Would shrinking the financial sector make the US economy more efficient and more equal?
“Regarding the financial sector, it strikes me that all of these talented people are doing things that aren’t even productive for society—a bloated financial sector means more inequality and means wasted resources, but a bloated financial sector also means wasted talent.”
America could pursue policies that would downsize the financial sector—doing so would arguably (A) free up a vast amount of resources for productive use and (B) reduce inequality. There is—of course—a massive amount of money and power at stake when it comes to the financial sector.
Regarding the financial sector, it strikes me that all of these talented people are doing things that aren’t even productive for society—a bloated financial sector means more inequality and means wasted resources, but a bloated financial sector also means wasted talent.
There’s an interesting 2011 drama film—Margin Call—that includes a couple of scenes that spotlight how tragic it is that talented people are doing dubious things on Wall Street. One character used to be a rocket scientist—another character used to build bridges. There’s a cost to society when talented people do unproductive things instead of doing productive things.
The “Free Market”
Someone might object that the government shouldn’t intervene in the “free market” in order to downsize a given sector, but the “free market” doesn’t actually exist—the issue isn’t whether to intervene or not, since intervention is inescapable.
Chang writes that “the free market is an illusion” and that markets only seem free when “we so totally accept the regulations that are propping them up that they become invisible”.
Dean Baker makes the same point in his free 2016 book Rigged—Baker writes that government policy “shapes market outcomes”, determines “levels of output and employment”, determines “the length and strength of patent and copyright monopolies”, and determines “the rules of corporate governance”. There’s “no way of escaping” this reality—there isn’t any “policy-free option out there” that you can choose to support. There are various policy decisions that affect income distribution—we can discuss what to do in this area or that area, but it’s dishonest to treat any of these policy decisions “as somehow given”.
Baker’s Argument for Shrinking Finance
Baker argues in the 2016 book that the American financial sector should be smaller—the financial sector was 4.5% of GDP in 1970, but the financial sector underwent a “massive expansion”, so the financial sector was 7.4% of GDP in 2015.
The financial sector “plays an essential function in processing payments, providing insurance, allowing families to save for the future, and allocating capital to those who want to invest or borrow”—the issue is that we don’t want to have a bloated financial sector for the exact same reason that “we don’t want to see a huge expansion in employment in the trucking industry or an explosion in the number of trucks and warehouses just to move the same quantity of goods”. It would be “a pure gain to the economy” to reverse “this expansion in the size of the financial sector without damaging its ability to serve the productive economy”—likewise the economy would benefit from eliminating trucking-industry waste.
There’s a 2012 paper—from Jon Bakija and others—that “found that 18.4 percent of primary taxpayers in the top 0.1 percent of the income distribution were employed in finance”. So downsizing finance is “likely to reduce” the extent to which a very small number of earners in the American economy are taking home a very large amount of money.
Baker goes through five areas where the financial sector earns economic rents “at the expense of the rest of the economy”—Baker concludes that eliminating “the various sources of rents in the financial sector has the potential to free up $460 billion to $636 billion in 2015, or between 2.6 and 3.5 percent of GDP”.
And Baker cites a 2015 paper from Ratna Sahay and others:
Baker writes that these two papers “find an inverted U-shaped relationship between the size of the financial sector and the rate of productivity growth”—you can look at “countries with underdeveloped financial sectors” and see that “a bigger financial sector is associated with more rapid growth”, but there’s “a certain level” past which “further expansion relative to the size of the economy is associated with slower growth”.
The idea is that “large financial sectors pull resources away from productive uses”—people “are doing tasks that provide little or no value” when these people “could be employed productively in other sectors of the economy”.
Downsizing the financial sector is beneficial if the primary effect is “comparable to finding a way to monitor truckers to ensure that they only take the most direct routes to get to their destination”—there’s financial-sector waste, but the financial sector also does productive things, so the issue is whether downsizing the financial sector “seriously impedes” those productive things.
Friedman and Solow
Friedman writes in his article that the key issue is “how well our financial system is performing its most basic function—allocating our scarce investment capital—and at what cost”. This basic function “is what our financial system is supposed to be doing”, so we “are therefore entitled to ask how well or poorly it is performing this role, and at what cost”.
There are three tasks when it comes to determining “the adequacy of our current financial system”—the first two tasks are “conceptually straightforward”, whereas the third task is actually conceptually challenging.
The first task is to “gain a well-grounded quantitative understanding of how successfully the financial sector is allocating our economy’s investment capital and how much that allocation of resources costs”—someone “should be commissioned to provide an answer”.
The second task is to “include in the overall cost estimate the risk of the occasional meltdowns to which our modern financial system exposes us”.
The third task is to “evaluate the performance side of the relationship” and determine how well the financial sector allocates “our economy’s investment capital”—the biggest issue on this front is that there’s no “obvious counterfactual” against which to compare the financial sector’s performance.
Friedman explains that these are the basic questions, but Friedman makes clear that there’s been—to Friedman’s knowledge—no effort to answer these basic questions.
Friedman observes that “salaries and bonuses” attract “many of our country’s best young mathematicians and physicists”—these talented minds engage in financial-sector activity that adds “little to the financial system’s ability to perform any of its economic functions”.
There’s a “substantial risk” to “financial markets as a whole” if a financial firm falls into “major difficulty”, so that risk is even worse than adding nothing to the financial sector’s economic functions.
And Solow writes in his article that any “discussion of financial policy and regulation should begin with an urgent reminder that the financial system is a means, not an end”.
The financial sector is supposed to (A) “intermediate between savers and investors” and (B) allow risk-averse people and institutions to offload risk onto risk-tolerant people and institutions—these are the financial sector’s “socially useful functions”, but “very large banks” combine leverage and interconnectedness and “sheer size” in a way that “can endanger the financial system’s ability to perform its socially useful functions”.
Solow suspects that “a sizable amount of financial activity” adds “little or nothing (or perhaps less than that)” to the real economy’s efficiency—Solow suspects that this sizable proportion of financial activity is harmful or useless or marginally beneficial when it comes to actual efficiency in the real economy.
It’s “all the better” if “a reduced financial sector leads more clever graduating seniors to materials science and fewer to investment banking”—society will be better off if these talented graduates go into materials science.