Is Modern Finance More Like Electricity or Junk Food?

Is modern finance more like electricity or junk food? This is, of course, the big question of the day.

If most of finance as currently organized is a form of electricity, then we obviously cannot run our globalized economy without it. We may worry about adverse consequences and potential network disruptions from operating this technology, but this is the cost of living in the modern world.

On the other hand, there is growing evidence that the vast majority of what happens in and around modern financial markets is much more like junk food – little nutritional value, bad for your health, and a hard habit to kick.

The issue is not finance per se, i.e., the process of intermediation between savings and investment. This we obviously need to some degree. But do we need a financial sector that now accounts 7 or 8 percent of GDP? (For numbers over time, see slide 19 in my June presentation.)

As far as we know, finance was about 1 or at most 2 percent of GDP during the heyday of American economic innovation and expansion – say from 1850. The financial system of the nineteenth century worked well, in terms of mobilizing capital for new enterprises.

Those banks had much higher capital-asset ratios than we have today. Even the dominant players were smaller in absolute terms and relative to the economy – JP Morgan (NYSE:JPM), at his peak, employed less than 100 people.

No one is suggesting we go back to the nineteenth century (although abolishing our central bank would certainly have undesirable consequences in that direction). But is it really healthy – or even sustainable – to have a finance sector as large as what we face today? (It is surely not a good idea for finance to account for 40 percent of total corporate profits, see slide 16 – such performance, in an intermediate input sector, suggests someone else in the economy is being severely squeezed.)

There is a great deal of research that finds finance is positively correlated with growth, but this work has a couple of serious limitations – if you want to derive any robust implications for policy.

First, it is about the amount of financial aggregates (e.g., money or credit, relative to GDP) rather than the share of financial sector GDP in total GDP. I know of no evidence that says you are better off with a financial sector at 8% rather than, say, 4% of GDP.

Second, the research shows correlations not causation. So all we really know is that richer countries have more financial flows relative to GDP, not that more finance raises GDP in any linear fashion. Attempts to dig into causation tend to show that financial development is not the bonanza that it is cracked up to be.

Third, we know finance can become “too big” relative to an economy. Ask Iceland.

The work in this area is still at any early stage. Given what we’ve seen over the past 12 months, which way should we lean: towards believing in the positive power of finance, until the opposite is proven; or towards being skeptical of finance in its modern form, until we see evidence that this actually makes sense?

Surely out skepticism should extend to financial innovation. Show me the evidence that this kind of innovation really adds value, socially speaking – rather than providing a very modern way to extract amazing “rents”.