Should American Progressives Be Calling for a “Public Option” in Banking?

November 30, 2011  |   Economics & Trade Politics and Policy Progressive Political Commentary

Proposals for a public banking option are almost unheard of in the U.S., where free-market orthodoxy has, throughout most of our history, held sway over collective approaches to the provision of public and private goods and services. Nonetheless, the concept deserves serious consideration based on the evidence in at least a couple of areas. First, there is the striking success of this model in other advanced and advancing economies for providing and directing lower-cost, long-term capital essential for growth. And second, while better financial sector regulation, oversight, and enforcement might mitigate the worst excesses of an opaque multinational private banking system, it remains doubtful that the resources of regulators can ever match those of the private banking system to circumvent regulations and evade the consequences of wrongdoing.

It is now widely understood that the private global banking and financial system has failed to serve the “real” economy, or what we often call, “Main Street.” This is not just the case in the U.S. Europe’s problems, while largely due to an ill-designed monetary union and the high sovereign debt of certain member countries, has been exacerbated by the same short-term-profit-driven, casino approach that has characterized the U.S. financial sector.

Perhaps the time has come to consider another model, one that treats banking and finance more like a public utility. A public bank would not have to be beholden to shareholders demanding a 20% annual return. It could circumvent incentives that induce management to take extraordinary risks (cognizant that in the worst-case outcome, taxpayers will bail them out) to boost short-term stock value. A public bank that didn’t demand usurious 30% interest rates on credit cards, didn’t charge outrageously high penalties and fees, and doesn’t raise your rate when you’re a week late on your payment would lower both the cost of living and the cost of doing business for small and medium-sized firms. A public option in banking, then, could benefit just about everyone, except, of course, financial sector executives.

Back when electricity was still a public utility, before the rate increases that industry advocates swore wouldn’t happen with a privatized and deregulated electric power sector, the electric company didn’t permanently raise your rates when you paid the electric bill a few days late – so why should that be allowed by your bank? Wouldn’t a modest, reasonable late payment fee to the institution cover the real cost of your late payment? It works that way for public banks elsewhere in the world.

The German “economic miracle” after World War II was based in part on a public banking system that worked alongside a robust private banking sector. The two are not mutually exclusive. A public option in banking, much as it would in health care, could rein in the more reckless impulses of the private banks, and help to ensure a more stable economic environment that fosters productive long-term investment and entrepreneurship.

Peter Dorman, professor of economics and researcher on environmental policy describes the German public banks, known as “landesbanken” as:
“…publicly owned entities that rest atop a pyramid of thousands of municipally owned savings banks. If you add in the specialized publicly owned real estate lenders, about half the total assets of the German banking system are in the public sector. (Another substantial chunk is in cooperative savings banks – institutions owned by their depositors.) They are key tools of German industrial policy, specializing in loans to the Mittelstand, the small-to-medium sized businesses that are at the core of that country’s export engine. Because of the landesbanken, small firms have as much access to capital as large firms; there are no economies of scale in finance. This also means that workers in the small business sector earn the same wages as those in big corporations, have the same skills and training, and are just as productive.” [Emphasis added]

Many of the most dynamic economies – those that have proven more resilient in the face of recent global financial crises – also have strong, stable publicly owned banks. India, China, and Brazil all come to mind. But there’s even a U.S. state economy that has fared pretty well, and it is the only state that has a state-owned bank. North Dakotas is the only state that has had a budget surplus every year since 2008, has the lowest unemployment rate of any state, and the lowest default rate on loans. North Dakota does have oil, but so do other states that are not faring nearly as well. Still, the German landesbanken system is, on the whole, likely the best model for consideration in the U.S.

After WWII, the German economy was in a state of collapse. Ten years later there were signs of an emerging economic miracle. Twenty years later, the German economy was the envy of the world, an economic powerhouse producing autos, machinery, chemicals and electrical equipment. Today, German unemployment stands at 6.8%, GDP growth in 2010 was 3.6%, manufacturing accounts for a quarter of GDP, and underlying this success are the small –to-medium sized firms that are supported by lending for R&D by the public banking sector.

There are multiple factors that aided the German miracle, of course. Post-war debt forgiveness, currency reform, and the elimination of price controls are oft-cited and must be credited with liberalizing the German economy. But the strong public banking system, designed to serve the public interest rather than private profit, has been instrumental in helping small firms secure a presence in global markets.

The tradition of public banking in Germany dates to the late 18th century when municipal non-profit banks were set up to help low income people save small sums in a secure institution. The banks were effective and popular, and they spread quickly. By the beginning of the 20th century, there were nearly 3,000 publicly operated banks in Germany. Today, a network of nearly 16,000 branches employs 250,000 people. They have a strong record of prudent investing in local businesses, which has supported community economies, and helped small firms reach global markets while making the landesbanken players in international markets.

Not all is rosy for the landesbanken. They have been under pressure since 2000 from private financial sector competitors (that comprised only 20% of the German market in 1999) pushing for privatization. Criticisms of the public banks revolve around a number of issues. Private banking sector advocates point to the low profitability of the public banks, and offer arguments in favor of privatization based on free market orthodoxy about “economic efficiency.”

While true that in general, profits are lackluster among Germany’s public banks, they have been incredibly steady in the postwar years. Comparing the tradeoffs between a banking system treated as a public utility aimed at serving long-term national economic goals, stable employment, and non-economic purposes such as community (and thus, social) stability versus an opaque and complex financial sector driven by short-term profit motives and treated as an end in itself, and subject to human greed and the vicissitudes of the market, a public option makes sense. Given that Germany’s public banking institutions have avoided much of crisis precipitated by huge losses that large private banks, gambling on exotic creations such as collateralized debt obligations and credit default swaps, have faced in recent years, the choice seems obvious under objective analysis. The public banks do what banks are supposed to do, accepting customer deposits and earning a modest profit by lending those funds out to businesses and individuals. They are stodgy, stable, institutions that serve the financial needs of their communities and thus promote economic stability and growth.

In fairness, it must be noted that under pressure to increase profitability, and branded as “bureaucratic” by opponents, Germany’s landesbanken did dip into derivatives markets and CDOs that were fraudulently rated triple A, but the extent of losses were miniscule compared to those of Goldman Sachs, Deutche Bank, Lehman Brothers, Citigroup, and other major private institutions. And in the end, the public is bearing the brunt (and will bear the brunt in future crises) of bailouts to private sector financial institutions anyway.

Given what would seem significant benefits of public banking, one ought to ask, “Are opponents’ arguments really based on their claims of economic efficiency, or merely a desire for the market share controlled by the popular landesbanken?”

In addition to pressure from Germany’s large private banks, calls for privatization have also come from the still-staunchly-neoliberal European Central Bank (ECB) and IMF leaders, who denounce the public banking system as violating established rules of competition. In a sense, that claim is correct, but perhaps it is neoliberal rules of competition that ought to be questioned. After all, what we’ve seen during the past decade or so is that so-called “free market/free trade” economies like the U.S. have been consistently losing out to mercantilist (export-led growth) approaches in countries like Germany, China, India, Brazil, and others. The ECB and IMF critiques of Germany’s public banks are based on an overtly ideological stance founded on an increasingly questionable neoliberal approach to economics and finance.

Despite their popularity with the German public, and their success at helping Germany become an economic powerhouse in the postwar era, the foundations of the landesbanken have been severely undermined in the past decade. The European Commission ruled in 2001 that the explicit state guarantees that allowed them to acquire and lend capital at better rates than private banks must end. This forced them to compete on the same terms as private banks (and propelled their ill-fated entry into derivatives and CDO markets, then seen as offering higher returns). Today, the landesbankens’ implicit state guarantees are not being considered in the “stress tests” for banking solvency that the European Banking Authority is conducting.

Thus, while privatization, widely unpopular with German voters, has not occurred, the landesbanken have been substantially stripped of the very thing that has made them able to serve the public interests of stability, low lending rates, and financial security. They no longer have the full faith and credit of government and the public behind them. They have been stripped of their ability to serve the public interest and forced to focus on the profit motive, leaving little to separate them from private sector banking institutions. That is a tremendous loss for Germany that will become increasingly clear in the years and decades ahead.

Essentially, the argument for or against a public option in banking comes down to this:
If one believes that an economy should be organized to meet broad, socially defined needs, you would support a public option in banking, even if the profits of individual institutions are modest. You would advocate that at least a portion of capital allocation should be responsive to public input. If you believe the market should allocate capital, except in rare cases of market failure, you would advocate for privatization (and deregulation) of the banking sector, even if it led to an increasingly unequal distribution of wealth and an exacerbation of boom-and-bust business cycles. The fact that markets tend to overreact rather than achieve stable equilibrium, in large part thanks to the herd dynamics of investors, would be irrelevant to you.

The long history of success that the landesbanken model has demonstrated in Germany, promoting economic growth and stability, enhancing the returns to investments in R&D, and providing a foundation for small and medium sized business employment has fallen victim in the past decade to the propaganda of neoliberals and profit-driven private bankers. That is unfortunate for the large majority of German citizens and workers. U.S. political leaders that are influential in formulating our banking and financial sector rules and regulations ought to look beyond the propaganda. They should consider the appropriate role for the banking sector in our economy. They might find that a public banking option, modeled on the landesbanken prior to the recent decade, might better serve Main Street rather than Wall Street.