The social value of finance: problems and solutions
How do we stop the financial system from occasionally blowing up the world and producing – as it has post 2007/8 – a severe post-crisis recession?
How do we stop the financial system from occasionally blowing up the world and producing – as it has post 2007/8 – a severe post-crisis recession? Let me start with the fact that finance has got much bigger. Over the last 50 years, finance has come to play a far bigger role in modern advanced economies. In the 1950s the total finance sector in the US accounted for about 2.5 per cent of GDP; by 2007, that was about eight per cent of GDP. There is a very similar growth pattern in the UK. In other countries the absolute figures are often smaller, but the direction of change is the same.
Finance in our economy is three times bigger than it was in the 1950s
Why is that? There are two dominant elements. One is that real economies became more leveraged. They borrowed more money. So if you take all the advanced economies together, in the early 1950s they had private sector debt to GDP of about 50 per cent, and by 2007 that had grown to 170 per cent. So the size of what the financial system did vis-a-vis the real economy in the debt markets had become much bigger. There had to be more money, more deposits, more bonds, more fixed-interest instruments of some sort.
The other reason why finance got much bigger is that it did far more trading with itself. It created a set of instruments that were intensively used within the financial system itself, such as derivatives.
So if you take a whole series of indices that relate a financial activity to a real economy activity, you get a dramatic increase in those ratios; you get far more foreign exchange trading relative to the value of actual real trade; you get an explosion of derivatives that had not previously existed, and in particular, you get a change in shape of the balance sheets of the major international banks.
How bank balance sheets changed
If you looked at the biggest banks of the world back in the 1950s, an ordinary person could understand them because, broadly speaking, on both the asset and the liability side there were a set of assets which were claims on households, companies, and governments, and on the liabilities side there were a set of liabilities to households and companies. But if you look at the balance sheet of Goldman Sachs, or Deutsche Bank, or Barclays today, you will find that the majority of the balance sheet is a set of claims vis-a-vis other parts of the financial sector. It is Barclays to Deutsche Bank. It is Deutsche Bank through Goldman Sachs, with a huge explosion of derivatives activities, trading activities, interbank activities.
Was it good that finance got so much bigger relative to real economy? Finance is very different from the real economy. It is very different because it is not a consumer good valued in itself; it is valuable if it is performing functions with regard to the real economy and performing them well. It connects savers and investors. It has a crucial role in the mobilisation and the allocation of capital. So it is crucial for us to ask the question: is it doing this as cost efficiently and as effectively as possible?
Praise from the economists for the system
Before the crisis in 2007, the predominant point of view of finance and macroeconomic theory expressed in many books and articles was very positive about the growth of the financial system. And the story that was told was broadly a very positive story about this process of financialisation and financial deepening. It had three elements.
First, there was a very strong assertion that markets in financial instruments are efficient and rational, and that they are more efficient the more liquid they are; that liquid equity markets achieve efficient processes of price discovery as defined by the efficient market hypothesis, and that the more liquid they are, the more trading they are, the more efficiently they do this.
Second, it was very strongly argued that debt contracts were a good thing because they enabled a mobilisation of capital that might not occur if every investment in the economy had to take an equity fall. If when you invested in a project you had to take an equity investment, you would not have invested so much. People, companies, or households, in particular, wanted the certainty of debt contracts, of what the economists called ‘non-state contingent contracts’.
Third, there was an argument that what had occurred in the arena of securitisation, credit structuring, and derivatives was that we had extended to the credit and debt markets the advantages of liquid trading and transparent prices, which we had always had in equity markets. And so it was a good thing that we had taken debt contracts off the liquid books of banks, turned them into liquid traded credit securities, which then – the story was – could be allocated round the economy and end up in the hands of the investors best-placed to absorb the specific risk and return of specific securities that had been tailored to more precise combinations of risk and return by the glories of securitisation collateralised debt obligations (CDOs), and of course, which could be hedged by the glories of credit default swaps (CDSs).
And the assertion was that those changes had not only made the financial system more efficient by doing its job of capital mobilisation and allocation more efficiently, but that it had also made the financial system, and therefore the macroeconomy, more stable.
If you read the IMF global financial stability review of April 2006, only 15 months before the biggest financial crisis in modern capitalism, you will read a paean of praise to the great glories in which structured credit, and derivatives, and trading, and shadow banking have made the financial system more stable.
Questioning economic orthodoxy
Seen from my point of view of stability and why the macroeconomy goes wrong, we have to question that orthodoxy after 2007 and 2008 in lots of different ways – first in relation to equity markets or liquid traded markets in total. I do not believe in the efficient market hypothesis. I fundamentally believe that the things that are true about the efficient market hypothesis are trivial and the things that could be important are untrue.
I think that all liquid traded markets are subject to herd effects, to irrational effects of the type that Robert Shiller and George Akerlof and others have written about, and that that has a set of consequences for the role of liquid traded markets and for other bits of the ecosystem of finance – such as venture capital – in the processes of capital allocation. The role of equity markets, of whether they do or do not serve long-term purposes, is something which Mariana Mazuccato and others have written about.
The third point, I think, was also totally wrong. In retrospect, the developments of shadow banking, of securitisation of derivatives and all the supposedly sophisticated risk management and trading mechanisms that we put in place, far from making the system more stable, essentially took the dangerous potential instability of the credit and asset price cycle and hardwired and turbocharged it.
Textbooks are wrong about banks
Were we right to consider that the growth of credit to GDP was a good thing? What do textbooks tell us about bank credit within the economy? If you pick up an economics undergraduate book, what it says is this: banks take deposits, savings from households, and they lend it to businesses/entrepreneurs to finance capital investment projects, thus achieving both an intermediation of saving and an efficient allocation between alternative capital investment projects.
The problem with that description of what banks do – and a problem right at the core of understanding financial instability – is that those words are completely mythological. And, indeed, they are wrong in two fundamental senses. Banks do not just take existing money and savings and intermediate it; they create money, credit, and purchasing power in the way that the Austrian economists such as Ludwig van Mises and Joseph Schumpeter and Friedrich Hayek described. And so, obviously, the question of who they give that new purchasing power and credit to, who is empowered with new credit, is absolutely fundamental to the dynamics of the economy. But the second way in which they are mythological is in believing that most bank credit is extended to businesses/entrepreneurs to fund new capital investment projects: that is not what banks do in the modern world.
Banks and real estate
Banks can do at least two other things: they can lend money to consumers, either in a mortgage form or in an unsecured form to bring forward consumption in the lifecycle (which could be welfare-enhancing if it optimally smooths consumption across the lifecycle within a permanent income constraint), and also, crucially, they can finance a competition for the ownership of assets that already exists. That can be, for instance, in the private equity market, where much of what private equity does is offer not venture capital or new capital investment, but leveraging up against assets which already exist. By far, the biggest element of where banks do this leveraging up against existing assets is in real estate.
Economist Alan Taylor and his colleagues have analysed 17 major advanced-economy banking systems over the last 140 years, and their conclusion was quite simple: “with very few exceptions the banks’ primary activity up to the 1920s and even the 1970s was non-mortgage lending to business but by 2007 banks in most countries had turned primarily into real estate lenders.” The intermediation of household savings for productive investment in the business sector constitutes only a very minor share of what modern banking systems do today. Thus, banks are not primarily doing what the textbooks say they do.
Now, that, of course, at the very least suggests that we should change the textbooks, but it also raises the question as to whether we should change the banks. Should we try and turn them back to what they were 50 years ago – which was lending money to businesses? I do not want to leap immediately to that conclusion, because I also suggest that we are not going to get rid of it, and we must not attack it too much.
Modern economies are bound to become more real estate-intensive over time. As people get richer they will tend to reach satiation in many categories of consumption, and one thing they will do with an increasing proportion of their rising income is compete more aggressively for the right to live in the nice part of town, for the nice bits of real estate, and effectively for the limited supply of urban land on which that real estate sits. So I think it is almost inherent that modern economies become more real estate-intensive. Banks or the capital markets are bound to do a significant amount of real estate lending. But we need to equally recognise that banks are likely to become more focussed on real estate than is socially optimal, with adverse macroeconomic and microeconomic effects.
Why we still have a weak recession
Real estate lending has proved to be the overwhelmingly predominant driver of financial crises and macroeconomic instability. And this, I believe, is the fundamental reason why in 2014, six years after 2008, we are still struggling with a weak and slow recession. It is not the weakness of the banks. It is the fact that we have overleveraged households and companies who got overleveraged in real estate. And real estate lending has an adverse economic and social effect; but it is an adverse social and economic externality because, seen from the point of view of the individual bank or credit security investor, it can appear to look low-risk and can actually be low-risk, even while it is producing those adverse collective effects.
Bank lending to real estate also appears to be a simpler, easier, cheaper thing than any other form of lending because you can credit-score it, or you can simply lend on a loan-to-value basis. By contrast, lending to a business that does not have real estate assets is tricky, expensive, requires analysis of the business activity, and can be risky. Left to itself, the banking system will overprovide credit for real estate purchase and for real estate investment, and will underprovide credit for business investment, business development, and business innovation. And that justifies public policy interventions, both to constrain and manage overall levels of credit and to produce a different allocation of credit than a purely free market model would produce.
Different solutions for different problems
I want to end by suggesting that policy interventions might lie in three different places, depending on the problem we are trying to solve.
If the problem is that there is not enough credit to small and medium enterprises in general – whether or not they are innovators – we could change the capital risk weights within the banking system. We could set higher capital requirements against real estate lending to reflect the social externality of real estate lending, which no individual, private banker will ever take into account.
Suppose, however, point two: that we were worried not about general business development but about innovation and funding breakthroughs in science and technology. Then I suspect that we have to be willing to step in with actual direct government support or specific government guarantees, rather than simply playing around with the risk weights.
Finally, suppose we were worried about infrastructure development – not the breakthroughs in solar energy but who’s going to fund the installation of large-scale solar energy or the installation of large-scale wind energy. Here it is less immediately obvious why there should be a market failure. The crucial issue here is about risk and return. One thing that the public sector can do, whether it be through development banks, or through guarantees, or through the design of utility regulation, is take risk off the table – because the public sector is a better manager of risk – and get down the cost of infrastructure finance, even if that infrastructure finance comes from the private sector.
Are we talking about general business development, about technological innovation per se, or about infrastructure development? I think the policy levers will differ, but the background – at least in relation to debt – is this: do not rely on the private sector, left to itself, to end up in a socially optimal space. The private sector, left to itself, will gravitate inevitably, not only to the necessary element of real estate finance, but to far too much real estate finance than makes sense in a socially optimal fashion. Those, therefore, are three questions with which I end up.
Adair Turner is a senior fellow at the Institute for New Economic Thinking and at the Center for Financial Studies in Frankfurt. He became Chairman of the UK Financial Services Authority as the financial crisis broke in September 2008, and played a leading role in the redesign of the global banking and shadow banking regulation as chair of the International Financial Stability Board’s major policy committee. Prior to 2008 he was a non-executive director at Standard Chartered Bank; vice-chair of Merrill Lynch Europe, and director general of the Confederation of British Industry. He is a crossbench member of the House of Lords.
This essay forms a contribution to Policy Network’s pamphlet Mission-Oriented Finance for Innovation: New Ideas for Investment-Led Growth
The image is Occupy Wall Street by Aaron Bauer, published under CC BY 2.0