Financial systems perform important and valuable roles in any market activity. Their development has played a crucial role in the great economic transformation of the last two centuries. But the extraordinary growth of financial markets, writes Adair Turner, head of Britain's Financial Services Authority, means we need to be far more vigilant in not allowing the system to become unmoored from ethical constraints.
The predominant neoclassical school of economics has perceived increased financial activity — greater market liquidity, more active trading, financial innovation — as a broadly positive development. This is because, in its way of conceptualizing the world, extensive financial activity is essential to "complete" markets.
But this benign view of limitless financial deepening — that is, of increased trading activity and innovation — is rejected by what we might label the Keynes/Minsky school of thought.
John Maynard Keynes argued (most famously in chapter 12 of his General Theory of Employment, Interest, and Money) that liquid financial markets did not ensure allocative efficiency through the attainment of a rational competitive equilibrium. Instead, he saw them as subject, for inherent and unavoidable reasons, to self-reinforcing herd effects and momentum effects.
Keynes knew of what he wrote since he was not just a macroeconomist, but a professional trader himself. Therefore, his views should be given special attention.
Keynes believed that the professional investor or trader — be it in equity markets, in currency markets, or (as he would have said today) in the market for credit default swaps — is "forced to concern himself with the anticipation of impending changes, in the news and in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced."
He also argued that pure speculation, detached from fundamentals, could drive self-reinforcing bubbles that not only serve no useful allocative role, but produce important destabilizing effects.
Major investment banks, for instance, use "value at risk" methodologies to assess potential losses from trading positions. These methodologies assume that the observed frequency distribution of market price movements over recent periods carries strong inferences for the probability distribution of future possible movements. Thus, they can be used to estimate the maximum losses that could be incurred at any given level of confidence (for example, the maximum loss that would occur 99% or 99.9% of the time).
But this assumption has turned out to be dangerous for three reasons. First, it was often assumed, for ease of modeling, that the distributions were "normal." Second, the reliance on observations of the recent past introduced a systematic tendency to pro-cyclical risk assessment.
Third, and most crucially, the very idea that in social science we can derive the objective probability distribution of future outcomes from observation of past outcomes is what is known as a philosophical category error, since no probability distribution of future outcomes objectively exists.
It is better to live in the real world of complexities imperfectly understood than to construct for ourselves an intellectually elegant set of assumptions that don't accord with real-world phenomena. The evidence from the crises of 1997 and of 2007-09 suggests that we should be highly skeptical about the benefits of general and limitless financial liberalization.
It is now obvious that this dominant ideology was wrong. It failed to allow for the potential downside of the instability that increased financial complexity might produce. And it failed to consider this possibility because it was based on the assumption that financial markets are rational and equilibrating. It did not do the world any service by rejecting, or ignoring, the Keynes/Minsky insight that financial markets can be subject to self-reinforcing swings of irrational exuberance and then despair.
A negative-sum game
The financial system collectively, via its own intra-financial system trading activities, can create volatility — against which the nonfinancial economy then has to hedge.
In some cases the nonfinancial economy has to pay the financial system for hedging against a risk that the financial system has itself created. That turns an initially zero-sum activity (proprietary trading against one another) into a positive-sum game for the financial industry — and a negative-sum game for all others.
What then is the balance between the real value added by the financial system and what must be labeled as distributive rent extraction? The honest answer is that we don't know. The only thing we do know for sure is that there is more potential for finance to generate redistributive rents than exists in most other sectors of the economy.
A lot of those rents stay with highly skilled employees, who de facto are often the chief beneficiaries of the current system. Shareholders may get high returns, but at the expense of higher risk. It is the explosion of investment bank and trading remuneration that is the more striking phenomenon — and the phenomenon now attracting very significant social concern.
This, of course, is not the same as saying that allfinancial activity is "socially useless." Financial systems perform important and valuable roles in any market economy, and their development played a crucial role in the great transformation of the last two centuries.
But it does mean that a financial system could grow beyond its socially optimal size. And when combined with the indirect nature of finance's value to the economy, it creates the danger that finance can become unmoored from the ethical constraints that apply in other areas of the economy and which limit the proliferation of purely redistributive or harmful activities.
In accounting terms, the value added of financial activity forms part of a nation's GDP. It enters GDP calculations either as an end product or service consumed directly by individuals, or as an intermediate product or service used as an input to the production activities of other businesses.
However, working out what the true nature of that contribution is — and what meaning one should attach to the figures estimated within national income accounts — is extremely complex. Indeed, not only is the meaning of the financial industry's contribution to a country's calculated GDP far less clear than is often supposed, it is, in many ways, dubious.