Is it possible to have too much finance? Harmed by the aftermath of financial crises, enraged by bailouts of financial institutions, irritated by the generous remuneration, aghast at repeated malfeasance and infuriated by the impunity of those responsible, most ordinary people would find it all too easy to answer: yes.
They are not alone. Both scholars and staff of influential international institutions, such as the International Monetary Fund and the Bank for International Settlements, agree. It is possible to have too much finance. More importantly, significant economies are in this position, among them Japan and the US.
It is easy to question the role of financial activity. After all, between January 2012 and December 2014, financial institutions paid $139 billion in fines to US enforcement agencies. More fundamental is the contrast between the 7 per cent average share of the financial sector in US gross domestic product between 1998 and 2014 and its 29 per cent average share in profits.
An organised society offers two ways of becoming rich. The normal way has been to exercise monopoly power. Historically, monopoly control over land, usually seized by force, has been the main route to wealth. A competitive market economy offers a socially more desirable alternative: invention and production of goods and services.
Alas, it is also possible to extract rents in markets. The financial sector with its complexity and implicit subsidies is in an excellent position to do so . But such practices do not only shift money from a large number of poorer people to a smaller number of richer ones. It may also gravely damage the economy.
This is the argument of Luigi Zingales of Chicago Booth School, a strong believer in free markets, in his presidential address to the American Finance Association. The harms take two forms.
The first is direct damage: an unsustainable credit-fuelled boom, say. Another is indirect damage that results from a breakdown in trust in financial arrangements, due to crises, pervasive “duping”, or both.
Vicious circle
Prof Zingales emphasises the indirect costs. He argues that a vicious circle may emerge between public outrage, rent extraction and back to yet more outrage. When outrage is high, it is difficult to maintain prompt and unbiased settlement of contracts. Without public support, financiers must seek political protection. But only those who enjoy large rents can afford the lobbying. Thus, in the face of public resentment, only rent-extracting finance – above all, the mightiest banks – survive. Inevitably, this further fuels the outrage.
None of this is to deny that finance is essential to any civilised and prosperous society. On the contrary, it is the very importance of finance that makes the abuses so dangerous. Indeed, there is substantial evidence that a rise in credit relative to gross domestic product initially raises economic growth. But this relationship appears to reverse once credit exceeds about 100 per cent of GDP. Other researchers have shown that rapid credit growth is a significant predictor of a crisis.
In a recent note, the IMF uses a more sophisticated indicator of financial development than the credit ratio. This shows that financial development has indeed proceeded apace, notably in advanced countries. It also shows that, after a point, finance damages growth.
Further investigation indicates that this negative effect is concentrated on the growth of “total factor productivity”. This measures the pace of innovation and of improvements in the efficiency with which labour and capital are used.
In particular, the IMF suggests, after a point, the allocation of capital and the efficacy of corporate control go awry. Thus, the impact of financial influences on the quality of corporate governance is an important challenge.
Houston, we have a problem. We have a great deal of evidence that too much finance damages economic stability and growth, distorts the distribution of income, undermines confidence in the market economy, corrupts politics and leads to an explosive and, in all probability, ineffective rise in regulation. This ought to worry everybody. But it should be particularly worrying for those who believe most in the moral and economic virtues of competitive markets.
So what is to do be done? Here are a few preliminary answers.
Financial morality
First, morality matters. As Zingales argues, if those who go into finance are encouraged to believe they are entitled to do whatever they can get away with, trust will break down. It is very costly to police markets riddled with conflicts of interest and asymmetric information. We do not, by and large, police doctors in this way because we trust them. We need to be able to trust financiers in much the same way.
Second, reduce incentives for excessive finance. The most important incentive by far is the tax deductibility of interest. This should be ended. In the long run, many debt contracts need to be turned into risk-sharing contracts.
Third, get rid of too big to fail and too big to jail. These two go together. The simplest way to get rid of too big to fail would be to raise the equity capital required of global systemically important financial institutions substantially.
Many would then choose to break themselves up. Once that has happened, fear of the consequences of prosecution should also diminish.
Personally, I would go further by separating the monetary from the financial systems, via the introduction of “narrow banking” – that is, backing demand deposits with reserves at the central bank.
Finally, everyone has to understand the incentives at work in all such “markets in promises”. These markets are exposed to corruption by people who do not care whether promises are kept or whether counterparts are even unable to understand what is being promised.
What is needed is not more finance, but better finance. Yes, this might also end up as substantially less finance. – Copyright The Financial Times Limited 2015
