Martin Wolf on the Workings of the Finance Brain

Apologies for being a tad late on this item, an article by the Financial Times’ lead editorial writer Martin Wolf, “Risks and rewards of today’s unshackled global finance.” Power went down in parts of Manhattan today, which put a crimp in my schedule. So I will be briefer than I might otherwise be.

I was struck by an odd disconnect. Wolf’s tone in this piece on what he calls the finance brain is largely reassuring (although he makes no bones about the conflicts of interest between financiers and the parties they allegedly serve). And he does point to research by Dani Rodrik that says the benefits of financial liberalization in emerging economies isn’t as great as in their first world counterparts (likely because it gives the elites yet another opportunity to skim). But towards the end, he segues into a long list of risks, followed by six “policy issues” that look like a call for root and branch reform. It feels as if Wolf is either pulling his punches, conflicted about where he stands, or perhaps simply had to finish the piece before his thinking had gelled fully. It’s a noteworthy departure from Wolf’s usual self-assured posture.

To Wolf:

Finance is the brain of the market economy. Alas, like the brains of individual human beings, it can shift in an instant from greed to fear. Sometimes, as now, the brain behaves as if indifferent to risks and uncertainties. At other times, it is consumed by anxiety. Today, moreover, as I argued last week, the brain has become active, global and self-confident. Is it also creating huge dangers for the world economy?

Critics would levy three big charges against modern financial capitalism: it is unjust; it is inefficient; and it is unstable. This charge sheet is as old as capitalism itself.

Two objections are made to the rewards gained by financiers. The large one is that making large sums out of speculation, rather than production, is distasteful. But this distinction is arbitrary. What matters far more is whether the activities are economically 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: 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, deception 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. It is impossible to align the interests of insiders with those of the people they ostensibly serve, let alone with those of the wider public. To take just one salient contemporary example, the least that managers of private equity or hedge funds can earn is the management fee. But their investors – or, more probably, the people who depend on the money their investors manage – may lose everything.

As Professor Dani Rodrik of Harvard university has pointed out in a comment in the FT’s Economists’ Forum, it has proved possible to tame domestic finance, more or less. In the US, the country 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 the evidence on the benefits of liberalisation in emerging economies, though not absent, is not as strong as proponents desire. This is not because there are no benefits. It is, instead, 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, as well (see charts). Yet, as the Bank for International Settlements points out in its latest annual report, still the best single official analysis of how the financial and monetary systems are evolving, that is the right time to worry. By the time crisis hits it is far too late. It is well before then that people make mistakes. Usually, moreover, it is not those responsible for the mistakes who suffer, but everybody else.

How big are those dangers today? Sizeable, would be my guess. The consensus is for continued, rapid and stable economic growth. But, as the BIS remarks: “It is not difficult to identify uncertainties that could conceivably cause the near-term forecast to come unstuck, or that could result in less welcome outcomes over a longer horizon.”

The risk of inflation is one such uncertainty, as capacity is used up across the globe. The exalted level of housing markets in most high-income countries is another. The continued reliance on US household spending and, more broadly, the elevated level of private consumption in almost all 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 a sizeable part 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, more leverage, more funding, higher prices, more collateral and, in turn, 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, short-sighted and destructive behaviour? What are the policy issues that we would be examining if we wanted to do so.

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. Even their critics should fear such a disaster. 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.