Jun 18, 2011


Jean-Louis Arcand, Enrico Berkes and Ugo Panizza asked a very important question in a piece at Vox yesterday – has finance gone too far? I’ve made my position rather clear over the years. I believe the inaccurate financial theories of the 60′s & 70′s created a world where markets were believed to be self regulating. Within that world we felt that it was right to tear down any and all barriers holding the banks back from increasing profits. This phenomenon was furthered by the actions of the Federal Reserve whose only true role in the economy is to help stabilize and strengthen the banking system. The Fed’s role became increasingly important as these unregulated entities became increasingly less stable and needed increased aid and stabilization. But ultimately, the growth of this industry helped to undermine the growth of the real economy by reaping an undeserved percentage of corporate profits largely at the expense of the American middle class.

This industry, though vital, is not the engine of capitalism. Instead of an engine of real growth, we have a massively financialized economy where everything from a person’s home to retirement accounts to commodities are seen as a tool that can generate profits for these banks. The result is an economy that is largely dependent on an industry that produces little while also hoping their bankrupt clients can continue their much needed consumption. Hyman Minsky called it money manager capitalism. I think “cannibalistic capitalism” is more appropriate.

But I digress. Arcand, Berkes and Panizza found that my inane ramblings above might not be so inane after all: “In a new paper (Arcand et al. 2011), we contribute to the literature on financial development and economic growth in three distinct ways.
First, we build a simple model finding that, even in the presence of credit rationing, the expectation of a bailout may lead to a financial sector that is too large with respect to the social optimum.
Second, we use different datasets (both at the country and industry-level) and empirical approaches (including semi-parametric estimations) to show that there can indeed be “too much” finance.

Our results show that the marginal effect of financial development on output growth becomes negative when credit to the private sector surpasses 110% of GDP. This result is surprisingly consistent across different types of estimators (simple regressions and semi-parametric estimations) and data (country-level and industry-level). The threshold at which we find that financial development starts having a negative effect on growth is similar to the threshold at which Easterly et al. 2000 find that financial development starts increasing volatility. This finding is consistent with the literature on the relationship between volatility and growth (Ramey and Ramey 1995) and that on the persistence of negative output shocks (Cerra and Saxena 2008).
Third, we discuss how our results relate to the current crisis and show that all the advanced economies that are now facing serious problems are located above our “too much” finance threshold.

We also run a battery of tests showing that the size of the financial sector played an important role in amplifying the effects of the global recession that followed the collapse of Lehman Brothers in September 2008. While most of the recent discussion on the negative effects of financial development concentrates on the advanced economies, we show that during the recent crisis the amplifying role of the financial sector was also important for developing countries.”

…There are two possible reasons why large financial systems may have a negative effect on economic growth. The first has to do with economic volatility and the increased probability of large economic crashes (Minsky, 1974, and Kindleberger, 1978) and the second relates to the potential misallocation of resources, even in good times (Tobin, 1984).

…We believe that our results have potentially important implications for financial regulation. The financial industry has argued that the Basel III capital requirements will have a negative effect on bank profits and lead to a contraction of lending with large negative consequences on future GDP growth (Institute for International Finance, 2010). While it is far from certain that higher capital ratios will reduce profitability (Admati et al., 2010), our analysis suggests that there are several countries for which tighter credit standards would actually be desirable.”

Unfortunately, we have an army of lobbyists in Washington who have succeeded in making sure that these institutions are not reined in. This crisis was the market screaming at us to contain and control the instability these institutions have caused. Instead, the banks have grown larger, the Fed more powerful and the US economy weaker.

Capitalism has a funny way of imposing its will on the weak. When it is allowed to work it is a system that is harsh, swift, efficient and just. We were unwise to turn a deaf ear to the market during the last downturn. And because of that we can be certain that this imbalance will continue to grow and generate instability within the US economy. Except next time this industry turns a recession into a near depression I hope the politicians will be smart enough to listen to the market and do what’s actually in the best interest of the American people.


I agree with final conclusion (paragraph)... What do you think? ... Monte

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