Modern societies need finance.  The evidence for this is wide-ranging and conclusive, and the relationship is clear and causal.  The first stages of industrialization and the growth of global trade coincided with the development of finance in Britain and the Netherlands. Across the world today, statistical evidence associates levels and growth of income per head with the development of finance.  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 only be prosperous 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.

       But does finance really deserve the deference it receives? 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 wide 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 our willingness to accept uncritically the proposition that finance has unique status has done much damage. All activities have their own practices and those who engage in them have their own language.  All industries I have ever dealt with believe their characteristics are unique, and there is something in this, although never as much as those 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 which it has itself generated.  Two branches of economics – finance theory and monetary economics – are devoted to it, a phenomenon which Larry Summers – the former US Treasury Secretary, dethroned President of Harvard and rejected candidate for Chair of the Federal Reserve Board- thirty years ago 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.

       But 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 -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 which 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  people it employs, the incomes which are earned from it, even the tax revenue derived from it.  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?

        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. A security is a paper claim against an asset – the property and revenues of a company, the tax receipts of a government, the resources of an individual. Almost any claim can be turned into a security. Perhaps the most bizarre development of recent years has been the growth of ‘high-frequency trading’ , 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.

       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.  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 such derivative contracts outstanding 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, add value or make money.  What, exactly, is wrong with this common sense perspective?

         Very little, is the answer. The apparent exceptional profitability of the finance industry is partly a result of the appropriation of wealth created elsewhere in  the economy , and partly an illusion. From 2003 through 2007, banks announced they had made large profits – based, in large part, on low quality lending and trading in complex financial instruments, paid a substantial share of these profits to their senior employees: only to recognise in 2008 that it had all been a mistake, wiping out much of their shareholders wealth and demanding taxpayer support.

              It is time to return to a smaller, simpler financial sector – focussed on the core functions of administering payments, managing household wealth, searching for new investment opportunities and providing stewardship of existing assets, enabling households to mitigate the risks of everyday life. And it is time for government to treat financial services as an industry like any other.  Regulation should be targeted on specific issues – deposit protection, consumer abuse, and the prevention of fraud.  Public subsidies, state guarantees, and other mechanisms of government support, including the increasingly ill-defined, yet extensively relied on, concept of ‘lender of last resort’, should be  withdrawn.   The financial sector should not be used as an instrument of economic policy, and the opinions of people in the financial sector on economic policy should be treated with the same (modest) regard appropriately accorded to the political opinions of other business people.