Thursday, August 27, 2009

Is The US Financial System Worth The Trouble?

One result of the US financial meltdown is that it has more people questioning whether the free market financial system is worth the costs. Here's a startling fact- in the first half of this decade the finance sector accounted for 34 percent of US corporate profits. This seems like far too much of our economic resources going into something that produces a relatively small economic output, even before you consider the mountains of tax dollars required to bail out the financial system when it failed. The following post from Economist's View discusses this important question.

Does the total cost of our financial system exceed the total benefits at the current scale of operation? Like Benjamin Friedman, I wish I knew the answer, though I suspect that much of the recent innovation would be difficult to justify on the margin:

Overmighty finance levies a tithe on growth, by Benjamin Friedman, Commentary, Financial Times:
...The crucial role of the financial system in a mostly free-enterprise economy is to allocate capital investment towards the most productive applications. The energetic growth and technological advance of the western economies suggest that our financial system has done this job pretty well over long periods. ... The financially triggered Great Recession of 2008-? blemishes this record but does not wipe it away.

Aside from the recession, it is important to ask what this once-admired mechanism costs to run. If a new fertilizer offers ... a higher crop yield but its price and the cost of transporting and spreading it exceeds what the additional produce will bring at market, it is a bad deal for the farmer. A financial system, which allocates scarce investment capital, is no different.

The discussion of the costs associated with our financial system has mostly focused on the paper value of its recent mistakes and what taxpayers have had to put up to supply first aid. ... The misused resources and the output foregone due to the recession are ... part of the calculation of how (in)efficient our financial system is. What has somehow escaped attention is the cost of running the system. ...

One part of that cost is ... much of the best young talent in the western world [going] to private financial firms. ... At the individual level, no one can blame these graduates. But at the level of the aggregate economy, we are wasting one of our most precious resources..., much of their activity adds no economic value.

In the US, both the share of all wages and salaries paid by the financial firms and those firms’ share of all profits earned have risen sharply in recent decades. In the early 1950s, the “finance” sector (not counting insurance and real estate) accounted for 3 per cent of all US wages and salaries; in the current decade that share is 7 per cent. From the 1950s to the 1980s, the finance sector accounted for 10 per cent of all profits earned by US corporations; in the first half of this decade it reached 34 per cent.

These wages and profits – and the office rents, utility bills, advertising and travel expenses – are all parts of the cost of running the mechanism that allocates our economy’s capital. To recall, what makes a new fertilizer a good deal for the farmer is not just that it delivers greater production per acre but that the added production is sufficient to buy the fertilizer and increase the farmer’s own return.

What makes a more efficient financial system worthwhile is not just that it allows us to achieve greater production and economic growth, but that the rest of the economy benefits. The more the financial system costs to run, the higher the hurdle. Does the increased efficiency our investment allocation system delivers meet that hurdle? We simply do not know.

Economic decisions are supposed to turn on weighing costs and benefits. It is time for some serious discussion of what our financial system is actually delivering to our economy and what it costs to do that.

This post has been republished from Mark Thoma's blog, Economist's View.

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