Financial Reform: It’s About Improving the Financial System, Not 2008

February 08, 2016

Dean Baker
Truthout, February 8, 2016

View article at original source.

As the Democratic presidential race heats up, the debate on financial reform has taken a bizarre twist. Somehow the measure of a good reform is its ability to prevent another 2008-type financial crisis.

While it is reasonable to subject a reform agenda to the 2008 test, this should be at most a side issue. After all, it is virtually certain that our next crisis will not look our last crisis. Financial reform first and foremost is not about preventing the last crisis, but rather about designing a financial system that more effectively serves the rest of the economy.

Finance is an intermediate good like trucking. It does not directly provide value like food or health care, the value in the financial sector depends exclusively on its ability to make the rest of the economy function better. This means effectively getting money to businesses and households who need to borrow. And it means providing safe investment vehicles for people to save for retirement or other purposes.

An efficient financial sector provides these services using as few resources as possible. With that in mind, it is hard to make the case that our financial system is efficient. It has exploded in size relative to the rest of the economy over the last four decades, with the narrow commodities and securities trading sector increasing fourfold.

If we were spending four times as much on trucking as a share of GDP in 2016 as we did in 1976, people would be looking for an explanation. If we could show that goods were getting around the country much quicker and we had many fewer problems with spoiled food or damaged merchandise, then perhaps the additional cost of the industry would make sense. But it is difficult to make this sort of case with finance.

Can anyone say with a straight face that we think capital is being allocated today than it was four decades ago? If so, this better allocation is not showing up in productivity growth. Since 2005 productivity growth has averaged just 1.1 percent annually. By contrast it averaged almost 3.0 percent annually from 1947 to 1973. Clearly many factors explain this slowdown, and perhaps productivity growth would have slowed even more without the expansion of the financial sector, but that seems a hard case to make.

The other side of the coin is whether people feel secure in their savings. Given the sharp gyrations in financial markets over the last two decades, it is hard to imagine people view their savings as safer today than in the three decades following World War II when the financial sector was much smaller.

In this context, Senator Bernie Sanders’ proposal for a financial transactions tax makes a great deal of sense. This would reduce the money spent on financial transactions by tens of billions of dollars annually, freeing up the resources used shuffling stocks, bonds, and derivatives for more productive purposes. Downsizing the industry in this way should be a central feature of any serious plan for financial reform.

It also makes sense to downsize the largest banks. We can debate whether “too big to fail” is over. It is hard for me to believe the government would let J.P. Morgan or Goldman Sachs go under if they faced bankruptcy, but let’s flip the question around.

Why should we allow banks to be so large? Megabanks are relatively new to the economy. We didn’t have these behemoths in the 1960s, 1970s, or even the 1980s. What would be wrong with going back to an era before all the large banks merged with each other? Most research indicates that banks can achieve all economies of scale at sizes that are an order of magnitude smaller than our biggest banks.

We often hear the argument that if we didn’t have megabanks we would lose out to foreign competition. This wouldn’t make sense even if it were true. We buy cars from Japan and shoes from China, why should we care if we get financial services from Swiss or French banks?

In addition to the too big to fail issue, there is also the political power issue. Our largest banks clearly have enormous influence. This can be seen simply by the fact that big bank CEOs like Jamie Dimon and Lloyd Blankfein (J.P. Morgan and Goldman Sachs, respectively) are widely known. How many people can identify the CEO of Boeing, the world’s largest airplane manufacturer or Walmart, the world’s largest retailer?

The banks use their power to craft regulation to meet their needs. Smaller banks can lobby as well, but are likely to be less effective than a small number of very large banks.

Finally, there is the question of whether bankers can go to jail. This is not a question of vindictiveness; it is a question of effective enforcement. Bankers can reasonably expect that most violations of the law will not be detected. If they as individuals do not face serious consequences on the occasions where they do get caught, then breaking the law becomes a one-way proposition.

The higher profits from law-breaking mean higher bonuses and more valuable stock options. Getting caught is embarrassing, but even in this unlikely event many executives may still come out ahead. If there is not a serious threat of imprisonment, the incentive structure does not encourage bank executives to take regulations seriously.

The basic point here is simple: we need to both downsize the financial industry and the largest firms in the industry. There is no doubt that the financial industry plays a crucial role in the economy. But we won’t have gotten the sector right until a bright young Harvard grad has as much cause to brag about a job in the trucking industry as a job on Wall Street.

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