Winston Churchill once remarked, when he was chancellor of the exchequer, that he would rather have finance less proud and industry more content.
Were he still alive, Churchill would find the position little changed: industry remains frustrated by its low relative status in the British economy. But the issue with finance is now not so much its pride (although that remains considerable) as its size. Finance has grown way too big relative to the real economy. In this month’s cover story, I explore the reasons that made this—and the scale of the economic crisis it has precipitated—possible.
The statistics are certainly astonishing. In the 1960s, finance accounted for just 10 per cent of corporate profits in Britain and America. By 2006 this had risen to 35 per cent. Last year, a staggering one in five Britons earned their living in finance. As George Soros has remarked, it is manifestly an “overblown” sector, and needs to shrink. Yet this size is a puzzlement even to those who, like Soros, have done well out of it.
For a long time, academics clung to the notion that finance performed a useful role, shunting capital to its most profitable outlet. If you accepted that, more finance was inevitably a good thing, as it meant the economy was becoming more efficient. Thanks to increasing distortions in financial markets and greater frequency of crashes, this idea has come under increasing attack. Now, drawing on recent research done by Paul Woolley, I make the case that finance is not efficient but dysfunctional—and that accepting this is a vital first step if we are to recover from the current economic crisis.