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Small is beautiful in finance

6 November 2013 By Edward Hadas

Some economic activity makes the world better, some is a cost of making the world better, and some actually makes the world worse. Where does the business of finance – lending, borrowing and securities trading – fit in? Mark Carney, the new governor of the Bank of England, recently said: “a vibrant financial sector brings substantial benefits.” The implication is that more finance is a good thing, as long as it is safe. That is simply wrong.

True, empirical studies show that financial activity increases along with incomes in poor countries. But this correlation has little bearing on developed economies with mature financial systems. In these countries, additional financial activity unquestionably adds to GDP, but the same can be said for the substitution of expensive medical care for cheap preventative action. The question is whether additional finance promotes overall economic good.

It can do so, but not directly. Finance is a cost. It is a means not an end, an input not an output. People and companies should engage in financial activity only to help them do other things – most notably to preserve or increase wealth, to coordinate expenditure with incomes and to help organise real investments, production and distribution.

Unnecessary financial activity is a wasted expense. Even if the excess does not directly cause problems – such as housing bubbles or fiscal crises – it makes the world worse because it wastes economic resources. The right goal for the financial system is to be as small as possible without doing economic harm.

By that standard, the current system is extremely wasteful. The waste can be seen in both the quantity of financial assets and pace of the financial activity. One measure of quantity is the ratio of debt to GDP. For the United States, which probably leads the world in financial excess, the calculation is aided by the U.S. Federal Reserve, which every quarter tots up all the outstanding debts, from government borrowing to bank loans. Total debts were 144 percent of GDP in 1975. In the most recent quarter, they were 263 percent.

Little, if any, of the increased borrowing has gone to fund additional income-generating investments, in factories, inventories or the expenses of growing businesses. Instead, the bulk of the debts are unproductive.

Some of the new borrowing provided funds which bid up the prices of assets that do not produce incomes – houses that are lived in, commodities that are stored or art that is collected. Governments are responsible for much of the additional debt. The ratio of government debts to GDP has at least doubled in most developed countries over the last four decades. There are reasonable excuses for some fiscal deficits, but the cumulative effect of years of deficit finance is disruptive. Tax revenues need to be higher to keep up interest payments, while the vast supply of bonds clutters financial markets, distracting investors and distorting monetary policies.

Also, claims between financial institutions – mostly loans and derivatives – have increased sharply, from 16 to 83 percent of U.S. GDP since 1975. A small portion of the new securities may provide helpful hedges, but most of them are only used for speculation. Worse, the huge new mass of purely financial debt has been balanced on relatively thin equity foundations. This leverage has made the whole financial system more precarious, as the 2008 crisis made clear.

The bigger financial balances explain some of the increase in the share of financial activity in GDP, which has expanded from 2 to 8 percent of U.S. GDP since the Second World War. During that period the cost of processing financial transactions has declined precipitously, so the actual increase in activity is much larger than that statistic suggests.

Additional financial market activity generally reduces the markets’ economic efficiency. Investors and speculators who trade more have less reason to care about the long term, since they will sell long before it arrives. When the annual volume of foreign exchange trading is roughly 40 times larger than the volume of trade between countries, the financial market has basically lost touch with the economy. The trade of already issued shares and bonds, the vast majority of activity in these markets, does no more for the economy than moving sacks of sand back and forth across a room.

Rather than promising to promote a larger and safer financial sector, Carney should be calling for more efficient finance. For one thing, more finance brings more debts and more speculation – and more opportunities for panics and chains of defaults. A larger sector is likely to be less safe than a smaller one. But even if Carney could find a safe way for the City of London to grow, he would be only expanding a part of the economy – pointless finance – which can do harm and cannot do good.


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