Ep74 Is The Financial Sector Good for Society?

[MUSIC] Welcome to the Lawter Institute at the University of Pennsylvania. I'm Jules van Binsberg, Director of the Institute and a Finance Professor at the Wharton School. And I'm Jonathan Burke, a finance professor at the Graduate School of Business, a Stanford University. This is the All Else Equal Podcast. Welcome back everybody. Today we're going to talk about a topic that Jonathan I think has come up in my finance class a thousand times. Which is this question that people have of what is the financial sector really for? What does it really do? Does it add any value to society? Would society essentially function just as well if we didn't have a financial sector? And then of course, as an academic, you are confronted with the question about what causal or scientific evidence do we have that the financial sector actually is adding value? And I thought that you and I should just have a conversation today a little bit about what evidence we think there is, how we think the financial sector works. And I think maybe that a lot of the confusion about what value it adds comes from people not having realistic expectations about how competitive markets actually work and what kind of outcomes we should be expecting to see in competitive markets. And that those outcomes in no way are indicative of the financial sector not adding value to say one more thing about this criticism. I think the criticism has really exploded since the financial crisis. I think that a lot of people believe that 2008 was just in 2009 was a poster child of proving that the financial sector really caused more problems than that added added value. And I think a lot of people at that point concluded that financial intermediaries were essentially just charlatans that were extracting rents from the rest of society without really adding anything. Okay, Jules, first let me disagree with you. I don't think we'll have a conversation about this. I think what I see this as us presenting our view, defending the idea that the financial sector is crucial to economic growth and is causal in making our lives as good as our lives are. Let me also say that I agree that people have lost confidence because of the financial crisis. It was just a naive view of how the world works. Essentially, because we hadn't had any financial crisis in a while, people somehow thought we'd solve the problem of uncertainty and bad shocks. And I just think it was naive. Of course, we were going to have a bad shock and we're going to have a bad shock again. And there's nothing the financial sector can do about the fact that the economy is sometimes good and sometimes bad. People tend to believe if they don't see it, they just believe it's not there. So, you know, if somebody looks at CEOs and sees their high pay and they think, well, I don't know what the guy does. I'm sure I could do the same job, right? I'm not going to pay that much. In other words, when it's not obviously clear how something works, people have a tendency to say, well, it just isn't there. And I think that's what the first problem with the financial sector is people look at the financial sector. They look at intermediaries. They're not quite sure why we need these intermediaries. And conclude, well, it's just people stealing money from other people. No, agreed. So, if I had to define what the financial sector is for, I would say first, the field of economics in my opinion in general is just the field that studies scarcity, meaning the field that says we have a limited amount of resources, there are lots of things we want to do. We can't do everything. We have to make a decision on what are the things that we want to do and don't want to do. And that resource allocation process is so important that it essentially defines whether your society succeeds or whether your society fails. And I think that if I had to describe the role of the financial sector, I would say it's just at the core of this resource allocation problem because through the financial flows, it contributes to allocating the resources to their most productive use. And I think people really don't appreciate how important those gains from trade are. People tend to think, I have my preferences and everybody else shares my preferences and that leads to their view that there isn't much gains from trade. And the truth is that people have very different preferences. And because of that, there's tremendous gains from trade. But then the question is, how does the financial sector help to accommodate achieving those gains of trade? Well, why don't we stop us first paying Devils Advocate? And let's take the position of the people who think the financial sector is actually a bad thing for the economy. And what arguments do those people make? Well, so let's first start with an observation that I think is a data point that we should take seriously, which is larger economies generally have larger financial sectors. The Devils Advocates would say, well, that's just because the larger economies would have been large in any case. And large pots of sugar attract a lot of flies. And so therefore, these financial intermediaries just come after these large economies and try to extract rents from them and become rich without really having to do much. Just to feel that you and I have worked in a lot and mutual funds, people would say, oh, these people just charge a fee from these poor investors. They don't really do anything for it and they just become rich by doing that. What would evidence have to look up to say that the financial intermediaries are actually slowing the economy down? Well, I think yes. I think that the experiment could be quite easy, which is let the government intervene, let the government start taxing the financial sector a lot, let it maybe even shut down certain parts of the financial sector because it thinks it's redundant. And then once we've shut down that part of the financial sector, then suddenly we see economic growth picking up all kinds of innovation happening that wasn't before and the economy becoming even more successful than it was before. And of course, I think that we know that every time that governments have tried to intervene in the free market economies that we study, generally this has led to large reductions in the sizes of those economies and their success. Take Venezuela as a recent example. Command and control economies have always failed. I know of no example anywhere of a commodity control economy having succeeded. The whole point of commodity control economy is you don't need an intermediary. Summary is allocating the resources and so you don't need markets and intermediaries to allocate resources. And so that to me is the strongest piece of evidence that the financial sector is a crucial part of economic growth. No, I agree with that. So the question is suppose you would take the exact same intermediaries in a command control economy and you would use them as the public officers who are allocating the resources would that leads to the same outcomes. And I think that the answer to that question is quite a resounding no because as soon as you put them in that system, their incentives to deliver the better economic outcomes have immediately been removed. And so I think that the financial sectors compensation and incentive scheme just like the rest of the market economy ensures that the resource allocation is done in the most productive manner. As soon as you take that incentive away, people will stop doing that. It's much more than just taking the incentive away. You're right, the incentives are important, but you have incentives in the opposite direction. When you have a bureaucrat or somebody who has no skill in the game making decisions, then he's so incredibly easily bribeable. And so in the end, these bureaucrats will make decisions that will actually harm the economy because of the fact that the incentives for individuals to influence them are so strong. That's one of the great, great advantages of the market. There's no one individual who can decide things. There's no one individual to bribe. And so it's much more resilient to nefarious activity than in a command control economy. But John, let's take for a second, the devils have confused you again, right? So I think that people on the other side of the debate would say, isn't it obvious that there exists unsophisticated agents, unsophisticated consumers, unsophisticated people in society that are getting clearly exploited by the financial sector? Don't do those people deserve better, and wouldn't it be better if we could just take out those financial intermediaries, remove them from the marketplace, and wouldn't that then make the unsophisticated agents better off? Yes. So I think it would be naive to say they are no crooks in the world. So there's no question that when you have a financial sector, they will be people who will try to exploit people who are naive. But I think the real question is, is that the financial sector or would these people be exploited anyway? My advisor Steve Ross used to have this great quote. He used to say competitive markets protect the sheep from the wolves, but they don't protect the sheep from themselves. So yes, it's true that the capitalist system allows naive people to be taken advantage of, but I would say it's not unique to the capitalist system. Those naive people would still be taken advantage of in a commodity control economy. That is one. And I think that the second thing, and we've discussed this in previous episodes, right, we cannot let the perfect be the enemy of the good. If you said my standard for the financial sector working is that no single individual is ever ripped off because that would be unfair, that's just an unattainable goal. And so we need to take for granted the fact that some people indeed, because they're not protected from themselves. And I do think that part of freedom and liberty is that nobody is protecting you from yourself. You're allowed to make these choices. And if you make mistakes, those mistakes of consequences. And not every mistake is preventable in that sense. So the question, I think, is if you believe that the financial sector currently is not very good for a particular group of unsophisticated agents, what exactly is the alternative? What are you exactly proposing we do to fix this? Yeah, and I think every time we propose an alternative system, it's never being as good. You know, I agree if we could have the alternative where we could all be rich and we could reduce inequality, then I think everybody would want that. The problem is when you reduce inequality, you stop everybody from being rich because the incentives get screwed up and people don't work as hard. So I was reading a post on the Russian moon shot. And I didn't realize this, but what screwed up the ability of the Russians to get to the moon was something really simple. It was that they couldn't fabricate a big enough engine for the first stage of the rocket. And so they instead decided they were going to use 24 small engines. And of course, coordinating the 24 engines was impossible, especially in those days before there was the kind of chips we have today. And basically what would happen is one engine would fail and that would imbalance the rockets and that lead to all kinds of problems. And I thought to myself, why couldn't they fabricate an engine big enough? America didn't have any problem fabricating an engine big enough. And my likely explanation was they didn't have enough people working on the problem. In other words, an American, the way it would work is NASA needed a big engine. They put out a bid to a bunch of people and say, bull does this big engine and tell us how much it's going to cost. And there would be competition amongst the people thinking about how to bull those engines. And so the engines would be bulls, okay, and it would be both of the lowest cost to NASA. It would still be very expensive because given the fact the Russians couldn't even do it, my guess is it required a tremendous amount of skill and people charged for skill. But I'm sure those engines cost a lot of money, but they were produced. And so having a mechanism, a market where people can put a bid out or people can compete with each other is crucial to economic growth. One thing that does worry me is the following. The thing that made these centrally planned economies fail, right, was this lack of coordination. Because you cannot possibly know everybody's preferences. You cannot possibly know everybody's actions. That's trying to micromanage this system is by definition going to fail. And the price mechanism was just a much better coordination device than any other system that has been used so far. But my question is, do you think that's still going to be true going forward? Is it going to be the case that if artificial intelligence can provide at this large scale, this level of coordination perfectly understands your preferences, knows what it is that you want, also knows your financial sophistication and therefore can prevent you from hurting yourself by entering in particular financial transactions? Do you think that under that much larger information set world for the AI, it could actually do better than the market system? First, let me point out that that was the Soviet Union. They decided, oh my God, we're not so much smaller about allocating resources. We don't need capitalism. We'll just do it properly. And we won't have all the problems with capitalism. So people have had that idea before. Now, of course, I don't know where AI is going, maybe, maybe not. I will say this though, you have to worry about incentives. The minute you have a situation where some computer program, in charge of some individuals, allocating resources, again, we're back in the boat where one person can be bribed, one person can be influenced and so my feeling is no, even if you've got AI, the incentive issues are so fundamental, it's not going to lead to a better allocation of resources. I mean, let's agree on something. There's nothing fair about the capitalist system. Rich people always get the good resources, right? There's nothing fair about capitalism. It's just that everybody seems to be better off with it. Yeah, but then it does depend a little bit on what your definition of fairness is. In economics, we have the concept that's called a Pareto improvement, which is that you can make everybody better off without making somebody worse off, and that you should definitely always implement those Pareto improvements. And I think there's white consensus that that is good policy and fair policy, that if you have the opportunity to make everybody better off, you do that. But there's nothing that says in that Pareto efficiency principle that everybody has to be equally well off by the end of it. But wouldn't you still say that the fair thing to do is to make everybody better off? Oh, yes. And that's what capitalism does. But I think there's a notion of fairness where we're making some people much better off than others. And people find that to be unfair, and I think if we could do it so that wasn't the case, it would all be faster, it would be in favor of it, but there's no evidence that that works. Once you take away that incentive and the competition, the entire system comes crumbling down. So it summarizes, there is a lot of confusion about what the financial sector does and what it doesn't do. I think that the nefarious interpretations of what the financial system does is you've pointed out is largely due to the fact that if people don't see it and can't put their finger on it, they assume it must not be very important. Even though of course the data shows that in the places where the financial sector wasn't able to do that part of the job, those economies did much more poorly, but I do agree with you that it's not that directly observable how this capital allocation process works. I do think that another fair conclusion is that we cannot be in a utopian perfect world. At some point, I think we need to be realistic about what any given system can actually accomplish, and I do understand that desire for progress implies that we always want to do better, but at some point you need to wonder, are the measures that you're now implementing not in the long run making things worse rather than better? I think also we have to realize that there really is no alternative system that has ever been proposed that was worked. The correlation between rich and competitive markets and working financial systems is just to me undeniable. That said, as you point out, it's not a perfect system. There's no question that in our system, many financial intermediaries are engaging in non-competitive behavior that enrich themselves through various nefarious things. I mean, you know my view on banks, I think banks are government subsidized institutions and that government pays for Jamie Dimons jets. So yes, like any system, they're going to be people that do that. But it's much, much, much smaller than it would be in a command and control economy where driving every single official gets you ahead. Thanks for listening to the All Health Equal Podcast. Please leave us a review and Apple podcasts we'd love to hear from our listeners. 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