There is a lot to say about the finance sector. I want to share some research, but also add my thoughts quickly first. Finance has done a lot of good, and could do a lot more good. The sector has found ways to expand access to credit and improved the lives of millions of people. Unfortunately, there is a lot wrong with the sector. Because of financial innovation (which, again, has done a lot of good), finance has expanded rapidly over the past 30 years. Fast expansion and innovation also happens to mean that markets in finance were not deliberately designed to function well and maximize societal welfare. The development of shadow banking, securitization, and different forms of asset management come to mind. Instead, it seems to me, the economic agents who got there first developed the best system for them to make money, and it is only now, with Dodd-Frank, that the federal government is trying to catch up. This story makes sense to me, and the evidence seems to support something like it.
Jobs in finance pay huge premiums. Why? I think it has to do with market power and rent-seeking. This study by Profs Lindley and McIntosh seems to find little other explanation.
The measure of wages used from the New Earnings Survey is annual earnings, which therefore includes annual bonus payments – an important consideration when analysing the finance sector. Holding constant gender, age, and region of residence, finance sector workers are found to earn 48% more on average than non-finance sector workers. Part of this difference will be due to the characteristics of workers who tend to work in finance, be they more motivated, driven etc. Because the New Earnings Survey is a longitudinal dataset that observes the same individuals over time, we can control for any such characteristics even when they are not measured – as long as they remain constant over time – by looking at the change in wages for individuals who move into, or out of, the finance sector, and whose fixed unobserved characteristics will not have changed. The results suggest a 37% change in wages, on average, when individuals move between the non-finance and finance sectors. Thus, much of the finance sector premium remains even after controlling for such unobserved differences across workers.
In summary, the available evidence is most consistent with the rent sharing explanation for the finance sector pay premium. For this explanation to work, however, we also need it to explain why the premium is rising. This could be due to a rising opportunity to engage in rent sharing, due to financial deregulation, implicit insurance against risk through bank bailouts, and increasing complexity of financial products creating more asymmetric information, as well as increased incentives to aim for a larger share of rents due to falling top-end marginal tax rates. Whether governments want to enact policies to try to reduce the premium depends on whether they view it as a private sector matter with benign effects on the economy as a whole, or as having a distorting effect on the labour market, attracting the best workers away from potentially more socially useful jobs.
They dismissed a variety of hypotheses (that are consistent with my personal observations). Finance is not necessarily more skill intensive, does not seem to require different or more valuable individual cognitive skills, and does not require different skills or technologies.
To me the growth of finance does not sound benign. Researchers at the Kauffman Foundation agree, and hypothesize about the wider economic consequences of growing finance. They focus specifically on employment/wages and entrepreneurship. At core, they find some evidence that large numbers of extremely intelligent people who studied STEM in secondary and post-secondary education that otherwise might be entering STEM-related jobs end up in finance because they get paid more (a lot more).
What are the consequences of capital misallocation? Fundamentally, it means that capital—both human and financial—is being inefficiently allocated in the economy, with the result being that some sectors and opportunities are being starved, relatively speaking, while other sectors see a flood of capital, potentially producing a positive feedback cycle that exacerbates one or both of the preceding effects. In particular, capital misallocation can lead to inflated (deflated) asset prices, lower productivity, less innovation, less entrepreneurship, and, thereby, lowered job creation and overall economic growth. The mechanism that creates each of these effects is, of course, the flow of capital in the economy as exacerbated and distorted by financialization.
These hypotheses are, it seems, validated by Prof Ugo Panizza’s research. Thinking about these issues is also nothing new. Minsky, Kindleberger, and Tobin all theorized about the results that we are seeing borne out in today’s data.
The financial system acts like the central nervous system of modern market economies. Without a functioning banking and payment system, it would be impossible to manage the complex web of economic relationships that are necessary for a modern decentralized economy. Finance facilitates the exchange of goods and services, allows diversifying and managing risk, and improves capital allocation through the production of information about investment opportunities.
However, there is also a dark side of finance. Hyman Minsky and Charles Kindleberger emphasized the relationship between finance and macroeconomic volatility and wrote extensively about financial instability and financial manias. James Tobin suggested that large financial sector can lead to a misallocation of resources and that “we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity.”
A large financial sector could also capture the political process and push for policies that may bring benefits to the sector but not to society at large. This process of political capture is partly driven by campaign contributions but also by the sector’s ability to promote a worldview in which what is good for finance is also good for the country. In an influential article on the lobbying power of the U.S. financial industry, former IMF chief economist Simon Johnson suggested that:
The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were crucial to America’s position in the world.
The objective of financial regulation is to strike the optimal balance between the risks and opportunities of financial deepening. After the collapse of Lehman Brothers, many observers and policymakers concluded that the process of financial deregulation that started in the 1980s went too far. It is in fact striking that, after 50 years of relative stability, deregulation was accompanied by a wave of banking, stock market, and financial crises. Calls for tighter financial regulation were eventually followed by the Dodd-Frank Wall Street Reform and Consumer Protection Act and by tighter capital standards in the Basel III international regulatory framework for banks.
Not surprisingly, the financial industry was not happy about this rather mild tightening in financial regulation. The Institute of International Finance argued that that tighter capital regulation will have a negative effect on bank profits and lead to a contraction of lending with negative consequences on future GDP growth. Along similar lines, the former chairman of the Federal Reserve, Alan Greenspan, wrote an op-ed in the Financial Times titled “Regulators must risk more, and intervene less,” stating that tighter regulation will lead to the accumulation of “idle resources that are not otherwise engaged in the production of goods and services” and are instead devoted “to fending off once-in-50 or 100-year crises,” resulting in an “excess of buffers at the expense of our standards of living”
Greenspan’s op-ed was followed by a debate on whether capital buffers are indeed idle resources or, as postulated by the Modigliani-Miller theorem, they have no effect on firms’ valuation. To the best of my knowledge, there was no discussion on Greenspan’s implicit assumption that larger financial sectors are always good for economic growth and that a reduction in total lending may have a negative effect on future standards of living.
In a new Working Paper titled “Too Much Finance?” and published by the International Monetary Fund, Jean Louis Arcand, Enrico Berkes, and I use various econometric techniques to test whether it is true that limiting the size of the financial sector has a negative effect on economic growth. We reproduce one standard result: at intermediate levels of financial depth, there is a positive relationship between the size of the financial system and economic growth. However, we also show that, at high levels of financial depth, a larger financial sector is associated with less growth. Our findings show that there can be “too much” finance. While Greenspan argued that less credit may hurt our future standard of living, our results indicate that, in countries with very large financial sectors, regulatory policies that reduce the size of the financial sector may have a positive effect on economic growth.
Countries with large financial sectors (the data are for the year 2006):
Source: Arcand, Berkes, and Panizza.