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The Nature of Modern Finance



Is modern finance more like electricity or junk food? This is, of course, the big question of the day.

If most of finance as currently organized is a form of electricity, then we obviously cannot run our globalized economy without it. We may worry about adverse consequences and potential network disruptions from operating this technology, but this is the cost of living in the modern world.

On the other hand, there is growing evidence that the vast majority of what happens in and around modern financial markets is much more like junk food—little nutritional value, bad for your health, and a hard habit to kick.

The issue is not finance per se, i.e., the process of intermediation between savings and investment. This we obviously need to some degree. But do we need a financial sector that now accounts for 7 or 8 percent of GDP? (For numbers over time, see slide 19 in my June presentation.)

As far as we know, finance was about 1 or, at most, 2 percent of GDP during the heyday of American economic innovation and expansion—say from 1850. The financial system of the nineteenth century worked well, in terms of mobilizing capital for new enterprises.

Those banks had much higher capital-asset ratios than we have today. Even the dominant players were smaller in absolute terms and relative to the economy—JP Morgan, at his peak, employed fewer than 100 people.

No one is suggesting we go back to the nineteenth century (although abolishing our central bank would certainly have undesirable consequences in that direction). But is it really healthy—or even sustainable—to have a finance sector as large as what we face today? (It is surely not a good idea for finance to account for 40 percent of total corporate profits, see slide 16—such performance, in an intermediate input sector, suggests someone else in the economy is being severely squeezed.)

There is a great deal of research that finds finance is positively correlated with growth, but this work has a couple of serious limitations if you want to derive any robust implications for policy.

First, it is about the amount of financial aggregates (e.g., money or credit, relative to GDP) rather than the share of financial sector GDP in total GDP. I know of no evidence that says you are better off with a financial sector at 8 percent rather than, say, 4 percent of GDP.

Second, the research shows correlations—not causation. So all we really know is that richer countries have more financial flows relative to GDP, not that more finance raises GDP in any linear fashion. Attempts to dig into causation tend to show that financial development is not the bonanza that it is cracked up to be.

Third, we know finance can become "too big" relative to an economy. Ask Iceland.

The work in this area is still at any early stage. Given what we've seen over the past 12 months, which way should we lean: toward believing in the positive power of finance until the opposite is proven; or toward being skeptical of finance in its modern form until we see evidence that this actually makes sense?

Surely our skepticism should extend to financial innovation. Show me the evidence that this kind of innovation really adds value, socially speaking—rather than providing a very modern way to extract amazing "rents".

Also posted on Simon Johnson's blog, Baseline Scenario. The following was previously posted on Baseline Scenario.

More on the Two-Track Economy—from the Wall Street Journal (WSJ) and Others

By Simon Johnson August 29th, 2009

The notion of a two-track economy seems to be taking hold. We kicked the concept around pretty well last week—your 130 comments (as of this morning) helped clarify a great deal of what we know, don't know, and need to worry about. The two-track concept overlaps with and builds on long-standing issues of inequality in the United Sstates, but it's also different. Within existing income classes, some people find themselves in relatively good shape and others are completely hammered.

New dimensions of differentiation are also taking hold within occupations and within industries—the WSJ this morning has nice illustrations. The contours of this differentiation begin to shape our recovery or, if you prefer, who recovers and who does not—it's hard to say how this will play out in conventional aggregate statistics, but these are likely to become increasingly misleading.

For now, I would highlight three points about the two-track future for banks—partly because this matters politically, and partly because ofthe way it impacts the rest of the process.

  1. The remaining big banks have become bigger and more powerful economically—the Washington Post emphasized deposits yesterday, a good point but only part of the picture. The Financial Roundtable is tickled pink about the government's "reform" proposals (except the consumer protection part), with good reason.
  2. Many smaller banks are getting squeezed—as reflected in the latest news on the FDIC's "danger/sick list." The smaller banks really do not seem to understand how they have been done in by the big banks—if they did get it, they'd be up on Capitol Hill and all over the media arguing strenuously for much tougher controls on bad big bank behavior. The lack of leadership among non-large banks is remarkable.
  3. The WSJ today has the data: borrowing costs for large banks are now lower than for small banks. This is, of course, a direct reflection of the government's firefighting/firesetting strategy: unlimited cheap resources for large big banks—for small banks, not so much.

So now it's all about whether you are a preferred client of Goldman Sachs or another big finance house.

If you're on the inside track, this is a great time to buy US assets that are being dumped by people without access to cheap credit, or assets overseas (e.g., Asia, where the "carry" or interest rate differential relative to the Federal Reserve is already positive and the exchange rate risk is all upside).

If you're on the outside track, you are experiencing a version of Naomi Klein's "Shock Doctrine." Some (former) members of the elite are in this category—this is another standard feature of emerging market crises and "recoveries." But mostly, of course, it's nonelite on the outside track and a more concentrated, reconfigured version of the elite on the inside.

This can lead to short-term growth—the speed of recovery in many emerging markets surprises many—from about 12 months after the crisis breaks. But it also leads to repeated crisis, to derailed growth, and to a loss of income, status, and prospects for most of society.

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