Finance is the brain of the market economy and, like the brains of individual human beings, it can shift in an instant from greed to fear; now the financial brain has become active, global and self-confident – is it creating huge dangers for the world economy? asks the FT’s Martin Wolf in his Wednesday column.
Critics would levy three big charges against modern financial capitalism, Wolf says: it is unjust; it is inefficient; and it is unstable. This charge sheet is as old as capitalism itself.
There are two widely raised objections to the rewards gained by financiers, he notes. The big one is that making large sums out of speculation, rather than production, is distasteful – but the real question is, is it helpful? A narrower objection is to the fiscal regimes under which successful financiers operate. Yet this, again, raises general questions about fiscal policy, not ones limited to the financial sector. Thus, the charge that there are injustices associated only with financial capitalism is hard to justify.
More interesting, therefore, is the second question, says Wolf: does the financial brain even know what it is doing? In other words, does the financial system add to economic efficiency?
The benefit and risk of finance are two sides of one coin. The benefit is the ability to reallocate resources among people at any point of time and over time. The risk is that the resulting pyramids of promises are vulnerable to fraud and irreducible uncertainty, and so to successive fits of optimism and panic.
These are indeed inescapable features of any financial system, to be managed, not eliminated, says Wolf.
As Professor Dani Rodrik of Harvard university noted in a comment in the FT’s Economists’ Forum, it has proved possible to tame domestic finance, more or less. In the US, with the most sophisticated financial system in the world, the financial sector seems to have generated much innovation, along with a reasonable degree of stability. But evidence of the benefits of liberalisation in emerging economies is not as strong as proponents desire. This is partly because the financial markets are primitive, partly because the interface between global and domestic markets is defective and partly because benefits have been overwhelmed by the costs of crises.
This brings us to the third item on the charge sheet: the ability of the financial brain to generate huge calamities. At present, that possibility looks remote. It is a decade since the Asian financial crisis began to roll across the globe. Today, we see a fast-growing global economy, with low spreads on risky assets, strong corporate balance sheets, easy issuance of debt and, inevitably, declining returns on speculative activity. Yet, as the Bank for International Settlements points out in its latest annual report, that is the right time to worry. By the time crisis hits it is far too late.
How big are those dangers today? Sizeable, is Wolf’s guess.
The risk of inflation is one uncertainty, as capacity is used up across the globe. The continued reliance on US household spending and, more broadly, the elevated level of private consumption in high-income countries is yet another. Not to be forgotten are persistent and massive deficits and surpluses in the global balance of payments and associated capital flows. Moreover, government intervention in foreign currency markets still accounts for much of the financing of the US current account deficit.
In addition, we have to consider what is going on in the financial markets themselves. How many investors, for example, are taking equity risks in return for poor bond returns? How many of them are even aware that these risks are being taken on their behalf? As the BIS notes: “There seems to be a natural tendency in markets for past successes to lead to more risk-taking…Moreover, should liquidity dry up and correlations among asset prices rise, the concern would be that prices might also overshoot on the downside.”
Is it possible to take advantage of the financial brain’s abilities, while limiting its capacity for irresponsible and destructive behaviour? The policy issues we would be examining if we wanted to do so include:
- First, for essentially political reasons, we must re-examine the taxation of income and wealth.
- Second, we should recognise that emerging and small economies have to manage their involvement with the global financial system cautiously.
- Third, we must also realise that the mixture of floating exchange rates with a number of important pegged rates is creating huge distortions.
- Fourth, we must look more closely at how monetary policy interacts with the financial sector and asset prices.
- Fifth, we should also look once again at how well vast rewards are aligned with risk in financial markets.
- Finally, we must encourage regulatory and fiscal authorities to achieve higher levels of co-ordination.
We will have to live with today’s financial markets, since policymakers would seek to curtail them only after a disaster, Wolf concludes. The task is, instead, to exploit the many benefits, while managing the risks. “This will never be done perfectly. But it can be done at least tolerably well. The alternative is too awful to consider”, he says.