September 06, 2023
As everyone learns in Econ 101, and immediately forgets, the purpose of the financial sector is to facilitate transactions and allocate capital. This seems like a simple and obvious point, but you would never know it in most discussions of the financial sector.
The point here is that we need finance for these purposes. We don’t need finance to develop elaborate betting games and complex financial instruments. Financial instruments are only useful when they serve the purpose of better facilitating transactions or improving the allocation of capital.
In this context, an efficient financial sector is a small financial sector. We want to use as few resources as possible to serve its function, just as we want to use as few resources as possible in the trucking industry.
Like finance, transporting goods is hugely important to the economy. But if the number of people and the amount of capital involved in the trucking industry doubled relative to the size of the economy, it would look like we had a very inefficient trucking industry, unless there was some obvious benefit, like radically reduced waste.
For some reason, finance is never talked about this way. That comes to mind in reading this NYT piece on the $700 million spent on legal fees in the bankruptcy cases of major crypto companies. Of course, $700 million is not huge relative to the size of the economy, but it is a lot of money to most of us. It’s equivalent to more than 320,000 food stamp person years, to take something people like to complain about.
Anyhow, when we see this $700 million figure for legal fees, it is worth asking exactly how crypto is helping to facilitate transactions or better allocate capital. Are we more quickly able to pay our monthly bills if we use crypto rather than a credit card with automatic withdrawals from our bank account?
Is crypto better allocating capital? Are there innovative startups that are getting capital with Bitcoin that could not raise money through the traditional financial system?
I’ve heard that the FTX folks did lots of drugs before its collapse wiped out their fortunes. It would probably take a lot of drugs for someone to answer “yes” to these questions. The money that went to the crypto gang has been a huge drain on the rest of the economy.
The $700 million in legal fees is just a tiny tip of the iceberg. The fortunes that many have accrued, in effect peddling nothing, is like counterfeit money that they will use to drive up the price of housing, travel, and anything else that is in limited supply in the economy.
This indictment can be directed at the financial sector more generally, which has exploded relative to the rest of the economy over the last half-century. To be fair, some innovations are real. Direct deposit of paychecks and direct payments of bills provide substantial savings in time. But these have been around for four decades.
The proliferation of derivative instruments and complex trading strategies has made some people very rich, but it does nothing to facilitate transactions or improve the allocation of capital. We waste hundreds of billions of dollars (several thousand dollars per family) supporting our bloated financial system.
A small financial transactions tax, similar to the sales tax most of us pay when we buy food, clothes, and most other items, would do wonders for improving the efficiency of the financial system and raise well over a hundred billion dollars annually. And, it would go far towards reducing inequality by eliminating many of the great fortunes made in finance.
But, there is little interest in this point in major media outlets. We can speculate on the reason, but as I said, the purpose of the financial sector is something that is forgotten immediately after leaving Econ 101.