Thursday, January 21, 2010

The Larger Problem

This is a follow-up to yesterday's post, which took brief excerpts from a post by Simon Johnson of the Baseline Scenario. Here's the complete post by Simon Johnson, and my thoughts along the way:

The Nature of Modern Finance

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.

Really?? We're talking about the roots of most serious economic problem in eight decades here, and we're comparing finance to electricity and junk food? Simon Johnson's "big question of the day" -- What a disappointment!

Not to be rude, but it's no wonder we can't solve our economic problems. We can't even discuss those problems intelligently. You would never -- never -- find Adam Smith or Alexis de Tocqueville or John Maynard Keynes using such dumbed-down comparisons.

"Electricity" is a necessity. "Junk food" is a problem. Neither "necessity" nor "problem" is a technical term. Neither requires that readers be coddled. I don't mean to criticize Mr. Johnson's writing style. But ideas are expressed in words. The better the words, the better the expression.

Is modern finance a necessity or a problem? That's a better question, but still not a good one. Unfortunately, modern finance is both a necessity and a problem.

That is the larger problem.

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.)

We "obviously" need "some" finance in our economy, Johnson says. He is concerned about excessive finance, as I am concerned about the excessive reliance on credit. It's the same concern. We should see eye-to-eye on this.

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.

Ah, but modern finance does not exist solely for the purpose of "mobilizing capital for new enterprises." As I said on the 15th:

Used to be, we'd use credit for growth. And for special circumstances.
Now we use credit for everything.

Modern finance. The mature economy. Excessive reliance on credit. We use credit for everything, and that creates problems.

For some reason, Mr. Johnson can only almost see this larger problem.

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, 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.)

Someone else is being squeezed. This is such an important point. It ought to be emphasized, not buried at the bottom of a paragraph that spans centuries with three dashes, two sets of parentheses, an unanswered question, and one technical drizzle of syllables ("an intermediate input sector").

Someone else is being squeezed. In other words, the profit flowing into finance is flowing out from somewhere. (Profit is income, by definition.) Income elsewhere in the economy is less, because profits are so great in the financial sector. In the twelve pages I wrote:

The growing cost of interest [in the economy as a whole] left less to divide up as wages and profits. Wages and profits both suffered as a result.

Simon Johnson speaks of "profit" where I write of "cost." He speaks of the "financial sector" where I write of "interest" as a factor cost. Our words differ, but we describe the same phenomenon. We see the same problem: excessive reliance on credit.

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.

Johnson objects to research that looks at not-quite-the-right numbers. He objects to evaluating "money or credit, relative to GDP." He prefers to look at "financial sector GDP." But as credit-use grows, so grows the financial sector. I think the objection here is minor. (It matters to me, because my oft-repeated "excessive reliance on credit" is probably a financial aggregates thing.)

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.

Ask Iceland? (I guess I do object to Simon Johnson's writing style, after all.)

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?

I can't believe he says "The work in this area is still at any early stage." I can't believe he's only looking back "over the past 12 months." And I can't believe he offers only the two absurd extremes: "believing in the positive power of finance, until the opposite is proven," or disbelieving in the positive power of finance, until the opposite is proven.

The extremes are the problem, after all.

Too much is too much. Yes, finance is good, but too much finance is not good. People know this. People have been up in arms about debt since the 1980s. People know when it is too much. But Simon Johnson, the "authority on financial crises," is considering only the past twelve months. And he's saying the work is still at an early stage.

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”.

By Simon Johnson

I'm just disappointed, that's all. I finally find a guy who has been nose-to-nose with the economic problem. But it turns out he doesn't know what the stink is.

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