The last couple of days have seen several commentators raise fundamental questions about the role and optimal size of the financial sector. Free Exchange very helpfully links to three pieces, including one discussing the extraordinary statements (given their provenance) by Lord Turner, chairman of the British FSA. Turner suggests that a lot of what the City does is socially useless, and that finance has gotten too large.
There are lots of issues to be discussed here, so let me just pick up on one for now. That is the argument that the UK (and arguably other Anglo-Saxon economies) is suffering from a form of Dutch Disease, with an expanding financial sector sucking in too many resources, and depriving other sectors of much-needed inputs.
A standard thing to say about the Dutch Disease is that it isn’t a disease at all. If workers flock into the booming sector (say natural gas) because of higher wages, that is efficient, since those higher wages reflect higher productivity in the booming sector. (The higher productivity is due not just to the physical productivity of the workers in that sector, but to the price of the sector’s output.)
The term ‘Dutch Disease’ is thus a misnomer.
On the other hand, you can clearly argue that high wages and bonuses in the City have reflected bubble conditions, and the relative prices guiding resource allocation have thus been ‘wrong’. There is therefore a much better case for regarding financial services expansion as a ‘disease’, and for government intervention of some sort to reduce the consequent misallocation of resources.
So: can anyone think of a nice alliterative label to replace ‘Dutch Disease’?
27 replies on “Non-Dutch Disease”
“Financial Rent-Racking”? I’m not at all convinced there is a real problem. But if there is a problem, high levels of financial sector remuneration have lasted through too many busts to be explained as a bubble. An obvious alternative explanation is that financial services can extract rents from other sectors, although it is beyond me to immediately explain how this may happen.
If there is a problem with financial sector earnings, these should be treated as a symptom. The underlying disease being a bubble. Treat that, not the symptoms. Remember that bankers and doctors live side-by-side on Ailesbury Road. Both ‘professions’ could be ‘over-earning’ and both could be simply a result of restricted competition. Pre-bubble, going back centuries, bankers have always earned a lot. Just figure out ways to make banking more competitive, as well as less bubble prone. And as a matter of fact, we do know how to do all this. The puzzle is why we don’t. From the FT yesterday, an argument that sorting out the bubble is infinitely preferable to a Tobin tax:
“As Lord Turner acknowledges, capital requirements must be much more demanding. When shareholders are wiped out, fresh capital must come not from the public purse but from forced debt-for-equity swaps. And, if it is impossible to treat creditors this way, up-front insurance must be required. A mighty financial sector is less troubling if banks can be allowed to fail safely.”
The rotten fruit of Usury ?
Some quotes from (“Irelands IFSC – A Story of Global Financial Success” by Fiona Reddan, Published 15 September 2008)
1.“The IFSC is the source of the greatest amount of revenue in the history of the State without any loss or investment by the tax payer”, Dermot Desmond
2. “The enormous funds flow from the IFSC has energised the Irish financial system by creating credit, huge amounts of credit that otherwise mightn’t have been available.” Brendan Logue, Former Head of Financial Services, IDA
3. In May 1990 the Minister for Finance told an audience at an IDA event in London that regulation of the IFSC was being achieved with “commendable flexibility and without detailed rule books”.
4. In the same month the Managing Director of Corporate and Investment Banking at Bank of Ireland told Euromoney ,”The authorities have never shown more flexibility and less bureaucracy.”
Is there any connection between the rapid growth in size of the financial services sector in Ireland in the last 10-15 years, its creation of “huge amounts of credit that otherwise mightn’t have been available.” , the “commendable flexibility” of the regulators, the credit driven housing boom, the inevitable bust and the current banking crisis?
Is the survival of the financial services industry a part of the government’s determination to construct NAMA the way it has?
“Smoke & Mirrors”?
IMO, there is a huge difference between a boom in a sector supplying “normal” goods/services and the financial sector.
What is currently being taught in Economics 101 about the functions of money/finance in an economy?
To compare the effects of a boom in natural gas with a boom in what appears to be little more than repackaged money (into ever more esoteric “products” – the major merit of which is the bonuses earned by those doing the parcels and selling the parcels on until somebody not in on the game insisted on opening the parcel to see the contents, which turned to be ????) with little or no relationship to the supply of goods/services strikes as just as strange as an earlier Dutch disease, when people went bust trading tulips!
In recent years, there was a oil-price boom in Alberta. But it did not take down the Canadian banks.
Similarly, the post-1973 boom in agricultural land prices here did not lead to huge as-yet-quantified state support for Irish banks nor to the freezing of credit to other sectors.
Nor did these lead to a run on the banks in either country – unlike the UK’s Northern Rock event.
Since its not really a disease: Netherlands neurosis?
@Donal: I don’t think students are taught nearly enough about banking and finance in EC101, or in graduate level programmes either. This is something that will have to change IMO.
Its interesting to note the number of chairs in finance and banking permantly endowed by the irish banks over the fat years, to ensure that the univeristies could do what KoR suggests…..ZERO.
So too will the rest of us have to learn about banking and finance – at least to the extent that we can become aware of the way in which the activities carried out in these businesses lead to economic crashes and hopefully, be able to limit the scope for excess spreading?
To what extent can booms in one sector be limited from bringing down whole chunks of economies, if at all? Is there any body of economic analysis on this aspect of booms?
Are levies on bank profits (which we have had here from time to time) example of efforts to draw off the excessive results of booms? Or things like SSIA?
Apart from the discussion of the effect of Government policies/practises on macro-economic cycles, is there similar research on booms arising from sectoral booms eg. price-controls during WW2?
Harder than coming up with new names for “Dutch diseases”
If you had found a role for money and banking in your DSGE models, we might have been more interested.
Interesting post, Kevin. One fact which has always interested me about finance is the allocation of talent from other industries towards finance.
Obviously, one of the resources a bloated finance sector takes is talented workers. A graph, whose source I can’t remember at the moment (if anyone knows where it’s from, please let me know) shows compensation in finance in the US as a percentage of the average US compensation from 1948 to 2007. We see parity between finance and other industries until around 1980, when wages in finance take off. This is surely evidence of a pull factor from other sectors and modes of employment: perhaps it’s less a Dutch disease than a ‘suit disease’?
Here’s the graph:
@ simpleton, The book I’m linking to below discusses several classes of models which incorporate money and banking naturally into stock flow consistent dynamic macro models, have a look: http://www.amazon.ca/Monetary-Economics-Integrated-Approach-Production/dp/0230500552.
Who would have sat in these chairs? How would they have been chosen? Whose interest would they have served? Would they have taught their students to be critical of those who ultimately paid their bills? The economist closest to the financial industries appear to have been the most clueless about their short comings. Though Rubin, Greenspan and Summers are all now multi-millionaires, strange that.
@Stephen: here is something similar but over a longer period, really nice work by Phillipon and Reshef:
(It also speaks to simpleton’s first comment on this thread.)
Nice try Professor but I’m not sure that even Professor Godley would claim to be part of modern mainstream macro. He might even be insulted. I’ve just had a flick through his much earlier text, written with Francis Cripps (now that dates me) and I’m guessing that not much has changed in the intervening decades. The debates being conducted between Krugman, de Long, Lucas, Prescott etc are what I was referring to, I think. It’s the 21st century disconnect between orthodix economics and the way the world works. The triumph of technique over relevance. Friedman tried to finesse is with the ‘as if’ assumption in the 1950s but it never really washed did it? Arrow and Debreu couldn’t find a role for money; Wynne Godley can, but I’m not sure that anything that eminently sensible chap has written would fit into a dynamic, stochastic general equilibrium model. What do we fill the heads of economics students these days, DSGE or Godley?
Much is being written of the need to rebuild macro. As an ex-practitoner, now a banker (of sorts), I can attest to the need for economics to reconnect with the real world. Surely it is uncontroversial to assert that if you want us to endow chairs we should demand a little relevance?
I’m more familiar with the Dutch Disease that killed all the Elm trees in the country a few decades ago.
I was struck by this article in the FT the other day http://www.ft.com/cms/s/0/861f8e84-91a3-11de-879d-00144feabdc0.html in which John Kay examines the banks through the prism of the Peter Principle (where people are promoted to their level of incompetence )
His argument runs that banks will continue (in a deregulated market) to expose themselves to risk until they find their level of incompetence. Kay uses the example of HypoRealEstate buying Depfra as a good illustration of his point.
In a heavily regulated banking market – like the one that existed here before the mid 1980s – the banks have few opportunities to find their level of incompetence because their ability to engage in more exotic financial practices is curtailed, which is perhaps the strongest argument out there against deregulation.
As for suggestions for how to describe the unnecessary size of the banking market, perhaps it is safe to say that we have an ’embarrassment of banks”. Which is a little different to embarrassing banks, but not very.
I am quite surprised by the terms of this thread. Even before you get to Economics 101, try looking at Wikipedia.
I find it quite a leap to apply this notion
to describe some form of inefficiency in the financial sector
It seems to me that a term exists already, that gets closer to Kevin O’Rourke’s worries i.e.
with quite some literature around it.
One of the articles cited is a diatribe published in the FT by Benjamin Friedman (whom I’d guess Kevin O’Rourke knows from his Harvard days).
Now if there is one thing I hate, it is sweeping generalisations, and particularly so from an elderly professor that also ought to know a thing or two about finance (and historians that should have a sound grounding in economics as well as finance).
Friedman thinks, that for those in finance, “These talented and energetic young citizens could surely be doing something more useful.” And “at the level of the aggregate economy, we are wasting one of our most precious resources”. My blood boils.
Ireland Inc has some very important economic and financial decisions to take, urgently. The costs and benefits of whichever road is travelled are massive. And so it is for most sovereigns and companies today when it comes to taking financial decisions. So it is generally worth paying up for sound, professional advice. I think that can be understood without taking Economics 101.
Slagging financiers, bankers and economists may give a bewildered public some comfort. (It is harder to make a scapegoat out of the historians!). Yet there will be no recovery – in Ireland or elsewhere – until economic and political conditions allow finance to function properly again.
@ simpleton, I never claimed Prof. Godley was part of the mainstream in economics.
It’s well off the point, and should perhaps be a new post really, but to be honest, having studied both orthodox and heterodox economics (at the New School in NYC), I’m really not sure a useful distinction exists between ‘mainstream’ and ‘non-mainstream’ economics-there are classes of models useful for describing certain situations and problems, useless in others. Ideology gets wrapped up in the choice of these models a bit too easily sometimes. The world is complicated enough to admit a vast array of descriptions. So it is with RBC/DSGE models, and every other type I’ve ever come across. I’m not saying I’m a huge fan of DSGE models, and methodology wouldn’t be my strong suit, but the point I think I made still holds–Godley et al have a nice set of macro models you might have a look at if you want to think about money and banking in macro. That’s what I try to fill my students’ heads with, I think. The Cripps book is damn near unreadable though, fair play to you for slogging through it!
@ Kevin that paper is just brilliant-thanks for pointing me towards it. (http://krugman.blogs.nytimes.com/2009/04/07/the-financial-factor/), it makes a lot of sense–and is really relevant–simultaneously.
Do either of you know of research on the velocity of money and how it has changed over the past decade? On a mundane level, travelling to a different currency area these days really highlights the change in how money works in an economy (e.g. Maestro cards, Oyster cards, etc.), and how the need for physical cash has diminished.
Perhaps all these changes are covered within “M3”, but my guess would be that major internal restructuring within M3 has as much consequence in day-to-day life and the impact of monetary policy as a blurring of the boundaries between M3 and M4/M2/M-whatever number one chooses…
Given the sophistication of your contributions, which I always enjoy, I do wonder at what prompted your choice of psudenomyn!
Just a small comment to point out that while Kevin hardly needs someone to defend him, your comment about economists’ failure to “find a role for money and banking in your DSGE models” is hardly best addressed at Kevin, since as far as I know, the use of such models has not been part of his research career.
I have stepped a bit closer to the DSGE universe (and must admit to having mastered some of its dark arts and teaching them to students) but I have generally been a sceptic. I do suspect that at DSGE central there is probably an acceptance that the models de jour of a few years ago turned out to be pretty useless for the recent crisis. It will be interesting to see what happens next with this school of thought.
Ponzi scheme because
The end is always the same. Massive losses with destruction of capital. In honest frb, the participants do not care if what they are doing will cause loss, they are paid to do it. In dishonest frb, shadow style, pure ponzi there means that those running it know that there will be a payoff and a massive loss. And they care!
It enables the creation of OPM for a series of transactions that benefit those who get in early and get out before the end.
is quite good
Thanks for that. At risk of being hyper sensitive – I’ve been looking at some of the exchanges on other threads – I hope I didn’t say anything to offend. My (light hearted) comments were really a response to BL’s apparent wish for lots more Chairs endowed by financial institutions!
Maybe M.Sarkozy is also getting to you, besides the superannuated prof!
It’s nice to see an insider like Adair Turner, rattling a few cages.
Looking at the US finance sector, what the Joe Sixpack on the street sees is a sector which grew from 8% of S&P 500 market cap in 1990 to almost 25% at the height of the housing boom when the Fed’s federal funds rate was 1%; which owns Congress in the words of Sen. Dick Durbin (“frankly own the place”), Obama’s former Illinois colleague – – an estimated $5 billion spent in lobbying and campaign contributions over a decade; gigantic payouts when even in a recovery, the real incomes of most American workers were falling; and Uncle Sam acting as a backstop to even for the likes of Goldman Sachs when it makes most of its money from hedge fund type operations.
Wall Streeter James Grant has written in The Wall Street Journal, that Wall Street is usually described as an industry, but it shares precious few characteristics with the metal-fasteners business or the auto-parts trade. The big brokerage firms are not in business so much to make a product or even to earn a competitive return for their stockholders. Rather, they open their doors to pay their employees — specifically, to maximize employee compensation in the short run. How best to do that? Why, to bear more risk by taking on more leverage.
Grant cites Morgan Stanley, which had a ratio of assets to equity of 33 times at year-end 2007 from 26.5 times at the close of 2004. In 2007, Morgan Stanley paid out 59% of its revenues in employee compensation, up from 46% in 2004.
“They borrow to the eyes and pay themselves lordly bonuses. Naturally — eventually — they drive themselves, and the economy, into a crisis. And to the scene of this inevitable accident rush the government’s first responders — the Fed, the Treasury or the government-sponsored enterprises — bearing the people’s money,” he said.
Last July, when Nymex crude hit an all-time record high of above $147 a barrel, investors had about $300 billion outstanding on energy indexes, roughly four times the level in January 2006, according to the International Energy Agency.
So when Citi energy trader Andrew Hall presses for his $100 million payout because his risky bets paid off, should Joe Sixpack wonder if part of the spike in his gasoline bill was not related to fundamentals, but to the likes of Andrew Hall?
The other side of the gambles got an airing last February when Deutsche Bank trader Boaz Weinstein, who was earning about $40 million p.a., was reported to have lost $1.8 billion in 2008, erasing more than two years of trading gains.
DB chief Dr. Josef Ackermann, told analysts that to earn a $1.5 billion profit from proprietary trading the bank needed to risk several times that amount in capital. “You can easily lose two to three billion. That’s what we have seen in 2008 and something we don’t want to see again,” he said.
Let me first point out that both Dutch Disease and Dutch Elm Disease are so called because they were first diagnosed in the Netherlands. These diseases are neither confined to the Netherlands nor do they reflect “Dutchness” in any shape or form.
It strikes me that the UK suffers from excess volatility because of overspecialisation. As economies globabilise, they specialise too, and single sector will always be more volatile than a balanced national economy.
Many African economies suffer from the same affliction, as do countries like Russia and Saudi Arabia. Diseases are only taken seriously, however, when they affect rich people. London City Blues may be an appropriate term.
Lord Turner’s remarks are much more appropriate to the U. Kingdom than to the other Anglo-Saxon economies (I assume that, as far as economies are concerned, Ireland for some reason is classed as an Anglo-Saxon economy).
The United Kingdom has a unique problem that the others (and certainly not Ireland) don’t have. Namely, abysmal industrial performance over a very long period of time. In 2009 the volume of manufacturing output in the U. Kingdom is lower than in 1973 (yes: 1973). In 1973, over 8 million were employed in manufacturing industry in the the U. Kingdom. In 2009, that is down to 2.5 million. Some U. Kingdom economists blame the growth in the financial services sector there for the long-term decline in manufacturing, the theory being that the best talent has shied away from engineering and such like because of the availability of lucrative careers in financial services.
Other Anglo-Saxon economies have fared much better in manufacturing than the U. Kingdom, therefore the argument is much less relevant to them. The U. States and Canada have both recorded significant growth in manufacturing output in recent decades that is not only much higher than the U. Kingdom, but much higher than non-Anglo-Saxon economies such as Germany, France and Italy.
And Lord Turner’s argument certainly does not apply to Ireland. In 2009, the volume of manufacturing output in Ireland is nearly 10 times what it was in 1973 (compared with an actual fall in the U. Kingdom), While, in 2009, the number employed in manufacturing in Ireland is higher than in 1973 (compared with an almost 70% fall in the U. Kingdom).
Im not sure how the details work at other universities but in TCD a chair, regardless of how funded, is appointed on academic grounds by a search committee selecting 4-5 to be interviewed ; they plus the entire college council (which consists of elected senior and junior academics from faculties plus some ex-officio members ) then so interview the shortlisted and make an offer. In my time on the council we frequently didn’t offer as we felt that, despite the enormously high quality of the academics shortlisted, they were nto what we wanted.
So : say AIB endowed a chair – it would be advertised internationally, with relevant staff encouraged to contact people who may be interested, they would have to apply and be shortlisted on pure academic grounds and go through the process above. They would be as likely to be “nice” to AIB as would someone who say got promoted internally . In fact, as in all probability they would be non-irish they would be less inclined to kowtow.