Martin Wolf's speech at the launch of the Brevan Howard Centre
Martin Wolf, Associate Editor and Chief Economics Commentator for the Financial Times, gave a keynote speech at the launch of the Centre. Below is the text of the speech.
29 September 2014
What we should want to know about Finance
“The war situation has developed not necessarily to Japan’s advantage.” This notorious comment by former Japanese Emperor Hirohito can also be applied to the development of an ever-larger financial sector and ever-greater financial activity in our economies. The results have not been what many hoped and most expected. They include a massive credit boom, a huge financial crisis, a gigantic loss of wealth, a prolonged rise in inequality and, in many economies, relatively poor aggregate economic performance. The creation of a new centre dedicated to the study of finance here in London is, therefore, timely. But it will be most valuable if it encourages people to ask the big questions about the current status and future prospects of finance.
Of the importance of finance, I have no doubt. It is the brain of any market economy. Its jobs of allocating capital, providing insurance and guiding business decisions are of paramount importance. That is why finance matters so much. But it is also why the malfunctioning of finance matters so much. Brain fever in finance may be devastating.
Today, surely, few can deny that finance malfunctioned seriously. At the end of a huge credit boom, our economy and that of many others had built up massive quantities of debt, particularly for the finance of property transactions. We then suffered a global financial seizure. In response to that seizure, governments felt obliged to put their entire balance sheets behind the core financial system. This surely is an astounding fact.
Central banks subsequently found it necessary to reduce interest rates to near zero, a condition that has now endured for some five year (and in the case of Japan for up to two decades). Even that was not enough. Central banks also expanded their balance sheets massively. Yet, despite all this effort, the recovery in the high-income economies has been anaemic, at best, with particularly poor productivity performance.
Beyond the issue of the dynamic instability of the system, there are also big questions about the distribution of the gains generated by financial sector activity and its impact on economic efficiency. Taking a view over the whole scene, Adair (Lord) Turner, former chairman of the Financial Services Authority, judged much of the activity to be “socially useless”. That may be a little harsh. But there is very far from a consensus on how much of it is actually socially useful. After the crisis, certainly, we cannot simply assume that what is profitable is a priori also of wider economic and social benefit. The pre-crisis activities looked profitable. But it would be a bold person who would insist that it was all of economic and social benefit.
So what are the questions that need to be addressed by serious researchers today? Here are ten issues that seem to me to be of huge importance, with massively significant unanswered questions.
First, how do the macroeconomics of finance work?
The financial sector, unlike almost any other sector, has huge impact on the stability of the entire economy. Indeed, I think of it as more like the nuclear power industry than anything else. When everything is going well, it provides a number of essential services. It is essentially an important utility whose job it is to look after people’s money and allocated funds sensibly. But when things go badly, finance may blow up the economy.
What do we need to understand here? We need to understand the nature of systemic risk and what causes it. This is partly a matter of the complex interconnections among institutions. But the core of it surely is that the liabilities of the core financial institutions are seen by their owners as safe and liquid, while their assets are neither safe nor liquid. This, at bottom, the financial sector is, in the best and worst senses, a “confidence trick”. Periodically, this confidence trick breaks down, with disastrous consequences and, because of pervasive ignorance of what lies in the financial sector’s balance sheets and what it is worth, that loss of confidence is contagious.
An important element in systemic risk lies in how the financial sector creates it. Hyman Minsky, a largely disregarded, but prescient, author, argued, above all, that stability destabilises – a powerful insight whose import I realised only after the deluge. In essence, he is saying that we are myopic, partly because of defective incentives within financial institutions, partly because we are fundamentally uncertain about the future and partly because we are, well, human. We did not evolve to be rational long-term maximisers – on the savannah, in the long term our ancestors were all dead if they did not survive in the short term ‑and so, not surprisingly, we are not long-term maximisers.
How does the financial system create systemic risk? Well, as Knut Wicksell noted, it creates money as it creates credit. A big question, then, is whether money is a special sort of financial asset. I would argue that it is. Government is always involved in the creation of money, in one way or the other, because it is so basic to any form of economic and political stability. Money is a guarantee of the ability to pay for things one wants, whatever happens. That is pretty important. The ability to create money is pretty important, too. A breakdown in confidence in the institutions that do this is always and necessarily a calamity.
Second, how should we regulate finance?
From understanding the macroeconomic role of finance, we come to a second huge question: how should finance be best regulated. Part of the problem here is that financial regulation seeks to do two things: protect users; and protect the economy. These are somewhat different objectives. Seeking to achieve both at the same time makes regulation enormously complicated.
The question of how to regulate finance has become far more difficult since the crisis, on many dimensions. Behind all the complexity, however, seems to me a big truth: we have lost confidence in the inherent stability and beneficence of a profit-seeking financial sector. This is a recipe for complex and intrusive regulation that must frequently fail. Then, when it does, surely the result will be still more regulation. Is there then any way of avoiding this trap?
This raises a third question: how might we restructure finance?
One of the ideas behind the Independent Commission on Banking on which I served was that structural reform would be an alternative to over-regulation. Similar ideas are being entertained in the European Union and the US, albeit in different ways. These ideas may be accompanied by arguments for higher capital requirements in core institutions, as David Miles of Imperial College has argued. I find both approaches very attractive. But are there other structural changes that we need to consider? One possibility that I have raised, as have several economists, is 100 per cent reserve banking. Would that be conducive to stability or merely move instability elsewhere, while depriving the economy of valuable banking services, in particular the ability of the banking sector to create money at will for the benefit of its customers.
At this point, I would like to add a fourth question that I feel has not been sufficiently discussed: Is there a way of achieving economy-wide post-crisis deleveraging relatively painlessly? In his recent review essay on my book, The Shifts and the Shocks, Kenneth Rogoff has repeated his view that the best way to deal with the overhang of debt that normally accompanies a post-crisis economy is by radical restructuring. I argue against him that this is going to be hard to do, politically. I also argue that it is particularly hard when the borrower is able to service the loans and has no desire to be marked as a defaulter. Is there a way of avoiding this difficulty? I believe the answer is no (except by changing contracts ex ante, on which more below). But is this right? I would really like to know.
At this point, I would like to raise a fifth question that seems to get surprisingly little attention by academics: Under what conditions is competition in banking desirable?
The general point here is that if negative externalities – spillover effects – are large, greater competition might be highly undesirable. Competition for market share, for example, would be destabilising in a credit boom and, in my view, it was. Again, competition among service providers will be undesirable if a tacit cartel subsidises the cost of the basic service: a deposit account. In this case, then, the “free if in credit” model would tend to move competition in the direction of how best to soak the innocent or vulnerable customer.
At this stage, let us turn to a sixth question: how does and should finance interact with the governance of companies and managerial incentives. This seems to me a huge set of issues. Indeed, it gets to the heart of the future of the capitalist economy. Many observers, such as John Kay, Colin Mayer and Andrew Smithers argue that the incentives created by the current relationship between markets and management are potentially disastrous. Of course, there are many profound difficulties here. But I, for one, have become sceptical of the idea that the combination of shareholder value maximisation with stock-price linked compensation and widely distributed share ownership is good for either companies or the wider economy in the long term. I hope that the Centre will encourage research in this area, as well.
That leads naturally to a seventh question: how far are trading and liquid markets desirable? The recent questions about “flash trading” are special examples of a general issue. Is it the case that these active markets help to improve resource allocation and benefit the ultimate investors? Or do they rather waste resources, with insiders benefitting at the expense of the outsiders.
This of course leads to the really big eighth question: how much rent extraction is going on inside the financial sector and, if so, at whose expense? I have never seen really good studies of this issue either positive or negative. But the case for trying to analyse the issues rigorously seems to be very strong. My own suspicion is that there is a great deal of rent extraction. It is of course an unpopular view, at least within the industry, but it is, it seems to me, a plausible one.
Now I want to turn to a ninth and perhaps even more fundamental question: can we make financial innovation useful? There are many dimensions of this.
One is what technological innovation itself going to do to the financial system: think of Bitcoin or the coming Google Finance or may it will be Amazon Finance. Does the informational advantage of banking even exist any more? If it does, how will banks make use of it?
Another dimension of innovation bears on systemic stability in a more direct way. This is how to create contracts that remove the cliff-hanging nature of debt when the borrower is on the borders of insolvency. One of the ways we might be able to reduce the instability generated by debt, particularly property-related debt, in our economy is by making it more like equity, for example. Considering how this might be done and learning from attempts elsewhere would be very useful. Another possibility would be to change the tax treatment of debt, which encourages leverage and so surely creates fragility.
This leads to a still broader set of innovations. The Nobel-laureate Robert Shiller of Yale has long argued for the value of new kinds of contracts designed to manage risk better. The room for improvements here seems to me huge. Consider the possibilities of moving away from conventional government debt within the eurozone, for example, or in emerging economies, where the central bank is unable to create the currency in which the government has borrowed.
Now let me turn to a tenth and last question: is there a point beyond which the expansion of finance lowers economic welfare and, if so, what determines it?
Many of the questions I have explored above relate to different aspects of this question. But there is now at least some evidence to suggest that while greater financial deepening seems to be beneficial up to a point, there comes a point when it is excessive. The UK might, for example, be on the wrong side of this curve. But it is clearly an extraordinarily big issue. The negative effects of finance – via systemic risk, rent extraction, corporate inefficiency, debt overhangs – might after a point offset the obvious benefits that greater finance can bring.
I recognise that I have gone well beyond my remit. I have not just looked at systemic stability and financial regulation. I know I have also gone well beyond the current brief of the Brevan Howard Centre. I apologise for this irresponsibility, at least a little. What I have tried to do instead is indicate at least some of the wide range of linked questions in finance that concern me. I became a journalist because I am unable to focus on one subject forw a long time and I have just demonstrated that this inability is deeply seated within me.
Nevertheless, I only apologise a little. Finance really is immensely important for our futures. Indeed, within economics I can think of few topics more important. I have tried to indicate how wide our interests should go. It is really inexhaustible and vital. This is why the establishment of the Centre by Alan Howard is so important and commendable. I wish it every success.
 In Prospect, August 2014.