Much More than New Regulation is Required to Fix Finance
The proximate causes of the global financial crisis are being addressed variously through new arrangements for macro-prudential supervision, which will result in tighter liquidity and capital rules for financial institutions. However, some other challenges that have long proved intractable still remain. In particular, the social repercussions of our growing financial markets are increasingly being questioned. The protests on Wall Street and in the City of London are testament to the outcry.
As long ago as 1936, in his General Theory, Keynes enquired about the benefits of efficient financial markets. He was concerned about their tendency towards destabilising speculation and unproductive diversion of capital away from business enterprise. These are old issues, still looking for answers.
Later in 1984, the eminent economist and Nobel laureate James Tobin reviewed the efficiency of financial markets from several vantage points. He concluded that while they seemed “informationally efficient” (that is, security prices generally impounded news) they frequently failed to deliver “valuation efficiency”, thereby questioning the basis of markets’ capital allocation function. Even more importantly, he examined their “functional efficiency”, or social usefulness, and noted politely that “the services of the system do not come cheap”.
Today, in the wake of a destructive financial crisis, there is renewed scrutiny of banks in particular, and finance more generally. Ordinary citizens are asking why finance and investment professionals earn so much. Even expert observers wonder why finance seems to extract such high rents. There is more than envy behind the enquiry: they are legitimate questions.
In response, there are several plausible answers. Financial innovation has allowed more and more assets and liabilities to be securitised and traded. The potential for high returns from transacting the securities may help financiers to command high incomes. While competition would normally be expected to bring down the price of these services, constant product changes through innovation, combined with price-insensitive agents who make decisions for investors, may have allowed high profitability to persist. In addition, growing economies of scale for gathering information and building expertise for active participation in financial markets may have led to oligopolistic competition. If the conjectures are correct, these are ingrained dysfunctions of financial markets. Ultimately, they can only be remedied through greater vigilance by investors: asset owners must demand fairer returns, better aligned with the risks; and they should insist that their agents abide by strict fiduciary duty.
Over the centuries, financial innovation has made an immense contribution to the advancing prosperity of liberal economies. Transferring wealth across time, joining investors with entrepreneurs, mitigating risk – these are just some of the socially useful functions performed by finance.
At the same time, financial markets have failed spectacularly over the last few years. As a result, the ongoing public debate about the role of finance in society concerns the intersection of free market economics, market efficiency and equitable distribution of wealth. These are issues that go beyond the latest crisis; a new regulatory architecture alone is not sufficient to address them. Indeed, they lie at the heart of our political economy. Therefore, politicians, regulators and finance professionals need to strive harder to find a better balance between these intertwining and competing aims. The wealth and welfare of our global society depends upon it.