The point of the financial sector isn't really that difficult to grasp. There are agents—households and businesses—in the economy who have more resources than they currently need and who would like to put those idle resources to productive use. And there are other agents who would like to put resources to productive use. The financial system exists to match up people who would like to invest with those who need investment capital.
An important question is: what does it take to do that job effectively? It's surprisingly difficult to settle on an answer. There are many financial innovations which seem to be serving some visible purpose worth the occasional damage markets do to the real economy. And there are others which seem to produce a great deal of wealth for financial intermediaries and little else. People are increasingly asking to what extent governments can shrink the financial sector without damaging economic growth.
In the US, both the share of all wages and salaries paid by the financial firms and those firms’ share of all profits earned have risen sharply in recent decades. In the early 1950s, the “finance” sector (not counting insurance and real estate) accounted for 3 per cent of all US wages and salaries; in the current decade that share is 7 per cent. From the 1950s to the 1980s, the finance sector accounted for 10 per cent of all profits earned by US corporations; in the first half of this decade it reached 34 per cent.
These wages and profits – and the office rents, utility bills, advertising and travel expenses – are all parts of the cost of running the mechanism that allocates our economy’s capital. To recall, what makes a new fertilizer a good deal for the farmer is not just that it delivers greater production per acre but that the added production is sufficient to buy the fertilizer and increase the farmer’s own return.
What makes a more efficient financial system worthwhile is not just that it allows us to achieve greater production and economic growth, but that the rest of the economy benefits. The more the financial system costs to run, the higher the hurdle. Does the increased efficiency our investment allocation system delivers meet that hurdle? We simply do not know.
Economic decisions are supposed to turn on weighing costs and benefits. It is time for some serious discussion of what our financial system is actually delivering to our economy and what it costs to do that.
These are important questions, without satisfying answers. Here are Simon Johnson and James Kwak:
The main purpose of financial innovation is to make financial intermediation happen where it would not have happened before. And that is what we have gotten over the last 30 years. As Ferguson said, “New vehicles like hedge funds gave investors like pension funds and endowments vastly more to choose from than the time-honored choice among cash, bonds, and stocks. Likewise, innovations like securitization lowered borrowing costs for most consumers.” But financial innovation is good only if it enables an economically productive use of money that would not otherwise occur. If a family is willing to pay $300,000 for a new house that costs $250,000 to build (including land), and they could pay off a loan comfortably over 30 years, then that is an economically productive use of money that would not occur if mortgages did not exist. But the mortgage does not make the world better in and of itself; that depends on someone else having found a useful way to employ money.
And here is Phillip Inman, discussing a policy proposal from Lord Turner, chairman of Britain's Financial Services Authority:
In a searing critique of the industry, Lord Turner described much of the City's activities as "socially useless" and questioned whether it has grown too large.
His comments, in an interview published by current affairs magazine Prospect, mark a shift in the debate on bonuses, which Turner characterised as a symptom rather than a cause of the financial crisis.
The FSA chairman, who has faced criticism for "going soft" on bankers' pay and would see his empire abolished by an incoming Tory government, said a tax on the millions of transactions in the Square Mile would cut banks' profits and reduce the pool of money available for bonuses.
The idea was recently put forward by anti-poverty campaigners who have argued that a small levy applied to each transaction would mean billions of pounds could be redirected to support developing nations. Turner said he sympathised with applying a tax that would be "a nice sensible revenue source for funding global public goods".
I would say that ordinarily, economic actors ought to be left in peace to do as they wish until it can be shown that their actions are causing some kind of harm. At this point, however, it seems fair to place the burden of proof on the financial sector that their practices are worth the trouble to society. If they can't demonstrate that reining in the financial sector in general and recent problem innovations specifically would significantly reduce economic growth, well, it's appropriate to begin looking for policies that will trim finance as a share of the economy, including, potentially a transaction tax.
Mr Benjamin's point is the right one: where are the benefits to justify these costs? And if those benefits primarily consist of financial sector earnings, why doesn't it make sense to take a larger share of those earnings for use elsewhere, to the benefit of those negatively impacted by the real economic pain that follows financial bust?