May 26, 2015 7:19 pm
Why finance is too much of a good thing
It is very costly to police markets riddled with conflicts of interest and asymmetric information
Alas, it is also possible to extract rents in markets. The financial sector with its complexity and implicit subsidies is in an excellent position to do so. But such practices do not only shift money from a large number of poorer people to a smaller number of richer ones. It may also gravely damage the economy.
This is the argument of Luigi Zingales of Chicago Booth School, a strong believer in free markets, in his presidential address to the American Finance Association. The harms take two forms. The first is direct damage: an unsustainable credit-fuelled boom, say. Another is indirect damage that results from a breakdown in trust in a financial arrangements, due to crises, pervasive “duping”, or both.
Prof Zingales emphasises the indirect costs. He argues that a vicious circle may emerge between public outrage, rent extraction and back to yet more outrage. When outrage is high, it is difficult to maintain prompt and unbiased settlement of contracts. Without public support, financiers must seek political protection. But only those who enjoy large rents can afford the lobbying. Thus, in the face of public resentment, only rent-extracting finance — above all, the mightiest banks — survive. Inevitably, this further fuels the outrage.
None of this is to deny that finance is essential to any civilised and prosperous society. On the contrary, it is the very importance of finance that makes the abuses so dangerous. Indeed, there is substantial evidence that a rise in credit relative to gross domestic product initially raises economic growth. But this relationship appears to reverse once credit exceeds about 100 per cent of GDP.
So what is to do be done? Here are a few preliminary answers.
First, morality matters. As Prof Zingales argues, if those who go into finance are encouraged to believe they are entitled to do whatever they can get away with, trust will break down. It is very costly to police markets riddled with conflicts of interest and asymmetric information. We do not, by and large, police doctors in this way because we trust them. We need to be able to trust financiers in much the same way.
Second, reduce incentives for excessive finance. The most important incentive by far is the tax deductibility of interest. This should be ended. In the long run, many debt contracts need to be turned into risk-sharing contracts.
Third, get rid of too big to fail and too big to jail. These two go together. The simplest way to get rid of too big to fail would be to raise the equity capital required of global systemically important financial institutions substantially.
Many would then choose to break themselves up. Once that has happened, fear of the consequences of prosecution should also diminish. Personally, I would go further by separating the monetary from the financial systems, via the introduction of “narrow banking” — that is, backing demand deposits with reserves at the central bank.
Finally, everyone has to understand the incentives at work in all such “markets in promises”. These markets are exposed to corruption by people who do not care whether promises are kept or whether counterparts are even unable to understand what is being promised.
What is needed is not more finance, but better finance. Yes, this might also end up as substantially less finance.