This is the introductory chapter of my latest book “Other People’s Money: Masters of the Universe or Servants of the People?”
In the City, they sell and buy. And nobody ever asks them why. But since it contents them to buy and sell, God forgive them, they might as well.
Humbert Wolfe, The Uncelestial City, 1930
Anyone passing the skyscrapers of Wall Street or the City of London and its annexe at Canary Wharf will be impressed by the scale and scope of modern finance. Logos display familiar names such as Citigroup and HSBC. More discreet brass plates identify organisations that do not deal with the general public. The most important headquarters building in the industry, the head office of Goldman Sachs, at 200 West Street in Manhattan, remains anonymous. The premises are lavish, the limousines ubiquitous. Individuals with offices in the executive suites earn more in a month than most people will expect in a lifetime. But what do these people do? To an extent that staggers the imagination, they deal with each other.
The assets of British banks are around £7 trillion – four times the aggregate of the yearly income of everyone in the country. The liabilities of these banks are a similar amount. The assets of British banks are five times the liabilities of the British government. But the assets of these banks mostly consist of claims on other banks. Their liabilities are mainly obligations to other financial institutions. Lending to firms and individuals engaged in the production of goods and services – which most people would imagine was the principal business of a bank – amounts to about 3 per cent of that total (see Chapter 6).
Modern banks – and most other financial institutions – trade in securities, and the growth of such trade is the main explanation of the growth of the finance sector. The finance sector establishes claims against assets – the operating assets and future profits of a company, or the physical property and prospective earnings of an individual – and almost any such claim can be turned into a tradable security. ‘High-frequency trading’ is undertaken by computers which are constantly offering to buy and sell securities. The interval for which these securities are held by their owner may – literally – be shorter than the blink of an eye. Spread Networks, a telecoms provider, has recently built a link through the Appalachian Mountains to reduce the time taken to transmit data between New York and Chicago by a little less than one millisecond.
World trade has grown rapidly, but trading in foreign exchange has grown much faster. The value of daily foreign exchange transactions is almost a hundred times the value of daily international trade in goods and services. The annual volume of payments processed in Britain is £75 trillion: about forty times Britain’s national income. Trade in securities has grown rapidly, but the explosion in the volume of financial activity is largely attributable to the development of markets in derivatives, so called because their value is derived from the value of other securities. If securities are claims on assets, derivative securities are claims on other securities, and their value depends on the price, and ultimately on the value, of these underlying securities. Once you have created derivative securities, you can create further layers of derivative securities whose values are dependent on the values of other derivative securities – and so on.The value of the assets underlying such derivative contracts is three times the value of all the physical assets in the world.
What is it all for? What is the purpose of this activity? And why is it so profitable? Common sense suggests that if a closed circle of people continuously exchange bits of paper with each other, the total value of these bits of paper will not change much, if at all. If some members of that closed circle make extraordinary profits, these profits can only be made at the expense of other members of the same circle. Common sense suggests that this activity leaves the value of the traded assets little changed, and cannot, taken as a whole, make money. What, exactly, is wrong with this commonsense perspective?
Not much, I will conclude. But to justify that conclusion, it will be necessary to examine the activities of the finance sector and the ways in which it does, or might, make our lives better and our businesses more efficient. Assessing the economic contribution of the industry is complex, because there are many difficulties in interpreting reported information about the output and profitability of financial sector activities. But I will show that its profitability is overstated, that the value of its output is poorly reported in economic statistics, and that much of what it does contributes little, if anything, to the betterment of lives and the efficiency of business. And yet many things that finance could do to advance these social and economic goals are not done well – or in some cases at all.
Modern societies need finance. The evidence for this is wide- ranging and conclusive, and the relationship is clear and causal. The first stages of industrialisation and the growth of global trade coincided with the development of finance in countries such as Britain and the Netherlands. If we look across the world today, statistical evidence associates levels and growth of income per head with the development of finance.1 Even modest initiatives in facilitating payments and providing small credits in poor countries can have substantial effects on economic dynamism.
And we have experienced a controlled experiment of sorts, in which Communist states suppressed finance. The development of financial institutions in Russia and China was arrested by their revolutions of 1917 and 1949. Czechoslovakia and East Germany had developed more sophisticated financial systems before the Second World War, but Communist governments closed markets in credit and securities in favour of the centrally planned allocation of funds to enterprises. The ineffectiveness and inefficiency of this process contributed directly to the dismal economic performance of these states.
A country can be prosperous only if it has a well-functioning financial system, but that does not imply that the larger the financial system a country has, the more prosperous it is likely to be. It is possible to have too much of a good thing. Financial innovation was critical to the creation of an industrial society; it does not follow that every modern financial innovation contributes to economic growth. Many good ideas become bad ideas when pursued to excess.
And so it is with finance. The finance sector today plays a major role in politics: it is the most powerful industrial lobby and a major provider of campaign finance. News bulletins report daily on what is happening in ‘the markets’ – by which they mean securities markets. Business policy is dominated by finance: the promotion of ‘shareholder value’ has been a mantra for two decades. Economic policy is conducted with a view to what ‘the markets’ think, and households are increasingly forced to rely on ‘the markets’ for their retirement security. Finance is the career of choice for a high proportion of the top graduates of the top schools and universities.
I will describe the process by which the finance sector has gained such a dominant economic role over the last thirty to forty years as ‘financialisation’. This ugly word provides a useful shorthand description for a historical process that has had profound implications for our politics, our economy and our society.2 I shall also use the term ‘global financial crisis’ to describe the events of 2007–9 and their consequences.3
However, this is not another book about the global financial crisis: it is a book about the nature of finance and the origins of financialisation. Major changes in social and economic organisation are generally the combined product of a rise in the political influence of particular social groups, the promotion of a supportive framework of ideas and a favourable overall conjuncture. That is how the modern market economy came into being, how democracy took root and how over the twentieth century socialism rose – and declined. That process explains the other major economic development of my lifetime: the expansion of the scope of the market economy from a population of fewer than a billion people to one that, for better and worse, embraced half the people of the globe. In the first part of this book I will describe the political changes, the intellectual framework and the wider technological and economic shifts that brought about financialisation.
A remarkable feature of the global financial crisis is that most people in finance seemed to regard it as self-evident that government and taxpayers had an obligation to ensure that the sector – its institutions, its activities and even the exceptional remuneration of the people who work in it – continued to operate in broadly its existing form. What is more remarkable still is that this proposition won broad acceptance among politicians and the public. The notion that finance was special was uncontroversial, and the inability of many intelligent people outside finance to understand quite what financiers did only reinforced that perception.
But finance is not special, and our willingness to accept uncritically the proposition that finance has a unique status has done much damage. All activities have their own practices, and those who engage in them have their own language. Every industry I have ever dealt with believes its characteristics are unique, and there is something in this, although never as much as those who work in them think. But the financial sector stands out for the strength of this conviction. The industry mostly trades with itself, talks to itself and judges itself by reference to performance criteria that it has itself generated. Two branches of economics – finance theory and monetary economics – are devoted to it, a phenomenon that Larry Summers mocked as ‘ketchup economics’ – the exercise of comparing the price of quart and pint bottles of ketchup without regard to the underlying value of the ketchup.4 Summers – variously brilliant academic, US Treasury secretary under Bill Clinton, dethroned president of Harvard, director of Barack Obama’s National Economic Council and rejected candidate for chairman of the Federal Reserve Board – is a figure who will appear several times in this book.
Summers’s derogatory references to ‘ketchup economics’ deny the unique character of finance and reject the view that a different and specialist intellectual apparatus is required to understand the nature of financial activity and the operation of financial markets. This book reiterates Summers’s challenge. Finance is a business like any other, and should be judged by reference to the same principles – the same tools of analysis, the same metrics of value – that we apply to other industries, such as railways, or retailing or electricity supply. I will not hesitate to draw lessons from these industries.
The perspective that views finance as just another business invites us to ask ‘What is finance for?’ – the question that dominates the second part of this book. What needs does the industry serve, viewed from the perspective of market users, rather than market participants? Financialisation has led to a substantial increase in the scale of resources devoted to finance. More people have been paid more. But what has happened to the quality of financial activity?
Finance can contribute to society and the economy in four principal ways. First, the payments system is the means by which we receive wages and salaries, and buy the goods and services we need; the same payments system enables business to contribute to these purposes. Second, finance matches lenders with borrowers, helping to direct savings to their most effective uses. Third, finance enables us to manage our personal finances across our lifetimes and between generations. Fourth, finance helps both individuals and businesses to manage the risks inevitably associated with everyday life and economic activity.
These four functions – the payments system, the matching of borrowers and lenders, the management of our household financial affairs and the control of risk – are the services that finance does, or at least can, provide. The utility of financial innovation is measured by the degree to which it advances the goals of making payments, allocating capital, managing personal finances and handling risk.
The economic significance of the finance industry is often described in other ways: by the number of jobs it provides, the incomes that are earned from it, even the tax revenue derived from it. There is a good deal of confusion here, discussed in Chapter 9. But the true value of the finance sector to the community is the value of the services it provides, not the returns recouped by those who work in it. These returns have recently seemed very large. In all the thousands of pages that have been written about the finance industry in recent years, very little space has been devoted to one fundamental question ‘Why is the industry so profitable?’
Or perhaps the relevant question is ‘Why does it appear so profitable?’ The common sense that suggests that the activity of exchanging bits of paper cannot make profits for everyone may be a clue that much of this profit is illusory: much of the growth of the finance sector represents not the creation of new wealth but the sector’s appropriation of wealth created elsewhere in the economy, mostly for the benefit of some of the people who work in the financial sector.
And yet, although the finance industry today displays many examples of egregious excess, the majority of those engaged in it are not guilty or representative of that excess. They are engaged in operating the payments system, facilitating financial intermediation, enabling individuals to control their personal finances and helping them to manage risks. Most people who work in finance are not aspiring Masters of the Universe. They are employed in relatively mundane processing activities in banking and insurance, for which they are rewarded with relatively modest salaries. We need them, and we need what they do.
So the third part of this book will be concerned with reform. Structural reform, not regulation. I will explain how the regulation which has been applied with more and more intensity and less and less effect through the era of financialisation is part of the problem – a major part – not part of the solution. There has not been too little regulation, but far too much. What is needed is an entirely different regulatory philosophy. We need to give attention to the structure of the industry, and the incentives of the individuals who work in it, and to address the political forces that have prevented the application of regulatory and legal sanctions that have existed for decades, even centuries. We should put an end to the seemingly endless proliferation of complex rule books which are even now beyond the comprehension of the far too numerous regulatory professionals.
The objective of reforming the finance industry should be to restore priority and respect for financial services that meet the needs of the real economy. There is something pejorative about the phrase ‘the real’ – meaning the non-financial – economy, and yet it captures a genuine insight: there is something unreal about the way in which finance has evolved, dematerialised and detached itself from ordinary business and everyday life.
If buying and selling in the City not only absorbs a significant amount of our national wealth but also occupies the time of a high proportion of the ablest people in society, Humbert Wolfe’s complacency – ‘since it contents them … they might as well’ – can no longer be easily justified. In the final chapters of this book I shall describe how we might focus attention on a more limited finance sector more effectively directed to real economic needs: making payments, matching borrowers with lenders, managing our money and reducing the costs of risk. We need finance. But today we have far too much of a good thing.