saving into long-term business loans; such a system is usual in the countries of EU western mainland Europe (eg. Denmark, France, Germany, Belgium, the Netherlands, etc.)

-The Shimomuran “investment credit” economies – in which the government has legislated for the investment-credit-creating central bank to discount regional and local bank business loans to provide extra liquidity to fund investment credits, and where industry can invest its profits, plus long-term bank loans, some of which loans have their origin in central bank or government created credit (eg, Japan, China, South Korea, Taiwan – and the USA from 1938-44).

The natural, slow-growth economies, where companies can only invest their retained profits, cannot possibly match the growth rates of the industrial banking economies of mainland Europe. British industry has continually lost out (often to Japanese industry) but also to German and French industry because the companies within the economies of mainland Europe have a regular source of industrial banking investment monies which UK companies do not possess. Because greater economic dynamism exists where investment is higher, the European mainland economies are sure to dominate Europe, with Britain remaining in the low-growth outer ring unless Britain changes its investment-funding system by introducing a more modern and more effective financial-industrial banking system. British and American industry are not competing in the world on any kind of level playing field: where bank loans are available on affordable terms and conditions, industry prospers, and where companies have to rely on internal funds for investment and growth, industry declines or is bought out by the industrial credits available abroad.

However, even the industrial banking economies cannot in the long run (or perhaps even in the medium term of a generation or so) compete with the investment credit economies of the Asian group, although the tariff wall of the EU could conceal that reality for a while. No nation can possibly save 40% to 50% of its national income to finance investment, and the idea that China has saved at that level has only been suggested by people who do not know what is going on. It is impossible for any nation to save over 30% of its national income, especially in a poor third world country (as China used to be). Such high “savings” can only have part of their source in the Keynesian-suggested Rooseveltian-practiced Shimomuran-explained and Kuriharan-described investment credit creation at the nation’s central bank.

Because these three kinds of economy naturally involve step-functions of higher productive investment at each level, so the natural-development economies cannot effectively compete with the industrial banking economies, which in turn are no match for the investment credit economies.

The financial-industrial system which produces the most rapid economic development is that of an investment credit economy, and that system is producing explosive economic development in many Asian economies. That is not a development which Western economists, politicians and bankers can afford to ignore.

The Western economies have historically contained the most inventive innovators and entrepreneurs in the world. Their capabilities are still alive – the bankers and politicians have discounted them and generally minimised their activity. Their innovative energies have been hampered and their enormous potential economic contributions have been and are limited by ineffective and not fit for purpose financial systems. As Ben Cant concluded in 1972:

“In the final analysis it is of course the majority of British people who will be the losers. They must accept now, as a result of the impotence of the British financial-cum-industrial structure to achieve effective investment that their real remuneration and social benefits will continue to be substantially less than those of their counterparts in the other leading members of the EEC.

They must also accept in the future that their pensions will become increasingly derisory in relation to the future European cost of living.”

Original report: Ben R Cant, Britain’s Economic Problems in International Historical Perspective, Discussion Document distributed by the Centre for Business Research in association with Manchester Business School, 1972. Also quoted on page 30 of George T Edwards, The Role Of Banks in Economic Development, The Economics of Industrial Resurgence, The Macmillan Press, London, 1987.

But the British political system is still a democracy (although it frequently acts like an elected dictatorship, in which the elected parties ignore in office the promises that got them elected) and utterly economically incompetent governments (like the current Conservative-Social-Democrat Coalition led by the Cameron-Osborne-Clegg triumvirate) can still be vigorously booted out of office.

That needs to happen, and the British financial-industrial system needs to be upgraded to provide adequate levels of industrial investment. The historical records show that a recovery from the current depression could be swift indeed if that happened.

In the interests of all our people, that should come to pass. 
 

© George Tait Edwards 2013

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This post was written by George Tait Edwards