What Has Finance Ever Done For Us?

In Monty Python’s movie, Life of Brian, one of the Jewish revolutionary leaders tries to whip up anti-Roman sentiment by asking, “What have the Romans ever done for us?”  They all hate the Romans, but when they stop to think about the question, the group discovers that they are grateful for numerous benefits that thew would miss if they overthrew Rome: roads, aqueducts, public safety, education, etc.  But, even though they expect to face hardships when they get rid of the Romans, they still want a revolution because of the injustice of Roman domination.  Overthrowing powerful control often leads to economic hardships.  The American revolutionaries in 1776 were undoubtedly worse off economically after the American war for independence, but the Americans didn’t fight for economic justice as much as for the political injustice of British colonial dominance.

Today the American people are rightly upset about the injustices perpetrated through our financial system, but before we let gold bugs like Ron Paul overthrow the foundations of our financial system, it is worth thinking about what finance does for us.  All finance does is shuffle around bits of paper and electronic communications with numbers (mostly numbers that follow a $-sign) and contracts on them.  That is it.  What could those numbers and contracts possibly add to the lives of ordinary people who produce and/or consume real goods and services?

This is an important question because finance has been growing as a share of GDP.  More and more of our annual income is going to the people who shuffle those numbers around instead of to people who actually make things that we use and do the work of teaching, cleaning, creating music, and other services.

Finance is purely an intermediary good that nobody wants for its own sake.  The only point of finance is to help us produce more of the right mix of goods and services at the right times.  Otherwise finance is useless.  Unfortunately, since WWII, finance has been getting less and less efficient at helping us produce primary goods and services.  The graph shows that it has been eating up an increasing share of our national income.

Finance is the central nervous system of the body of capitalism.  It commands where energy and matter should flow, and when.  Capitalism cannot survive the death of finance any more than a human can survive total brain death.  Even though the health of the rest of the body may be perfect, it will immediately die when the information processing power of the central nervous system stops working.  This kind of metaphor should make bankers feel pretty big and important, but really everything is interdependent.  Finance cannot survive without agriculture any more than our brains can survive without our digestive systems.  Finance needs the other sectors of the economy like education, transportation, and government just as much as the rest of the economy needs finance.  But, like our brains, finance is more fragile than other crucial sectors of the economy and can seize up all on its own.  It was the equivalent of a financial seizure that caused the great depression and the great recession of 2008.

So what does finance do to make our lives better off (when it is functioning properly)?

  1. It facilitates saving.  Without finance, the only way to save is to stockpile physical goods that you can use later.  Finance allows us to save virtual goods.  Financial savings are claims on other people’s goods in the future.  That is really what money is.  It is an IOU to provide stuff in the future.  This makes people better off because they can smooth their consumption during times when they cannot work like during an illness or retirement.
  2. It facilitates borrowing.  Borrowing is the other side of the savings coin.  The only way to have savings (other than to stockpile physical objects) is to get other people to borrow your money.  Borrowing is useful because it helps increase productivity (or ‘capital’ in econospeak).  Many people who have ideas for investments in greater future productivity (like getting a college education), do not have the money to pay for that productivity investment.  If they can borrow the money, they can buy things that will help them become more productive later.  And higher productivity will help them pay back the loan with interest.
  3. Insurance:  Finance eliminates financial risk through the law of large numbers and redistributes money from people who are feeling comfortable with their financial situation to people who need the money more due to a personal financial emergency.  This is what insurance does.
  4. It facilitates transactions between strangers across distances of time and geography that is a miracle of trust.
  5. It facilitates the communication of information via the price system.  This is how finance is like a central nervous system.  Foreign exchange markets tell people if they should import more (because foreign goods are cheap) or less (because they are expensive).  Interest rates tell people if they should borrow more or save more.  Most of the information is provided by diffuse market players.  Speculators can sometimes help markets work better, but they can also contribute to violent swings.  This is perhaps the most important role of finance.

That is about it.  How could finance have increased its share of the income at the expense of the rest of us in ‘the real economy’?

  1. Increased savings?  Nope.  Savings was down until the 2008 crisis and has recovered somewhat since then.
  2. Increased borrowing?  Finance has accomplished increased debt (pdf) despite stagnant savings via increased leverage until 2008.  Total borrowing has fallen somewhat since then.
  3. Increased insurance?  I don’t know of any measures.  The rising cost of healthcare has increased health insurance as a fraction of the economy despite more uninsured people.  There should be more annuities as the population ages.  Extended warranties have boomed, and they are a kind of insurance, but they mostly take advantage of naive consumers rather than decrease risk and help people out of financial emergencies.
  4. Transactions fees between buyers and sellers may have risen, but this isn’t adding value to people’s lives.  It is subtracting value.  As electronic payments account for a growing share of purchases, the monopoly power of the companies that own these networks (mainly Visa and Mastercard) is producing ever greater fees.  Hopefully, this is more efficient than using cash or checks, so this might be an increase in productivity, but society would be even more productive if they did not charge 2% of every purchase plus exorbitant late payment fees and other charges.
  5. Other? Where are all the increased financial industry profits coming from?  Why isn’t anyone working on answering this?

Has the expansion of finance been good for the median American?  Finance was working well from the depression until the 1970s when finance was stagnant and median income grew robustly, but since then the median income has stagnated and much of the increase in inequality can be explained by the rising incomes of billionaires working in finance.  Almost a quarter of the top 1% highest-income Americans work in finance.  Why have salaries been rising so fast in finance?  Why have financial profits been rising?  What has finance been doing for the rest of us?  Financial innovation has inflated salaries and profits in finance, but has it helped anyone else?  Paul Volker famously said that the only useful financial innovation of the past two decades was the ATM.  Most of the other financial innovations have led to financial crises.

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