We used to think that finance performed a useful role, shunting capital to the most profitable outlets. Its growth was thus a function of success. But after the crunch, a new generation of critics, such as Paul Woolley, are challenging this thesisby Jonathan Ford / November 23, 2008 / Leave a comment
The enormous growth of the financial sector is one of the wonders of our age. In the 1960s the business of banking, broking and insuring accounted for just 10 per cent of total corporate profits in most developed economies. By 2005, this proportion had swelled to nearly 35 per cent in the US and roughly the same in Britain—the two countries that host the world’s largest financial centres. Last year a staggering one in five Britons earned their living in finance.
Of course, the profitability of the financial sector is declining on account of the credit crisis. But the politicians and financial authorities have felt obliged to plug the holes that have appeared in a deflating system with vast public support, and now even direct capital injections. Finance is now not only big, but worryingly unstable. Moreover, embedded in this growth is a mystery. Whereas companies such as Microsoft and Google have risen by devising products that have added to the productive capacity of the economy, finance provides no such final good or product. It is a utilitarian mechanism for bringing together savers and borrowers, and this has not changed markedly since the 1960s (although, as we shall see it has become considerably more complex). So what explains its relentless expansion?
This question is far from idle. It perplexes even those who have benefited mightily from finance’s advance. George Soros recently observed in a Prospect roundtable (July 2008) that the sector had got overblown and needed to shrink. “The size of the financial sector is out of proportion to the rest of the economy. It has been growing excessively… ending in this super-bubble of the last 25 years.” Another financier turned academic, Paul Woolley, has come up with a powerful critique questioning whether the growth of the sector has benefited society and suggesting that super-sized finance is levying an unjustifiable tax on the productive economy.
Various attempts have been made to explain the mushrooming of finance. In the 1970s and 1980s, as the sector started its relentless climb, economists and others rationalised it by applying to finance the conventional wisdom that views competition as a guarantee of efficiency, and profits as a reward for doing a useful job well.
This was not unreasonable. After all, financial services companies do compete and can earn big profits. Not all are winners: for every Goldman Sachs there is a Barings or…