Johnathan Ford, writing in Prospect Magazine, argues that the financial industry has grown far beyond its rational economic size. It’s no longer entirely a service so much as a separate organism whose survival needs do not necessarily coincide with the economy it ‘serves’.
The enormous growth of the financial sector is one of the wonders of our age. In the 1960s the business of banking, broking and insuring accounted for just 10 per cent of total corporate profits in most developed economies. By 2005, this proportion had swelled to nearly 35 per cent in the US and roughly the same in Britain—the two countries that host the world’s largest financial centres. Last year a staggering one in five Britons earned their living in finance.
Of course, the profitability of the financial sector is declining on account of the credit crisis. But the politicians and financial authorities have felt obliged to plug the holes that have appeared in a deflating system with vast public support, and now even direct capital injections. Finance is now not only big, but worryingly unstable.
It’s a well known historical fact that great powers prefer to deal with each other because it makes deal-making and the division of spoils easier. Attempts at cartelizing power often precedes a fatal rivalry. Barabara Tuchman, describing the roots of the Great War in the Guns of August wrote:
Germany might have had an English entente for herself had not her leaders, suspecting English motives, rebuffed the overtures of the Colonial Secretary, Joseph Chamberlain, in 1899 and again in 1901. Neither the shadowy Holstein who conducted Germany’s foreign affairs from behind the scenes nor the elegant and erudite Chancellor, Prince Bülow, nor the Kaiser himself was quite sure what they suspected England of but they were certain it was something perfidious. The Kaiser always wanted an agreement with England if he could get one without seeming to want it. Once, affected by English surroundings and family sentiment at the funeral of Queen Victoria, he allowed himself to confess the wish to Edward. “Not a mouse could stir in Europe without our permission,” was the way he visualized an Anglo-German alliance. But as soon as the English showed signs of willingness, he and his ministers veered off, suspecting some trick. Fearing to be taken advantage of at the conference table, they preferred to stay away altogether and depend upon an ever-growing navy to frighten the English into coming to terms.
Ford argues that big finance needs a big government to provide it with rents because the market alone would never sustain such a bloated thing.
Paul Woolley, a former academic, policymaker, IMF economist and fund manager, argues that efficient market theory falls down because of the “asymmetric information” problem. This, simply put, is the difference in the quality of information enjoyed by agents—the banks, fund managers, brokers and so forth—and the principals, or end investors. The agents know more than the principals, and they exploit this to maximise their own wealth—setting aside the risk and reward objectives of the client. While this worry isn’t new, critics have in the past focused on banking and corporate finance and on abuses such as insider trading. Woolley’s new emphasis, which he has investigated through academic institutes he has established at the London School of Economics and Toulouse university, has been to apply it to investment management. He argues that asymmetric information, especially in this area, has far graver consequences for the functioning of finance.
Perhaps the best example of asymmetric information is the famous “wallet auction,” in which an auctioneer offers to sell his wallet to the highest bidder, while reserving the right not to sell. The asymmetry arises because only the vendor knows how much money is in his wallet. Rationally he will only sell if the bidders overpay. To the jaundiced eye, financial markets often appear like a series of wallet auctions.
This “agency” problem leads on to two bleak conclusions. First, that capital markets do not necessarily price assets efficiently and capital can get misallocated. When the misallocation gets big enough, as it has now, it can lead to substantial macro-economic dislocation. Second, it allows banks and financial intermediaries to capture too big a share of the economic gains from capital investment, and thus from growth itself. And this share (the “croupier’s take” in the celebrated phrase of Warren Buffett’s partner, Charlie Munger) has been going up as financiers have become ever more cunning about exploiting their advantage. Woolley argues that big and unstable capital markets make it likely that we will suffer more and potentially bigger upsets in the future.
Open thread.
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