Why the Finance Industry is Destroying America’s Economy
According to a study by Harvard Business School professors Robin Greenwood and David Scharfstein, the percentage of GDP attributable to the financial industry tripled from 1950 to the 2000s. The percentage attributable to asset management alone increased by more than a factor of ten just since 1980. Has any of this increase improved the services rendered by the financial services industry to the real economy? If it hasn’t, why not? If the increase in activity has in fact been harmful rather than beneficial, what can be done about it?
All of these questions are answered in economist John Kay’s splendid new book, Other People’s Money: The Real Business of Finance. I will not be able to do this book sufficient justice in a review, so I recommend that all participants in the financial industry, as well as in the real economy, should read it in its entirety.
What has the modern financial industry done for the real economy?
The purpose of financial intermediation, Kay explains, is to channel capital – which derives from personal savings – to two uses. The first channel takes bank deposits and converts them to loans, chiefly for mortgages. The second channel takes another part of personal savings and channels it to investments. The purpose is to enable savers to grow their savings, and to provide homeowners, governments and businesses with needed capital. Between the source and the applications of the funds, in both channels, are financial intermediaries.
According to Kay, until a few short decades ago these financial intermediaries were staffed with second-tier college graduates with leisurely, boring jobs who were better at relationships – such as on the golf course – than at technical challenges. They earned adequate but not spectacular incomes.
Since then, the financial intermediaries have increasingly hired the top-tier college and university graduates. Their average incomes, especially those in the upper levels of the industry, have pulled light-years ahead of other people’s incomes, taking – by dint of association – the incomes of top-tier executives in non-financial industries with them.
Has this change improved the routing of personal savings to capital needs in the two channels? Not discernibly. And it seems to have increased risks, even to whole economies. In addition, it imposes a tax on the entire non-financial sector.
How has this happened?
This has happened through a combination of concepts emanating from academic institutions, financial enticements to industry insiders and their supplicants and regulators, and information asymmetries, which I’ll discuss in detail later. Financial industry intermediaries have managed to obtain financial support for their self-dealing by imposing taxes on users of finance and obtaining catastrophe insurance from governments – either free or at below-market cost.
The extent to which not only users of the financial system, but also the language of regulatory structure itself have been captured by the financial intermediaries can be measured by the disproportionate importance conferred on the pursuit of “liquidity.” Says Kay, “Nothing illustrates the self-referential nature of the dialogue in modern financial markets more clearly than this constant repetition of the mantra of liquidity.”
What’s so important about liquidity? Kay again: “[E]nd-users – households, non-financial businesses, governments – have very modest requirements for liquidity from securities markets … these needs could be met in almost every case if markets opened once a week – perhaps once a year – for small volumes of trade.”
Then what is the purpose of liquidity? “The pursuit of liquidity often seems to mean little more than the facilitation of trading activity as an end in itself: trading is to be welcomed because it promotes trading.”
The industry of ever more highly paid financial intermediaries trading only with themselves has captured regulators – and even the financially literate media – by winning widespread acceptance of its mantras of liquidity, price discovery and transparency. Liquidity and price discovery promote only trading for traders; transparency promotes, or at least does not mitigate, information asymmetry by requiring the delivery of an unassimilable amount of confusing information.