15 June 2015

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