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Starving the Squid

BERKELEY – Is America’s financial sector slowly draining the lifeblood from its real economy? The journalist Matt Taibbi’s memorable description in 2009 of Goldman Sachs – “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money” – still resonates, and for good reason.

Back in 2011, I noted that finance and insurance in the United States accounted for 2.8% of GDP in 1950 compared to 8.4% of GDP three years after the worst financial crisis in almost 80 years. “[I]f the US were getting good value from the extra…$750 billion diverted annually from paying people who make directly useful goods and provide directly useful services, it would be obvious in the statistics.”

Such a massive diversion of resources “away from goods and services directly useful this year,” I argued, “is a good bargain only if it boosts overall annual economic growth by 0.3% – or 6% per 25-year generation.” In other words, it is a good bargain only if it collectively has a substantial amount of what financiers call “alpha.”

That had not happened, so I asked why so much financial skill and enterprise had not yielded “obvious economic dividends.” The reason, I proposed, was that “[t]here are two sustainable ways to make money in finance: find people with risks that need to be carried and match them with people with unused risk-bearing capacity, or find people with such risks and match them with people who are clueless but who have money.”

Over the past year and a half, in the wake of Thomas Philippon and Ariell Reshef’s estimate that 2% of US GDP has been wasted in the pointless hypertrophy of the financial sector, evidence that America’s financial system is less a device for efficiently sharing risk and more a device for separating rich people from their money – a Las Vegas without the glitz – has mounted.

This is not a partisan view. Bruce Bartlett, a senior official in the Reagan and George H. W. Bush administrations, recently pointed to research showing the sharp rise in the financialization of the US economy. He then cited empirical work suggesting that financial deepening is useful only in the early stages of economic development, evidence of a negative correlation between financial deepening and real investment, and the withering conclusion of Adair Turner, Britain’s former top financial regulator: “There is no clear evidence that the growth in the scale and complexity of the financial system in the rich developed world over the last 20 to 30 years has driven increased growth or stability.”

Four years ago, during the 2008-9 crisis, I was largely ambivalent about financialization. It seemed to me that, yes, our modern sophisticated financial systems had created enormous macroeconomic risks. But it also seemed to me that a world short of risk-bearing capacity needed virtually anything that induced people to commit their money to long-term risky investments.

In other words, such a world needed either the reality or the illusion that finance could, as John Maynard Keynes put it, “defeat the dark forces of time and ignorance which envelop our future.” Most reforms that would guard against macroeconomic risk would also limit the ability of finance to persuade people to commit to long-term risky investments, and hence further lower the supply of finance willing to assume such undertakings.

But events and economic research since the crisis have demonstrated three things. First, modern finance is simply too politically powerful for legislatures or regulators to restrain its ability to create systemic macroeconomic risk. At the same time, it has not preserved its ability to entice customers with promises of safe, sophisticated money management.

Second, the correlations between economic growth and financial deepening on which I relied do indeed vanish when countries’ financial systems move beyond banks, electronic funds transfer, and bond markets to more sophisticated instruments.

Finally, the social returns from investment in finance as the industry of the future have largely disappeared over the past generation. A back-of-the-envelope calculation of mine in 2007 suggested that the world paid financial institutions roughly $800 billion every year for mergers and acquisitions that yielded about $170 billion of real economic value. That rather poor cost-benefit ratio does not appear to be improving.

Back in 2011, I should have read Keynes’s General Theory a little further, to where he suggests that “when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” At that point, it is time either for creative thinking about how funding can be channeled to the real economy in a way that bypasses modern finance, with its large negative alpha, or to risk being sucked dry.