Finance should support and facilitate a prosperous society but after 2008 it became clear that society supports a prosperous finance industry.
It is easy to question the role of financial activity. After all, between January 2012 and December 2014, financial institutions paid $139bn 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, according to Marin Wolf (FT May 26).
In this year’s presidential address to the American Financial Association, Luigi Zingales asked “Does Finance Benefit Society?”. He concluded that “at the current state of knowledge there is no theoretical reason to support the notion that all the growth of the financial sector in the last 40 years has been beneficial to society”. And a recent paper from the Bank of International Settlements, the central bankers’ central bank, concluded that “the level of financial development is good only up to a point, after which it becomes a drag on growth”.
The finance sector damages the economy because it does not function as well as the models contend. Asset bubbles can and do form. Buyers of debt fail to prudently assess whether the borrowers can repay. The incentives that govern the actions of financial sector employees tend to reward speculation, rather than long-term wealth creation. Some of this is to do with the way that governments have regulated the financial system. But much of it is to do with the psychological foibles that make us human. A good actual example is China, it’s fast-growing middle class absolutely loves playing the stock market. Chinese families are opening accounts and borrowing money to trade on margin at an astonishing pace. Not surprisingly the stock market went completely crazy this year. But what goes up must go down and the Chinese markets continued to fall this week, down by 30% from their previous rise in less than two weeks!
The Economist published a brilliant article, “What’s wrong with Finance” (May 1), and is summarized below.
Traditional finance theories still hold sway in academia because they look good in textbooks; they are based on mathematical formula that can be easily adapted to analyse any trend in the markets. “Theorists like models with order, harmony and beauty” says Robert Shiller of Yale, who won the Nobel prize for economics in 2013. “Academics like ideas that will lead to econometric studies.” By contrast, economists who speak of the influence of behaviour on markets have to use fuzzier language, and this can seem unconvincing. “People in ambiguous situations will focus on the person who has the most coherent model” adds Mr Shiller.
Markets display a herd mentality in which assets become fashionable. Investors pile in, driving prices higher and encouraging more investors to take part. Charles Kindleberger, the economic historian, said that “There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.” If other people are making a fortune by buying tech stocks, or by trading up in the housing market, then there is a huge temptation to take part, in case one gets left behind. This herd mentality means that financial assets are not like other goods; demand tends to increase when they rise in price. To the extent that investors worry about valuations, they tend to be extremely flexible; expectations of future profits growth are adjusted higher until the price can be justified. Or “alternative” valuation measures are dreamed up (during the internet era, there was “price-to-click”) that make the price look reasonable. When confidence falters, there are many sellers and virtually no buyers, driving prices sharply downwards. Indeed, in 2008, assets that had not previously been correlated with each other all fell at once, further confounding the banks’ models of investment banks. Assets that were supposedly safe (like AAA-rated securities linked to subprime mortgages) fell heavily in price.
When this happened with dotcom stocks in 2000-2002, the problem was survivable. Some technology funds lost 90% of their value but, for most investors, such funds formed only a small portion of their savings. The problems became more intense with subprime mortgages because the owners of such assets were leveraged; that is, they had financed their purchases with borrowed money. They were forced to sell to cover their debts. And when some could not cover their debts, confidence in the whole system broke.
Leverage was a factor that was not really allowed for in mainstream economic models. To economists, debt is important to the extent that, in a sophisticated economy, it allows individuals to smooth their consumption over their lifetimes. For every debtor, there is a creditor, so a loss to one side must be offset by a gain to another; net global debt is always zero.
What is the finance sector supposed to do?
Essentially, it needs to perform a number of basic economic functions. First and foremost, it operates the payments system without which most transactions could not occur. Secondly, it channels funds from individual savers to the corporate sector so the latter can finance its expansion. In doing so, it does the highly useful service of maturity transformation; allowing households to have short-term assets (deposits) while making long-term loans. It also creates diversified products (such as mutual funds) that help to reduce the risk to savers of catastrophic loss. Thirdly, it provides liquidity to the market by buying and selling assets. The prices established in the course of this process are a useful signal of which companies offer the most attractive use for capital and which governments are the most profligate. Fourthly, the sector helps individuals and companies to manage risks, whether physical (fire and theft) or financial (sudden currency movements).
But the problem is that the basic utility functions of banking (payments, corporate lending) are boring and not that profitable. The big money has been made elsewhere. In their paper for the BIS, Stephen Cecchetti and Enisse Kharroubi show that rapid growth in the finance sector tends to a lead to a decline in productivity growth. Two factors may be at work. First, the high salaries offered in finance divert the smartest graduates away from other sectors of the economy. Second, bankers prefer to lend against solid collateral, in particular property; periods of rapid credit growth tend to be associated with property booms. But construction and property are not particularly productive sectors. The net effect is that resources are diverted away from the most productivity-enhancing sectors of the economy.
In his speech, Luigi Zingales cast doubt on some of the finance sector’s other services. “There is remarkably little evidence that the existence or the size of an equity market matters for growth” he said, adding that the same is true for the junk bond market, the options and futures market or the development of over-the-counter derivatives. That raises the uncomfortable possibility that a lot of the finance sector’s returns may be down to the exploitation of customers.
Regulators have tried to tackle some of these issues by insisting that banks hold more capital on their balance sheet, to make them less vulnerable to plunging asset prices. The rules also mean that banks devote less capital to trading. But these approaches run into the St Augustine problem, who proclaimed “Lord, give me chastity, but not yet.” The efforts of the banks to improve their capital base has made them chary about lending to business, thereby slowing the recovery. Their retreat from market-making has made financial markets less liquid; some fund managers fear the next crisis may occur in corporate bonds, which investors have bought in search of higher yields. When investors try to sell, the banks will be unwilling to offer a market, causing prices to plunge; some funds may be forced to suspend redemptions, leading to a crisis of confidence.
Another regulatory approach is to focus on “macro-prudential policy”. One of the reasons central bankers were reluctant to tackle high asset prices was that their only tool was interest rates. But higher rates would damage the rest of the economy, as much as it would tackle market excess. A more sophisticated approach would use other tools, such as restricting the ratio of loans to property values. At the peak of the boom, no deposits were required. But it remains to be seen whether regulators will have the willpower to use such tools at the top of the next boom or indeed whether eager homeowners will find ways round the rules, for example by borrowing from unregulated lenders.
What about the response of economists? There has been a lot of work in recent years about the role of debt including, most famously, the studies of Carmen Reinhart and Kenneth Rogoff. Unfortunately, this debate has been sidelined on to the narrow issue of the level of government debt rather than the aggregate level of debt in the economy. Iceland and Ireland did not have a lot of government debt before the crisis; it was their bank debt that caused the trouble.
The use of quantitative easing (QE) to stabilise economies has made it a lot easier to service debts and indeed has prompted many to argue that deficits are irrelevant in a country that borrows in its own currency and has a compliant central bank. Very little of the pre-crisis debt has been eliminated; it has just been redistributed onto government balance sheets. But QE has also forced up asset prices, boosting the wealth of the richest, and making it even more difficult for central banks to reverse policy.
Even now, many years after the crisis, and with their economies growing and unemployment having fallen, the Federal Reserve and Bank of England have yet to push up rates. Perhaps they will never be able to return rates to what, before the crisis, would have been deemed normal levels (4-5%) nor indeed will they be able to unwind all their asset purchases. So we have ended up, after three decades of worshipping free markets, with a system in which the single most dominant players in setting asset prices are central banks and in which financiers are much bigger receivers of government largesse than any welfare cheat could dream about. Economic and financial theory have not adjusted to this situation.
For too long economists ignored the role that debt and asset bubbles play in exacerbating economic booms and busts; it needs to be much more closely studied, as concluded in the Economist.
So what is to do be done? Here are a few preliminary answers according to Martin Wolf (FT May 26).
First, morality matters. As Prof 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.
How sustainable is finance? We still have a long way to go…