Bankers: Who Needs Them?

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Would the world be a happier place if we just got rid of all the bankers? Well, no. The financial sector, for all of its foibles, is as necessary for the economy as blood is for our bodies: it facilitates trade, allocates capital, and takes care of all sorts of nuts-and-bolts economic activities that make it possible for economies to not only survive but grow and flourish.

The more interesting questions are: do we really need to have so many bankers, and pay them as much as we do? Do we really need to have such a massive amount of money sloshing around in our financial system? The answer to these questions is also, most likely, no.

Back in the 1950s, an era of economic growth and prosperity, the financial sector accounted for only 3 percent of our Gross Domestic Product; these days, it eats up more than 8 percent of our GDP, and as you may have noticed our economy is a mess.

As economist James Tobin once observed,

“We are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity.”

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A new working paper prepared by three economists for the International Monetary Fund asks bluntly if we’ve got  “Too Much Finance?” That is, would we do better, economically speaking, if we reduced the size of our financial sector?  According to their study, the answer is yes. While countries with relatively small financial sectors tend to do better when they put more of their resources into finance, that equation reverses once the size of the financial sector reaches a certain threshold – one that the United States has definitely passed.

As UN economist Ugo Panizza, one of the authors of the study, explains:

“Our findings show that there can be “too much” finance. While [opponents of regulation like Alan] Greenspan argued that less credit may hurt our future standard of living, our results indicate that, in countries with very large financial sectors, regulatory policies that reduce the size of the financial sector may have a positive effect on economic growth.”

But what about the question of pay? Even if we reduce the size of the financial sector, finance is complicated stuff. Don’t we need to pay a premium in order to make sure that the people running the system are smart enough to handle it?

Thomas Philippon of NYU’s Stern School of Business has looked into that question. While agreeing that better pay means smarter bankers, he notes that it’s still possible to overpay for these sorts of skills, and that’s exactly what we’re doing. As he figures it, the “compensation of employees in the financial industry appears to be too high to be consistent with a sustainable labour-market equilibrium” and that in recent years bankers have been paid anywhere from 30 to 50 percent more than they’re worth. At pay levels like this, bankers aren’t adding value to the economy; they’re extracting a “rent” paid for by the rest of us.

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Not everyone agrees with this analysis. In his book Finance and the Good Society, which came out this spring, economist Robert Shiller sets forth a defense of sorts for our much-criticized financial sector. But in his zeal to remind us all of the good and necessary functions the financial sector serves, he ends up offering an unbalanced paean to finance. As he figures it, the best way to improve our financial sector isn’t to “restrain financial innovation but instead to release it. … better financial instruments, not less activity in finance, is what we need to reduce the probability of financial crises in the future.”

Really? The financial instruments that contributed to the craziness of the past several years were designed by some very clever, and very well-compensated people. It’s hard to imagine that “unleashing” more such “innovation” is going to make the world a better or more prosperous place – except for those in our financial sector — who get paid very, very well when things go well but are almost never punished when things go very, very badly.

The genius of capitalism is that, at its best, it aligns self-interest with the interests of society large. In finance, that equation seems to have broken down. If we can’t realign these interests, our financial sector will keep costing us more than it’s worth.