Edmund Phelps sits pretty near the top of the pantheon of great economists. Not only did he win the Nobel Prize in 2006, his studies are so well known that any student of economics – from A level and above – will have heard of him.

Yesterday, he made some interesting pronouncements about the speed of economic recovery – warning it could take 15 years to rebuild wealth lost in the recession; more to follow.

But while digging around, we came across some fascinating insights from the economist that just happen to coincide with a view expressed here often enough on the real problems with banks.

Edmund Phelps’s first famous contribution to economics is not popular in all quarters these days. He did a lot of work in the 1960s on one of the most famous of all economic theories – the so-called Phillips Curve – this is the idea that there is a trade off between inflation and unemployment. Phelps’s contribution related to expectations. If wages go up with inflation, and people don’t factor in the effect of inflation, then there will be a fall in unemployment.

The problem is that once inflation sets in, we start to expect it. The lesson of the 1970s is that, actually, there is no trade off between unemployment and inflation in the long-run. Rather, the trade off is between expected inflation and unemployment, or perhaps a better way to put it is rising inflation and unemployment.

Anyhow, later on he came up with other, perhaps more interesting, theories on the role of the value of business assets in promoting wealth.

Yesterday, he told Bloomberg TV: “The only way we’re going to get a healthy, full recovery is over a long period of time, involving households rebuilding their balance sheets and companies in trouble rebalancing their balance sheets.” He added: “There’s no silver bullet that’s going to get us into good shape quickly.” He reckons this could take as long as 15 years.

Last year, in an article for Spiegel, he argued: “Increasingly over the past two decades, the banks have tried to make money with mortgages, residential and commercial,” but that, “unfortunately, the banks for the most part appear to have lost the expertise to make business loans and investments, which they once had in the fabulous years of investment banks such as Deutsche Bank and J.P. Morgan.”

Similar arguments have been made here. There is no wealth creation in rising house prices. Wealth goes up if we find new or better ways to produce goods and services. For years banks lent money for mortgages – because that is safe. They lent money to hedge funds, because they were perceived to be safe. But even during the credit boom an entrepreneur who could really contribute to the economy was faced with the same old difficulties.

In his Spiegel article Phelps said: “It seems likely that highly regulated banks are not the ideal sources of finance for business investment, particularly for innovative business investments. A natural source of finance for new startup firms are the rich uncles, called ‘angel investors,’ who know more about the startup entrepreneur than a banker would be in a position to know.”

He is dead right. And it’s a point that often gets missed by the mainstream.

© Investment & Business News 2013