I had pointed earlier to a superb lecture on Inequality in US by Frank Levy where he said:
When we say that the top one percent of tax filers now receive something over 17 percent of all taxable income, it will not surprise you that a significant fraction of that top 1 percent comes from the financial sector.
I had covered the concerns from various angles financial innnovation, my views on modern finance and then this one on political economy of finance where I pointed to a comment from Liz Warren (Harvard Law Professor)
The consumer financial services industry has been the single biggest contributor in the 2000 election cycle, in the 2002 election cycle, and they’re on target to do it again in the 2004 election cycle. George W. Bush’s single biggest contributor to his  presidential campaign was MBNA, the second biggest credit card issuer in the country.
And now I came across this superb lecture from Kemal Dervis, Administrator of the United Nations Development Programme. (I came to know about the lecture from this superb Dr Virmani presentation). The lecture is on developments in World Economy and Mr Dervis touches on financial sector as well.
It seems clear that the last two decades have been characterized by rapid and accelerating world growth, with the trend interrupted three times: around 1997, around 2001 and now again around 2008, although we do not know yet how serious this interruption will be. These recent interruptions are not associated with wars or periods of trade disintegration. Instead all three of them have been caused by financial sector difficulties of a more or less global nature.
The causes..irrational exuberance
In all three cases it was a certain “irrational exuberance” in the financial sector that led to the shock. The Asian crisis was caused by excessive private capital flows to the emerging markets with very open capital accounts and excessive appreciation of assets in or relating to these emerging markets.
The dot com crisis was caused by a similar type of exuberance, but this time focused on the new high-tech and start up enterprises linked to the information technology revolution, mostly in the United States. When the bubble burst the crash was quite severe in that sector.
In the ongoing crisis we have seen enough irrational exuberance (call it greed). What about the policy responses?
Moreover, as had been the case with the Asian crisis, there was a vigorous policy response in the form of greatly expansionary fiscal and monetary policies in the United States. The fiscal balance changed from a 2.4 percent of GDP surplus in 2000 to a smaller surplus of 1.3 percent in 2001 and deficit of 1.5 percent in 2002 and almost 3.5 percent in 2003 (US CBO 2008). The federal funds rate set by the US Federal Reserve was lowered from 6 percent in early January of 2001 to 3.75 percent in late une of 2001 to 1.25 percent by November of 2002 and further to 1 percent by June of 2003.
It is important to note whereas Asian policies are always criticised, the developed world is no better. As I always say, in times of crisis all policymakers act in a similar way with monetary easing and fiscal stimulus. However, in developed we call this “prudent policies” and for others it is called “careless polices”. The latter are called careless as no lessons are learnt (moral hazard) …we don’t see any lessons learnt in former as well. Above all by cutting interest rates, they lead to huge inflows in emerging economies.
Back to finance
Over this period capitalism in the rich countries has increasingly changed its nature from one where the lead sector was manufacturing, to one where the role of traditional industries has declined, the share of services has increased and the financial sector is playing a leading role. Figure 4 presents a rather amazing picture. In the early 1980s the share of the financial sector in both, corporate value-added and profits in the American economy, was about 5 to 6 percent. The share of financials in value added has steadily increased and has reached about 8 percent in 2006-2007. The share of profits, however, climbed to reach an extraordinary 40 percent and more!
At the end of the day, the rate of return on financial assets on average and over the long term, must reflect the rate on return in the real economy. That rate of return can be higher than the growth rate, but it cannot be expected to be multiple times the real growth rate of GDP. If real growth in an economy is 3 percent, which is the maximum rate at which most analysts say potential output can grow in the most advanced economies, than it is simply not reasonable to insist on 12 or 15 percent profit rates.
Yeah 40%. So out of every $ 100 of profits, 40 go to the finance sector in US. He also suggests that financial sector is important but what we see is short termism in the financial transactions:
Many believe that this much increased role of the financial sector works in favour of greater efficiency, by forcing out lethargic managers, encouraging a relentless search for greater productivity and profits, and allowing a constant restructuring and adjustment that increases flexibility and innovation throughout the economy. All this may be quite true but the pre-eminence of the financial sector also imparts a greater amount of “short-termism” to the system with immediate profits a more important driver than long term considerations.
So what do we do? Regulation
To avoid this constant repetition of the same scenario, it would seem to be highly desirable to regulate and supervise the financial sector in such a way that incentives become more symmetric, so that losses also have serious personal financial consequences for those whose decisions cause them, and that rewards are tied to long term success, rather than quick short term gains. This requires a degree of intrusive public policy that is not necessary in other sectors and will be resisted.
Finally, a superb food for thought
The fact, however, is that the financial sector can never be a purely private affair. It is at the heart of the modern market economy and plays an organizing role that is a public good. Its failure affects the whole economy and all citizens. The public policy maker cannot let the financial sector fail in a systemic manner and has to, in one way or another, rescue it. It is important and fair, therefore, that it is regulated in a way that encourages responsibility, a longer term horizon and an evaluation of risk by its managers, that is not truncated by the unavoidable need for the socialization of large losses.
Great speech, with lots of insights. Highly recommended.