The financial sector we want.

Have you seen this graph?

There’s a lot of talk about this-or-that kind of banking regulation, how or why we should cap sizes or exposures. I think it is important to often go one level higher than that – what do we expect our financial sector to do? Or to put it a different way, when can we tell if our financial sector is doing a good job at a meta-level, and when does it have problems?

I take a rather radical view of an often dismissed or misinterpreted idea in finance, the Modigliani-Miller (MM) Theorem (a more extensive pdf here). The story of the MM Theorem is quite interesting. In the 1950s, these two economists were hired to teach a corporate finance class, which they had never been exposed to before. Looking over the textbooks, they were amazed – how could any of this create any actual economic value? Sure enough, they used some math to prove, in perfect markets, it couldn’t, using some argument techniques that became the basis of financial engineering.

One can go on at length about how people use and mis-use this concept, but at its heart is the idea that in a perfect market, corporate finance would add no value. Slicing up corporate payouts this way or that way wouldn’t matter, as the market would simply adjust accordingly. Only the fact that there are imperfect markets means there is value in corporate finance. (My view is esoteric, because I view, with a personal take on the Efficient Market Hypothesis, that this is largely true of finance as a whole.)

What does that mean? Picture a perfect market:

A doctor works hard to save up $1,000. There’s a factory that can get a 10% return on money that is invested in it. The doctor walks over to the factory, and a year later, the factory gives her the money back. That’s in a perfect market. Economists do this all the time in their models to simplify; agents simply not consume some of their pay and it gets invested. The money gets returned the next period, and nobody has to call a lawyer or a broker.

However markets don’t work like that. There are a lot of problems on both ends, so we hire a financial service to act as the go-between. They get a cut.

Now what I esoterically read the MM Theorem as teaching us is that we can say that the financial sector here is only adding value if and only if it is resolving a market imperfection. There is asymmetric information – the factory knows its profitability better than the Doctor does, and could rob her. So we hire analysts to keep an eye on the investments. There are coordination problems – the factor might need 1,000 doctors to each give $1,000 before it can make its profit. There are costs associated with having to declare bankruptcy and there are benefits to having debt – you can write it off your taxes. As such, you’ll want to hire some corporate finance people to set up your company correctly.

Note that none of this creates value. The Doctor works hard and saves, and the factory innovates and makes excellent products. The financial sector makes neither of them more productive. It may get them more money to work with on either end, but the Doctor is still the same Doctor, and the factory producers the same, no matter how good their broker is. Now the financial services are essential to making that happen, but they, in and of themselves, aren’t the things to be celebrating.

I use this as an analogy. Think of your favorite city. Now start naming the things you like about it. Depending on the place, you may have brought up the roads or the public transit system. Now wouldn’t it be weird if the roads were the only thing you brought up? Roads aren’t valuable by themselves – they are valuable because they take you places you want to go; to your loved ones, to your work, to public and private spaces for community or for shopping and trading. Now roads and transit can be great, or they can be a disaster – and they are always essential – but we wouldn’t celebrate a city for just having great roads. And if the public transit budget’s had a profit of 40% of all corporate profits, like in that chart above, you should be mad as hell.

Oliver Wendell Holmes once said “Taxes are the price we pay for civilization” – I think that the financial sector’s profits are the price we pay for capitalism. They are essential to resolving the market limitations we have in this real world, but they are nothing to celebrate in and of themselves. So I propose a simple way of thinking of the financial sector going forward.

1) The financial sector should be large enough to support the transactions, production and investment of the rest of the economy and resolve the market failures inherit in them, and not a penny larger.
2) We should be incredibly dubious that the financial sector is earning a profit because it is providing a real good – the obligation should be on them to explain what market failures they’ve overcome to earn that profit. We should be incredibly dubious when risk disappears, or returns on investments rise because of financial shuffling.
3) We should admit that we may need to bailout the financial sector now and again to keep the whole system running.
4) Some say that having banks be very large helps reduce turmoil. I tend to thing that small and easily replaceable is a much better model. For the geeks and computer kids, in my mind the idea banking system would be one in which banks were hot-swappable. One goes down, tear it out and put in the new one, while the system doesn’t even notice.

I think settling on an economy with these as a component feature would move us best towards a crucial goal of broadly shared prosperity.