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Andrew Glyn
© Andrew Glyn 2007
Adam Smith described money as the "great wheel of circulation". By facilitating economic expansion, the financial system plays its part in raising living standards. For these functions the banks have always taken their cut. However this has increased dramatically in recent decades. US financial companies earned 10-15% of total US corporate profits in the 1950s and 1960s, but now account for 30 - 40% of the total. If profits from the financial activities of industrial and commercial companies are included, finance in this broader sense could soon account for a majority of US corporate profits.
This trend for finance to grow much faster than the "real" economy is also apparent in the UK and elsewhere. In return for absorbing a rising share of society's resources, especially highly qualified workers, what is being delivered in return?
A sophisticated financial system is supposed to encourage capital accumulation, and the massive real investments made in telecoms during the Internet boom seem an excellent example. By 2002, however, less than half of the US telecoms capacity was being used. Michael Jensen, a leading finance academic and proselytiser for the financial markets' drive for shareholder value, noted bitterly that investment banks had played their part in the "catastrophic overvaluation" of stock markets by contributing to the "misinformation and manipulation" that fed it. If this process was the "creative destruction" that Joseph Schumpeter described, then the scales came down heavily on the destructive side. After the bust, capital stock growth in the USA fell more steeply than in any post-war recession. Throughout the OECD capital stock has been growing at barely 2 per cent per year since 2000. This is less than half the growth rate of the 1960s when the financial sector was tightly constrained, and lower even than in the 1970s when macroeconomic conditions were so turbulent. The dynamism of world capital accumulation is centred in China and other developing economies whose financial sectors are thus far much less "sophisticated".
In the UK, of course, the City occupies a special position. The financial services sector is often promoted as a key factor in the balance of payments, helping to fill the gap left by enfeebled manufacturing. In fact this contribution is quite modest. In 2005 overseas earnings from the provision of insurance, banking and other financial services was about £21billion, only one tenth of earnings from exporting goods.
The downsides of the extraordinary expansion of finance are all too apparent in the current controversy about the tax breaks enjoyed by private equity companies. These institutions, together with the hedge funds, whose leading managers "earn" hundreds of millions of dollars each year, have made a major contribution to the appalling rise in inequality at the top of the income distribution, especially in the UK and USA.
Even more serious, the financial sector itself is a potential source of disastrous instability for the "real" economy inhabited by the rest of us According to recent data there are now 9,000 hedge funds world wide, the value of their assets has grown from $221 billion in 1999 to $1,223 billion in 2006, and they are now responsible for 25-50% of the turnover on many financial markets. The bets they make can go spectacularly wrong as shown by regular collapses of individual funds - 10% of those in existence disappear each year!
The problems posed by the activities of these funds are evident in assessment after assessment from the international financial institutions. The Financial Times (June 2, 2006) main headline announced "ECB [European Central Bank] Warns of Hedge Fund Threat to Stability" and reported that the bank had likened the collapse of a key hedge fund to a bird flu pandemic as the sort of shock which could trigger fresh disruption in financial markets. The IMF's Global Financial Stability Report noted in 2006 that should economic growth slow or inflation rise "it is reasonable to wonder whether financial markets might react to less favourable developments in a way that would amplify - rather than dampen - the emerging risks. In particular concerns have been raised about the potential for illiquidity to emerge in response to unexpected stress in markets for new and complex financial instruments". A wide ranging assessment by William White of the Bank for International Settlements, the central regulatory body for the international financial system, drew the alarming conclusion that "the modern financial system seems to be subject to a wide range of problems: operational disruptions, institutional insolvencies, short-term market volatility, medium-term misalignments and contagion across countries and markets."
Gerald Corrigan, a former president of the New York Fed and now a partner in Goldman Sachs, claimed there was also agreement amongst leading bankers that "another major shock is likely and that the potential damage could be greater". Mr Corrigan gives three reasons for this increased toxicity: speed, complexity and tighter linkages across institutions and markets, as the system has become more integrated thanks to financial innovation. 'The trouble', he adds, 'is that we do not have the capacity to anticipate the timing and triggers of such a shock - every now and then stuff happens.'" (Financial Times January 30, 2007.)
The fact that spectacular crashes by individual hedge funds have not yet brought a major financial crisis is frequently used as evidence of the resilience of the financial system. The conclusion is drawn that there is no reason to regulate them despite the fact they exist in what has been described as a "regulatory black hole". Ben Bernanke, Alan Greenspan's successor as Chairman of the US Federal Reserve, has argued that it made "economic sense" to allow those who lend to hedge funds to monitor the risks involved rather than impose regulation from outside. But the highly profitable lending by the banks to hedge funds was called by one respondent to a Financial Times survey "the crack cocaine of the financial system". Can drug dealers really be trusted with ensuring that the addicts do not overdose?
Andrew Glyn teaches economics at Oxford University and is the author of Capitalism Unleashed published by Oxford University Press.
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