Is the Financial Sector Worth What We Pay It?

by John on October 19, 2012

Plenty more where that came from!

(This article is cross posted from my article for OECD Insights where they provide discussion of a wide range of subjects that influence world development)

A basic capitalist tenet is that the market represents the most efficient way to allocate capital. How well is it working?

We are rapidly evolving a fast-moving, increasingly cybernetically interlinked capital marketplace that, as Lord May observes in the Santa Fe Institute Journal, has become intertwined in ever-more complex interdependent patterns. He goes on to ask how much are we, societally, paying the financial sector to allocate capital? More importantly, is the sector allocating capital to further societal goals, or merely enriching itself and a narrow segment of the world’s population? Human nature is powerful. John Stuart Mills said, in Social Freedom: “Men do not merely desire to be rich, but richer than other men”.

Benjamin Friedman holds, in The Moral Consequences of Economic Growth, that “greater opportunity, tolerance of diversity, social mobility, commitment to fairness and dedication to democracy” derive directly from economic growth. He shows that even during stagnation–let alone recession and depression–those values can vanish easily. Brad Delong observes, in reviewing Friedman, that if the majority of the people do not see an improving future, these values are at risk even in countries where absolute material prosperity remains high. Given rising political intransigence and loss of common social purpose in the U.S., and the rise of nationalistic political sentiments in Europe, the effects of increasing stagnation and inequality are becoming more evident, despite the financial sector’s phenomenal growth.

In a 2006 speech on the growing integration of the financial sector and the broader economy, Rodrigo deRato, Managing Director of the IMF, noted its supposed general stability and growth, and that from 1990-2005 the estimated sum of equity-market capitalization, outstanding total bond issues (sovereign and corporate) and global bank assets rose from 81% to 137% of GDP, while over-the-counter derivatives markets tripled in the latter five years to $285 trillion, six times global GDP, 50 times the U.S. public debt. So if the financial sector has worked, we should see proportional acceleration of growth plus improved consequences for all society.

This is not happening, as Cornia and Court report in Inequality, Growth and Poverty in the Era of Liberalization and Globalization.Global poverty reduction has stalled for 30-40 years, despite an approach to growth based on “…a neo-liberal policy package, [including] stringent focus on macroeconomic stability, liberalization of domestic markets, privatization, market solutions to the provision of public goods, and rapid external trade and financial liberalization.” They reveal that inequality has grown faster during the same period in the majority of countries for which data is available. The paper also shows that increased inequality greatly encumbers the climb from poverty and that excessively low or high levels of inequality impede growth, provoking various ills, including crime, social conflict and uncertain property rights. In the US, bank employees were found to be signing thousands of foreclosure documents without checking the information in them in so-called robo-signings that rendered the documents illegal.

All the data seem to affirm Friedman’s assertion that all societal strata should participate to maximize the moral benefits of economic growth. Further support can be found in Court’s conjecture about an optimum range of equality. This is confirmed by modeling work at Dominican University, discussed in a previous OECD Insights post, which shows that there is indeed an optimum level of equality for a given economic structure useable for policy planning, to insure capital allocation to economic growth for public purposes. Returning us to Lord May’s point that we must know how much economies are ‘paying’ the financial sector to allocate capital, including payments to banks, sovereign funds, hedge funds, private equity, and the managers, often in major international banks, of the estimated $21-32 trillion of largely secret “offshore” financial assets.

The financial crisis and subsequent Euro problems show that we are paying vast sums for a system that, as Joseph Stiglitz, former chief economist of the IMF, points out, doesn’t allocate capital where needed, causing capital flows that are pro-cyclic, exacerbating peaks and lows of business cycles.   What efficient capital distributive function is served by the approximately $1.5 trillion of daily flows sloshing about in the casino of OTC foreign exchange activities, and the nearly 70% of all U.S. market trades conducted algorithmically, without human intervention?

Keynes may have lost the 1944 Bretton Woods battle for a solution that transcended national financial self-interest but his plans for an international clearing agency are prophetic, especially considering how the combined financial sector dominates national and international policy for its own ends “ As Keynes said, “… no country can . . . safely allow the flight of funds for political reasons or to evade domestic taxation or in anticipation of the owner turning refugee. Equally, there is no country that can safely receive fugitive funds, which constitute an unwanted import of capital, yet cannot safely be used for fixed investment.” Right again, Lord Maynard.

Useful links

OECD work on financial markets

{ 5 comments… read them below or add one }

Katz October 20, 2012 at 3:55 am

Yet democratically elected governments from the 1970s onwards enacted the dismantlement of the Bretton Woods system. Governments that attempted to resist this dismantlement found themselves threatened by a capital strike.

Fast forward to the second decade of the 21st century and we see that virtually nowhere does any major political party espouse the return of anything like a Bretton Woods system.

Any party in a western democracy that espouses restrictions on cross-border capital flows will face electoral annihilation.

Perhaps voters haven’t suffered sufficiently yet.

Globalism of finance, though not globalisation of labour mobility, are more the consensus today than in the 1970s, despite the disruption of the GFC.


Koen Deconinck October 20, 2012 at 12:01 pm

Hi John,
I haven’t read the Cornia and Court report you refer to, but I’m surprised to read that “Global poverty reduction has stalled for 30-40 years” – assuming that by global you mean “across the planet”, I don’t understand where that’s coming from. Using the World Bank “dollar-a-day” extreme poverty line, both the poverty headcount and the poverty rate have fallen dramatically between 1980 and today – from roughly 50% of world population to 25%. (See this article by Chen and Ravaillon for instance: ; this one’s behind a paywall but there are working paper versions around).

I don’t necessarily disagree with your claims about the financial sector, but I think you’re being overly pessimistic about global poverty!


John October 20, 2012 at 1:08 pm

The UN World Institute for Development Economics Research has a developing database at which is the basis of their analysis. They do use some World Bank information. The UN-WIDER site is well worth visiting.


Tyler Durden Volland October 22, 2012 at 4:45 pm

“Is the Financial Sector Worth What We Pay It?”

Excuse me… but I do not understand the question… I cannot see the connection…

“What we pay” is a simple question of power, and if someone has it, then they will get paid.

Please explain to a non-American, where you see a connection to “is the return we get worth it”?

What is this? A blog for 12-year olds?


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