ON GOOD AND BAD FINANCE

PERSPECTIVE

The Economist makes an excellent point before starting out on a review of a new book on global finance:

"FINANCIAL history has been sliced in two: there is BC and AD—Before Crisis and After Disaster."

An excellent point indeed to keep in mind, especially as we contemplate the world past November of 2008.  The Economist goes on with it's review*:

"Any financial book conceived in far-off BC times would seem unlikely to be relevant in the AD era. But Martin Wolf’s “Fixing Global Finance” is an exception.
If Mr Wolf were to rewrite his book—a new edition is promised at some point—he would no doubt shift his emphasis. But his first run at the subject, which grew out of a series of lectures delivered in early 2006 and comes out in Britain later this month after being published in America last September, holds up remarkably well despite all that has happened.

Mr Wolf, chief economics commentator for the Financial Times, begins with a truth that is easy to forget: sophisticated finance does bring benefits. Finance allows the creation of vast enterprises out of the combined capital, supplied at modest cost, of millions of people.

It permits upstarts to launch companies, challenging the power of incumbents. It allows people to smooth their spending over a lifetime. It facilitates risk sharing and insurance. Empirical studies confirm that these advantages are real. Countries that had large financial sectors in 1960 grew faster over the next three decades than those that did not.

A doubling in the size of private credit in a developing country has been shown to boost the growth rate by an average of 2 percentage points a year. Developing countries that open their stock markets to foreign investors reap big benefits: output per worker grows by 2.3 percentage points faster than it would have done otherwise.

So financial sophistication is a boon. But it is also dangerous."

We now all to well how dangerous, and that story has not yet fully unfolded unfortunately.  But it is precisely at this time A.D. (after disaster), we need to keep in mind the benefits of "sophisticated finance".  May we see those benefits again some day, with of course the necessary precautions and oversights.

* Image source.

Comments

[Alex Tolley]

Just catching up on past issues? :)

Another solution is capital controls, which Malaysia imposed after their crisis, and was largely in place through much of the post WWII period in the OECD.

I do think we need to separate "sophisticated" from "complex and opaque". We've had a lot of financial instruments to improve the quality of life for the population for a long time. What was different this time around, was the complex nature of the instruments, that no-one really understood, and used in vast amounts. Given that the US banking sector was drawing around 30% of the profits of the S&P500, it is arguable that the purpose of these instruments was less to facilitate commerce, than to enrich bankers.

The roots of this can be traced to the huge forex markets that exploded in the wake of the collapse of the Bretton Woods fixed exchange rate regime. Forex transactions vastly exceeded global trade requirements and it is pretty evident this was a game being played by banks to make money. Finance for its own sake, rather than serving the needs of the economy.

No need to put the financial genie back in the bottle. But there was a reason you only got 3 wishes from the genie