Wednesday, December 18, 2013

Cost Gravity

Peter Hintjens

For fifty years, Moore's Law has reliably predicted the exponential upward trend of our silicon future. Yet every now and then, technology tabloids warn that Moore's Law is about to end. It can't last, we're told, and when it ends, the future will fall into darkness and uncertainty. But inevitably and without fail, scientists find yet another way to extend it, and we collectively sigh in relief. Moore's Law isn't a mythical beast that magically materialized in 1965 and threatens to unpredictably vanish at any moment. In fact, it's part of a broader ancient mechanism that has no intention of stopping. This mechanism, which I call cost gravity, pulls down the price of technology by about half every two years [..].

What Happened to Wall Street? [..]

Let's rewind 30 years and see how the banks work. We're in 1980, and banks are the shining cornerstones of modern society. They are large, boring financial machine houses. The banks arbitrate between those who have money and those who need it, a vital service for which people gladly pay. Critically, this service takes vast amounts of computing power. Simply adding and subtracting and multiplying and dividing all those figures takes industrial-strength brute force. Banks have huge data centers: rows of blinking mainframes and humming disk drives, all adding up to tons of heavy metal in massive air-conditioned halls.
Meanwhile -- silent and unstoppable -- the spread of knowledge drives down the cost of computers. First, smaller and cheaper minicomputers spread into departments. Then the personal computer explodes into the home, university, and business. Large firms like IBM try to keep their prices stable, meaning they give their customers more and more computing power for the same price. The true cost of building a bank-sized data center drops by 50% every two years. The result is that older banks start to face competition from small aggressive competitors, especially as the Internet begins to make the front-office branch obsolete. The big banks grow by buying smaller local banks, an easy task due to the fact that they possess lots of excess capacity. Then, they cut costs by shutting branches and merge with insurance companies in order to expand their services.

But all the while, competition is driving down profit margins. If your bank asked 5% per year for a mortgage, and another 1,000 km away offered 4%, you would not hesitate to go with the lower rate. Similarly, if your bank offered 3% interest on savings, but a foreign competitor offers 6%, where would you put your money? For years, in Europe, you could literally earn 2-3% more on deposits than you had to pay on a mortgage. This should have been a clear sign of trouble, but people just assumed there was some magic at play.

Fast-forward a few more years, and banks' main traditional markets are close to worthless. The European single market means they face ever more competition. But they're in a trap, borrowing money from the stock markets in order to expand internationally so that they can compete. It's a one-way trip. If you don't make your quarterly profits, your stock price will fall and your cost of borrowing will rise. The only banks that escape are those who stuck to luxury products for the richest clients and avoided the stock markets.

The large banks must find ways to continue to make their 6% profit annually. And higher profits come only from higher risks; there is no other route. So governments oblige by removing regulations, and banks get new high-risk space to move into. They push mortgages onto people who cannot afford them. They push credit cards so aggressively that even a dog can get one. And as they accumulate more and more risk, they hide it from view by repackaging it all into derivatives, which they sell to foreign banks. Eventually, the trade in derivatives becomes the new territory and banks turn into bookmakers, betting against themselves and taking a commission on each deal.

Meanwhile, cost gravity never stops. By 2013, the cost of running a 1980's bank had fallen by 128,000 times. If it cost $10 per month to handle one customer in 1980, by 2013 it cost just over $75 per month for 1M customers. And by 2052, it will cost only $1 per month to handle the banking needs of every person on Earth.

The collapse happened because those ever-riskier bets didn't pay off. It was predictable [..] but there was a huge incentive for those involved to not think it through. You may feel it was criminally stupid to make those bets. Certainly, it was immoral to have the public purse pay the debt while still giving bonuses to all involved. As I write this, not a single prosecution has been brought against anyone involved in the collapse. In the end, every empire bets on borrowed time. It's always the same, whether the timescale is "next quarter" or "next century." Bank or beggar, life is always "so far, so good."

When we understand that cost gravity caused the banking crash, we can try to predict the future of banking. Banking is an essential service, but it cannot be profitable except by rolling back time and banning cheap information technology, or by creating artificial barriers to competition.

There seem to be two plausible outcomes. One is to nationalize the large banks and turn banking and insurance into a not-for-profit service of the state. The other is to grant the major banks a monopoly control over the market, so they can extract profits as before. Europe seems to be going the first way. For example, a Belgian state bank, ASLK, was privatized in the early 1990's. Roughly 20 years later, its multinational successor, Dexia, was nationalized to save it from bankruptcy.

The USA seems to be heading the other way, matching the way it treats other sectors like the mobile phone industry. Profits are more important than competition, it seems. Canada takes a middle path, granting monopolies to its banks but regulating how much profit they can charge.