Finance Gone Wild (Simon Johnson)

Posted this morning to the NYT Economix blog:

By Simon Johnson | September 3, 2009, 7:24 am

Simon Johnson, a professor of entrepreneurship at M.I.T.'s Sloan School of Management, is the former chief economist at the International Monetary Fund.

What is finance?

At one level and in most economics textbooks, this is an easy question with a rather encouraging answer. The financial sector connects savers and borrowers—providing "intermediation services." You want to save for retirement and would obviously like your savings to earn a respectable rate of return. I have a business idea but not enough money to make it happen by myself. So you put your money in the bank and the bank makes me a loan. Or I issue securities—stocks and bonds—that you or your pension fund can buy.

In this view, finance is win-win for everyone involved. And financial flows of some kind are essential to any modern economy—at least since 1800, finance has played an important role in America's economic development.

Unfortunately, 200 years of experience with real-world finance reveal that it also has at least three serious pathologies—features that can go seriously wrong and derail an economy.

First, the financial sector often acquires or aspires to political power. The fact that banks have a great deal of cash on hand always makes it easy or tempting to buy some political favors, and to obtain privilege and power for big financial enterprises. President Andrew Jackson had exactly this struggle with the Second Bank of the United States in the 1830s.

Second, the financial sector can obtain disproportionate power over industry. The "money trust" idea of the early 20th century may have been somewhat exaggerated—money cannot be corralled as effectively by private players as can, say, copper or steel—but there is no doubt that 100 years ago, Wall Street banks dominated the process of consolidating railroads and of creating pernicious industrial trusts. Trust-busting required  taking on the country's most powerful financiers.

Third, finance can also go crazy, running up speculative frenzies. This is what happened the 1920s, leading to the  Great Crash of 1929 and the struggle to effectively constrain finance during and after the long, depressed 1930s.

Which kind of financial sector pathologies do we face today?

Unfortunately: all of the above. And, not just in nature but also in size, we face a financial sector much more potentially debilitating than anything stared down by Jackson, Teddy Roosevelt or Franklin Roosevelt.

In our previous showdowns with finance, the sector was small. During the 19th century, the value of financial intermediation services was no more than 1 or 2 percent of gross domestic product, and in the early 20th century, the extent to which real resources—including talented people—were drawn into this sector remained very limited. J.P. Morgan, in his heyday, had great economic and political power, but he never employed more than 100 people.

With the growth of a much bigger and more diversified economy after World War II, there was some increase in financial activity as a share of G.D.P., but the really big jump came after the deregulation of the 1980s.

Just a few years ago, finance accounted for an astonishing—and unprecedented for the United States—40 percent of all corporate profits, and even today the sector generates around 7 percent of what we measure as G.D.P. Even ardent defenders of finance now concede that the sector may or even should end up significantly smaller as a share of the economy.

But at current scale, the financial sector has great ability, through political donations and other means, to maintain its lightly regulated environment. Note that there is nothing (other than the proposed consumer protection agency for financial products) to which the industry has ever objected in the administration's financial reform proposals.

And yet the amount of risk-taking that this sector can pursue remains mind-boggling, and its ability to "put" the cost of big failed bets onto the government is undiminished. Financial "innovation" remains mad and bad, and when it all goes wrong—you know who gets the bill. The implications for your future taxes and job security are not good.

We need finance, but finance as it currently operates in the United States has become a problem. Yet, with the headline numbers for the economy beginning to improve, the impetus for any real reform of this sector—within the United States or internationally—starts to fade. The likely future is: more of the same, at least until we find a Jackson or a Roosevelt.

Read the original post (which includes several hyperlinks).