Thursday, 31 March 2011

The financial sector is sitting on an unjustified pedestal

Forget his debatable feats as chairman of the Federal Reserve, Alan Greenspan's article in the Financial Times on Wednesday raised an insightful question that I wish was being addressed too: To what extent does a large and 'sophisticated' financial sector improve our quality of life?

Greenspan's comment piece points to problems implementing the Dodd-Frank Act, a broad set of principles designed to stop the excesses that caused the financial crisis from happening again in the USA. He argues that the lawmakers and regulators tasked with turning the principles into a set of regulations, will 1) be unable to produce a list of regulations that could deal with all possible future crises (several regulatory bodies failed to foresee the 2008 crisis!), 2) create inconsistencies among the numerous rules, and 3) fail to acknowledge the degree of global interconnectedness in the financial sector.  

Dodd-Frank has its flaws, but complicated regulation, admittedly with holes in, is the cost of complex modern day financing, which we need to maintain economic growth. Right? 

The assumption that the modern state of finance is necessary for economic growth has pervaded the air. Since the second world war, the share of GDP devoted to finance in countries like the UK (one measure of the rising complexity of the system) has increased alongside a rise in living standards, but it is not obvious that there has been a causal relationship. A complex financial sector might increase the wealth of a minority with the know how, and there are reasons to think that their disproportionate wealth could reach others through some sort of trickle down effect, but is that enough when, as we well know, the financial sector can create such instability and crisis for us all?! 

Ireland has had to put aside about €70bn to bail out its banks, an amount equal to over half its GDP! Ireland has borrowed this money from its own people, who will also be paying for the servicing of the debt for many years to come. To put it into perspective, consider that Ireland is borrowing the equivalent of €35,000 per citizen, which is equal to the average annual wage before tax! 

Banking crises won't go away, but regulation and reforms can be put in place to reduce risk and contain the cost of crises when they occur. In deciding the best steps forward, we seem to be faced with a tradeoff between reduced risk and economic growth i.e. reforms that significantly reduce risk, such as a return to the simpler banking practises of half a century ago, will sabotage economic growth. 

I think the modern financial sector is sitting on an unjustified pedestal. The UK government, and policy makers worldwide, need to consider the long term and take heed of Greenspan's comment that: "In moving forward with regulatory repair, we may have to address the as yet unproved tie between the degree of financial complexity and higher standards of living."  

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