Finance is under attack. The war against Wall Street re-ignited after the financial crisis of 2007-2009. Paul Krugman fired the first major salvo against academic macroeconomics and finance in 2008. John Cochrane responded in kind shortly thereafter. These critiques and counter-critiques were somewhat tame to a layman’s eyes–Krugman and Cochrane slug it out over the implications of theory that not even all economists understand. (I will ignore the debate as it evolved in the popular press, which is best summarized as “Left hates Greedy Bankers and Right hates Occupy Wall Street and their champion, the socialist Obama regime.” I focus instead on the debate roiling at the fringe of respectable (scientific) academia.) The Krugman-Cochrane debate quickly devolved into a clash of assumptions. On faction assumes, essentially, that Krugman is right to indict finance theory and practice as essentially at fault for every deleterious event of the last few years. The other faction…doesn’t exist. No one is really defending modern finance theory and practice in academia.
I challenge readers to recall the last paper or blog that seriously defended the modern financial artifice and the fruits borne by it over the last few decades. (This is still the only country in the world where any individual with a steady job, decent credit, and a modest down payment can purchase a veritable palace after suffering through almost three or four solid hours of paper work. I asked one of my Chinese students if such miracles were possible in his homeland. “Yes,” he replied. Turns out he thought I was asking if it were possible to rent an apartment.) On the other hand, the vast majority of popularly accessible papers, speeches, and blogs delivered by most academics assumes that modern finance is inherently nefarious.
These (Is Globalisation Great?) remarks appended below were recently delivered by Stephen Cecchetti at the Bank for International Settlements Annual Conference. He is the Head of the BIS Monetary and Economic Department and he is speaking before other professional economic policymakers who perch at the highest level. His mantra? Finance seems benign, but really it’s harmful–he assumes that modern finance is the primary cause of the worlds’ recent backsliding. I present his remarks below because they are representative of the “Finance is bad” critique; and, because they are such an easy target. I present his series of arguments and then offer a critique.
He begins benignly enough:
…I am led to ask two questions, namely: how much globalisation is good and how much finance is good. Over the next two days we will reflect on these questions. Let me give you my answers to my questions up front: financial deepening is great, but only up to a point. And, this means that the globalisation of finance is great, too; but only up to a point.
Don’t be fooled. He blames finance, not ‘too much finance,’ for most of our problems as the speech progresses. He continues:
To see why I have come to these conclusions, I will take a minute to describe the relationship of finance to growth in general, and then draw out implications for cross-border banking; that is, the part related to the globalisation of finance. My comments build on work that has been going on at the BIS for some time.
In other words, he is definitely not offering up an opinion trumped up with loosely tailored and selectively chosen regressions. And by the way, other people have agreed with him in the past; his arguments must be true.
For most people, the term globalisation means cross-border trade in real goods and services; something that we would all agree has brought the greatest benefits to a large number of people. Trade very clearly supports middle-class living standards, among other things putting literally tens of thousands of different products on the shelves of even a modest-sized supermarket.
Interestingly, Cecchetti notes that ‘trade supports the middle-class’ by increasing the variety of ketchup available at the local grocery and he fails to mention (purposefully?) that the globalization of trade has lifted hundreds of millions of people (who should be counted regardless of the fact that they are not middle-class) from the most dire poverty.
But this real side of globalization relies on financial intermediaries to fund the trading of all this stuff across borders. And the recent crisis showed how problems both on and off the intermediaries’ balance sheets can have very large, very real and very bad implications. Many of us have started to ask if finance has a dark side.
Cecchetti is a little late to the party. The tradition of attacking the purported excesses and evils of finance date back at least to the Pujo Committee, which lambasted John Morgan for his shortcomings shortly after he almost singlehandedly saved the equity markets from certain disaster during the Panic of 1907.
Let the self-flagellation disguised as scholarly inquisitiveness begin:
First, can a financial system get too big? Put differently, is there some optimal size for the financial industry after which it drags down the rest of the economy? Second, how far should countries go in outsourcing the provision of financial services? Does specialisation in financial services by some countries impose vulnerabilities on others? How we think about and answer these questions will surely have an impact on the financial system’s structure and thus on the future of globalisation.
Turning to some facts, consider the relationship between the size of a country’s financial system and growth. We teach that, because it allocates scarce resources to their most efficient uses, one of the best ways to promote long-run growth is to promote financial development. And, a sufficiently well-developed financial system provides the opportunity for everyone – households, corporations and governments – to reduce the volatility of their consumption and investment.
It sure sounds like finance is great. But experience shows that a growing financial system is great for a while – until it isn’t. Look at how, by encouraging borrowing, the financial system encourages an excessive amount of residential construction in some locations. The results, empty three-car garages in the desert, do not suggest a more efficient use of capital!
Cecchetti’s words are persuasive and pick at the emotional sore spot opened up by the most recent financial crisis–employing the same trick that every critic of every era has employed. He assumes that the financial system ‘encouraged’ borrowing (without offering any evidence) and relies upon his audience to know what he means by ‘encouraging.’ In my deepest southern drawl, I ask myself, “Why goodness, whatever does that mean? The financial system ‘encouraged’ borrowing? But for those encouraging bankers, nobody would have borrowed too much money?” Thank goodness that customers never get involved in all of this encouragement. If borrowers had sought money to buy second homes or used their homes as ATMs of their own free will, then things might have really gotten out of control.
Financial development can create fragility. When credit extension goes into reverse, or even just stops, it can induce economic instability and crises. Bankruptcies, credit crunches, bank failures and depressed spending are now the all-too familiar landmarks of the bust that follows a credit-induced boom.
Every first-year economics student is taught the Post Hoc, Ergo Propter Hoc (‘coming after, therefore because of”) fallacy. Cecchetti is not alone in noting that asset price booms are caused by easy credit booms. It is difficult to fault Cecchetti and others for blaming booms on easy credit (which should be distinguished from low interest rates), because of the mass of research which observes that most financial crises are precipitated by credit-fueled asset price booms. But precedence is not causality; and, blaming the financial system for a gunman’s shooting spree is like blaming ammo makers for producing too many bullets. The shooting spree might not have occurred if bullets were rare, but that ignores the fact that cops, soldiers, and angry ex-husbands need bullets for good reasons, and ammunition stockpiles do not cause shooting sprees. Why blame the credit system for providing credit to those who asked for it?
What is more, financial development is not costless. The expansion of finance consumes scarce resources that could be used elsewhere. And finance’s large rewards attract the best and the brightest. When I was a student, my classmates dreamed of curing cancer, unifying field theory or flying to Mars. Those in today’s cohort want to become hedge fund managers. Given finance’s booms and busts, is this the most efficient allocation for such scarce resources? I doubt it.
Where is it written that finance is an ignoble enterprise? That Wall Street diverts otherwise decent and competent human beings away from supposedly more noble enterprises is pure conjecture. And he doesn’t even pretend to argue that finance professionals haven’t made the world a better place. He just assumes that it’s true because he chooses to blame Wall Street for the recent crisis. Cancer will not be cured, field theory won’t be unified, and humanity will never walk on Mars unless financiers help to make it happen. I charge anyone to name a single innovation of the last century that wasn’t financed somewhere along the way. Cecchetti think that we can will ourselves to live in a Star Trek-like universe where money doesn’t matter. (And it doesn’t matter if finance is costly. No one has ever claimed that it wasn’t. The question is whether the resources devoted to finance would be more productive elsewhere. Cecchetti never addresses this except to (again) conjecture that nobody wants to cure cancer anymore because bankers are greedy. (That’s too bad. I didn’t get that memo. No one wants to cure cancer anymore apparently because someone told college students the secret that money buys things. Shucks. And if recent college graduates are flocking to hedge funds instead of oncology labs, maybe that’s because high finance is where those particular professionals belong. After all, maybe these would-be cancer curers will be more adept at financing the cure than at finding it. Maybe that’s what has held back the cure; efforts to find the cure haven’t been properly financed!)
Cecchetti now sets out to prove that there is such a thing as too much finance:
So, when does financial deepening turn from good to bad and become a drag on the economy? Somewhat surprisingly, we get a consistent story regardless of how we measure financial development.
In our 2011 paper for the Federal Reserve Bank of Kansas City’s Jackson Hole Symposium, Madhu Mohanty, Fabrizio Zampolli and I found that the effect of debt – public, household or corporate – turns from good to bad, when it reaches something like 90% of GDP, regardless of the type of debt. To prevent adverse developments – both natural and man-made – policy should normally strive to keep debt levels well below this line.
Yep, he really just said that. Policy, instead of markets, should aim to properly allocate credit. If only the government would step in and discourage lending beyond a some unknown point, then more people would want to cure cancer. And then there is the counterfactual problem: we don’t know what the economic environment would look like it government enacted policies to limit debt levels below that nefarious line that Cecchetti picks on. Has this been tried? If so, then he doesn’t mention that evidence.
If we measure the scale of the financial industry by employment or output, as Enisse Kharroubi and I do in a paper completed earlier this year, we come to the same conclusion. (Cecchetti and E Kharroubi, “Reassessing the impact of finance on growth”, mimeo, January 2012.) When average growth in output per worker is plotted…against the share of employment in finance… a parabola summarises the scatter… Again, the conclusion emerges that there is a point where both financial development and the financial system’s size turn from good to bad. That point lies at 3.2% for the fraction of employment and at 6.5% for the fraction of value added in finance. Based on 2008 data, the United States, Canada, the United Kingdom and Ireland were all beyond the threshold for employment (4.1%, 5.7%, 3.5% and 4.5%). And the United States and Ireland were also beyond the threshold for value added (7.7% and 10.4%).
(Disclaimer: I have not read the above cited paper…correction: I just read it, and it is just as argumentative as his remarks.) Cecchetti claims that because he has found a parabolic relationship between the number of financial workers in a country and that country’s economic growth, that he has “proven” that there was “too much financial development” in crisis countries. At best, his finding fail to disprove his hypothesis; not by a long shot does his unconfirmed finding prove anything. (On this basis alone I discount his entire paper.)
If financial development is only good up to a point, it follows that financial globalisation might only be good up to a point. Financial globalisation is about making it irrelevant to investors and borrowers where the services and the funds they draw on are actually located. But the spillovers during the financial crisis, when one country’s troubles spread to others, raise the question: does it matter where the funds are coming from? That is, how should we think about cross-border flows and financial specialisation?
This is a valid question. Many blame the severity of the Asian Financial Crisis on the lack of capital controls imposed by the Tigers. Indeed, Malaysia may have suffered less from the Asian crisis in part due to the quick imposition of capital controls.
As economists, we are trained to think that specialisation is great. Within an economy, we believe that when individuals exploit comparative advantage, it benefits everyone. And, we have created an entire infrastructure where, for example, I am able to write and speak about macroeconomic and financial stability policy full time, but still purchase groceries. The alternative, where I would barter my insights for food, would surely not work as well.
Agreed. Go on…
I’ll let you be the judge of whether, in my specific case, the market is yielding the right social solution. But for the world as a whole, global welfare is enhanced when we encourage international trade in goods and services. And international trade benefits emerging and advanced countries alike when it exploits comparative advantage. And this inevitably leads to specialisation.
I, too, have taken Economics 101. And please continue…
Trade and specialisation reach their limits where economics meets national security. As an individual, I can rely on someone else to produce my food, trusting that some combination of the market and the legal system will look out for me. But would a country want to outsource its entire food production? And what about energy? National security concerns dictate that some amount of self-sufficiency is cultivated, simply as a precaution. Some concern about food and energy security is certainly warranted. The same is probably true for strategic technologies. But clothing or coffee security is probably not worth worrying about.
Maybe YOU don’t lay up nights sweating the possibility that our nation’s coffee supplies with be choked off in some African hell hole, but I am not that complacent. Idea: We need to develop the SCR: Strategic Coffee Reserve. Do we have any empty salt caverns left? Cecchetti isn’t really saying much…maybe he’s setting me up?
Where does finance stand on this spectrum between the essential and the superfluous? More specifically, can countries become vulnerable by excessively specialising in finance or by overly relying on people outside their borders for the provision of financial services? Has financial globalisation gone too far in some countries?
Excellent questions. The national security aspects of financial system development have not been studied enough by our profession. But still…what is he getting at?
Over the past 30 years, the international financial system has come to be dominated by a relatively small number of large banks headquartered in a handful of advanced counties. Their growth has coincided with a push to remove impediments to the free flow of capital. As a result, a highly concentrated banking sector dominates the international provision of capital and maintains large balance sheet positions with respect to many countries. And when these balance sheet linkages are large (relative to GDP or the capital stock or domestic tax base), problems in one country’s financial sector quickly transmit themselves to other countries and markets. In short, financial globalisation is bound up with a specialisation in financial services that makes countries much more vulnerable to each other’s mishaps.
It is true that globalization increases the risk of financial or economic contagion between countries. So, should we pass a law that bans contagion? I am still unsure what Cecchetti is driving at.
The experience of some countries during the crisis suggests that too much international capital, like too much debt, can be bad. For example, credit booms in the years preceding the crisis tended to outrun domestic funding and to depend on funds from abroad at the margin. Countries that relied heavily on international credit sources to finance domestic booms found themselves high and dry when these off-shore sources of funding went into reverse – which happened as soon as the foreign creditor banks ran in to trouble.
And that is his bug uppercut. But I’m still standing. His arguments are superficial enough and easily dismissed. But the threat from the anti-finance movement within our community isn’t from the power of their arguments, but instead due to the deeply embedded assumption that finance is the problem.
No one put a gun to bankers’ heads and told them to make loans (that crossed borders! Oh, the humanity!). And no one forced borrowers to suck up credit from abroad. (Of course, almost the ENTIRE POINT of cross-border lending is to spread risks. If the credit system is working properly, then there MUST be some contagion in downturns. Otherwise, risks have not been dispersed and therefore credit has been sub-optimally allocated.
And, the implication of his concern about cross-border lending is that controls should be put in place that restrict cross border credit flows. We should trust the same officials to design a credit control system that did such a smashing job of allocating credit just a few years back? Some of us are all too aware that the definition of insanity is doing the same thing and expecting different results.
In all, Cecchetti has a few good points and he is right to push the finance community to take a closer look at these questions. (That is our job, after all.) But he is much too like the rest of the most vocal in the finance community of late. He starts from the presumption that somehow Big Finance is to blame for the recent crisis. It may be true. But as scientists (or even policymakers) we shouldn’t begin with a proposition and then search for evidence to prove it. And if so many of us are going to do just that, then we need a few more people (like John Cochrane, for example) who do not see finance as the problem, but instead see finance theory and practice as a rich set of tools we can use to navigate our way to a better future.
Finance is a science and a profession that has helped usher in the greatest era of prosperity humanity has ever known. There are shortcomings, to be sure. But let’s continue our examination of the field with an open mind. Scientists aren’t supposed to be advocates until all of the evidence is in. Until that day comes, we need to stoop to the anti-finance faction’s level and champion our field. Big Finance Rocks!