Mises Wire

Coffee Sellers Are Not Fundamentally Different from Banks

With the 2007-8 financial crisis came a splendid alphabetical soup of central bank interventions to stimulate financial markets, lower interest rates, provide astonishing amounts of liquidity to banks and, allegedly, prevent another Great Depression. Likening the failure of big banks to falling elephants crushing even the smallest grass, former Fed Chairman Bernanke argued that consequences from bank failures would have caused much more havoc to the economy than the liquidity provision and bailouts his Fed oversaw.

Now, do banks really deserve special consideration in this sense? Let me illustrate by comparing the fates of two imaginary entrepreneurs:

Our first entrepreneur — let’s call him John — sees an opportunity in the beverage business. Specifically, he’s convinced that he can source high-quality Brazilian coffee beans, roast and serve impeccably aromatic coffee in downtown Manhattan. He draws up the business plan, estimates what he believes coffee-craving New Yorkers would be willing to pay for his coffee and assesses how many customers he could reasonably serve per day.

Setting his plan in action, he borrows some money from friends and family, rents an appropriate space, hires a construction team and interior designers to create the coffee-scented heaven he imagines, finds some competent baristas to staff it and finally opens his doors to hesitantly curious customers. From here, as in all entrepreneurial ventures, there are two paths John’s business may take:

  1. If customers love his coffee and willingly part with their dollars , enough so that John can cover costs as well as offer some return to his shareholders/creditors, we consider John’s venture successful. The profits describe the added value for consumers, regardless of whether you see John as a Misesian uncertainty-carrying and future-appreciating speculator or a Kirznerian arbitrageur, alert to discrepancies between prices of higher and lower-order goods.
  2. If customers scoff at his atrocious coffee-like concoction, and refuse to buy drinks in the amounts John estimated, we consider John’s venture unsuccessful. The losses he is bound to incur similarly describe the (negative) value his venture created by combining scarce producer goods into less-valuable consumer goods.

When John, under the second scenario, closes up shop, fire-sells his remaining inventory at prices far below those at which he bought them, defaults on his loans and outstanding rent obligations to his landlord, there are losses all around. His creditors lost the money they invested; the property owner lost the remaining unpaid rent, and the wholesale provider of coffee beans might not see his last invoice paid in full. We may call them and other losses externalities. Losses may bankrupt John’s suppliers. For example, John’s failed venture might drive other entrepreneurs out of business by ending their access to an important customer.) But we accept them as part of the creative flux of markets where profits and losses indicate consumer valuations, validating the entrepreneur’s prior and speculative actions. Even if these losses would be huge (say the wholesaler of coffee beans goes bankrupt and all her employees lose their jobs), we lament their personal fates, but don’t call for government to subsidize John, keep the wholesaler from bankruptcy, or provide liquidity so they can stay in business.

Enter our second entrepreneur — Jane. Jane is somewhat more financially savvy and spots an underappreciated opportunity in an entirely different market. Majoring in finance, she knows that the yield curve (the difference in yields between bonds of long maturity and bonds of short maturity) is generally upward-sloping. For a variety of reasons investors require a term premium for holding long-dated debt. Jane knows this, but believes that the input prices of her proposed business are still undervalued: she raises a sizable amount of money, offers slightly better short-term rates than prevailing in the market — by overbidding other entrepreneurs gains access to an even larger pool of funds — combines it all into an efficiently-staffed office with the latest credit-rating models and starts offering long-term loans to home-owners at attractive rates.

Careful not to make John’s mistake in his second scenario, she ensures that the margins between her input costs (what she pays her investors and wholesale funders in interest) and output prices (the annual interest rates she earns from her large and suitably diversified portfolio of mortgage lending) are markedly positive, earning a serious amount of income for herself and her shareholders.

Even though she is aware of the liquidity risk she incurs (“My clients won’t pay me back for a very long time: what happens if I can’t repay – roll over – my 3-month wholesale funding?”), she judges it a minor worry and decides not to take out any kind of interest-rate hedges or liquidity insurance. She’s confident that her initial disbelief at other market actors’ pricing is incorrect. In any case, she can always find new short-term funding at suitable rates should some of her funders refuse to roll over their loans.

At this point, let’s briefly summarize our two entrepreneurs: they both entrepreneurially speculated on an uncertain future, believing they could provide a product (coffee or loans) at certain prices above their cost of operation (office, overhead, employees) plus their input costs (coffee-beans wholesale or wholesale funding). The economic analysis, similarly, is no different: profit-and-loss statements indicate whether John and Jane serve their customers well, adding value through their business ventures. That’s also where the comparison allegedly ends.

For where John’s mistaken entrepreneurial decisions over coffee preferences, wholesale prices and consumers’ willingness to pay warrant no particular attention from governments, central banks and economists, Jane’s case is, for some unfathomable reason, entirely different.

When Jane one day wakes up to wholesalers refusing to rollover her funding and she’s urgently in need of liquid assets to pay the debt that’s falling due, the trust in profit-and-loss statements for revealing consumer value creation is entirely absent. Calls for alphabet-soup government agencies are heard from central bank offices to Treasury departments and New York Times columns: fire-selling Jane’s remaining assets (mortgage loans) at low prices will bankrupt her, not to mention all other Jane-like ventures that hold similar assets, creating a devastating downward spiral. Jane’s business is simply too important to go bankrupt. Letting her successful banking business go under would be catastrophic for all her employees, clients, suppliers as well as for the financial system.

The analytical mistake in arguing for public assistance to Jane — but not John — seems obvious, but well-read economists might still disagree, offering versions of the three following arguments:

  1. Jane’s business is solvent but illiquid, whereas John’s coffee store is insolvent.
  2. There is an externality aspect to Jane’s business model not present in John’s; when Jane’s assets are liquidated, the prices of all other such assets are likely to fall, thus hurting anyone who hold them, including innocent third parties.
  3. Jane’s employees have unique information about her clients; she knows their creditworthiness better than anyone, even other banks. Part of the value she creates is unique to her firm and cannot be sold as easily as the title to the assets she’s holding. Since this information is socially valuable, letting Jane’s bank fail would amount to a societal loss.

All of these claims are mistaken. First, like all banks, Jane’s business is to manage liquidity. Banks’ business model, in addition to appropriately evaluate clients’ creditworthiness, is to correctly manage the maturity transformation they are engaged in. The amount of liquidity risk a financial institution takes on is part of its entrepreneurial decision; it is not an accidental exogenous event as most of the banking literature seems to believe. Heavily exploiting the yield curve, earning hefty interest rate margins between illiquid long-dated assets and liquid short-term liabilities without (costly) risk-mitigating interest rate hedges, is no different from high entrepreneurial risk-taking in other industries.

The second reason equally applies for John: when he sells his left-over coffee inventory he greatly depresses the going market price of unused coffee beans, threatening all other wholesalers of coffee beans with bankruptcy; should John’s supply be large enough and the market for coffee beans thin enough, he could be depressing the prices for longer than those suppliers can stay in business. In the exact same way Jane’s fire-selling threatens other businesses “through no fault of their own,” John’s liquidation depresses prices for others, threatening their businesses. There is, in other words, no special reason why banks deserve public support for their business models when coffee stores do not.

As for the third objection, John’s coffee bean store also has particular enterprise-unique information; his baristas knows which variety of coffees their regular customers want. A new coffee store may only imperfectly replace the detailed and intricate coffee desires John satisfied. The fact that John’s store could not cover its costs is evidence enough that this unique knowledge was not sufficiently valuable.

In sum, banking and banks’ liquidity are not subject to other economic laws than are coffee stores, and they should not be given special consideration.

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