“If bankers are busy, something is wrong.”

– Walter Bagehot

I’ve argued that the Leave vote in the UK was driven by concern about four important issues facing the country: the lack of democracy in the EU, the increasing financialization of the UK economy, the ever-growing mountain of debt that had resulted from globally coordinated central banker policies, and soaring inequality. In my last post we dealt with democracy. In this post we’ll take up financialization.

Virtually everyone who has studied modern capitalist economies has bemoaned the increasing share of GDP that is going to financial activity. Certainly a healthy and honest financial sector is crucial to the operation of a free market economy. When working properly, the sector allocates credit efficiently, allows economic actors to mitigate risk, provides useful price signals, and so on. But the financial sector has a bad habit of gobbling up GDP – thereby slowing the growth of more productive sectors – and gobbling up talent – with the same result.

Just within the past year or so several studies have addressed the problem of burgeoning financial sectors. In “Does Finance Benefit Society?” Chicago Booth professor Luigi Zingales, in his presidential address to the American Finance Association at Harvard, concluded that “there is no theoretical basis for the presumption that financial innovation … increases welfare.”

Similarly, the Bank for International Settlements recently published a paper entitled “Why Does Financial Sector Growth Crowd Out Real Economic Growth?” The BIS paper concluded that a large financial sector disproportionately benefits high collateral, low productivity businesses, and that as more talented workers gravitate to highly compensated financial sectors overall economic productivity slows down.

In the early days of a market economy people are mainly poor. Few have excess capital to invest and those who do have little choice but to invest it directly in productive assets. But this is a very high-risk activity, best left to financiers and captains of industry. Investing in new enterprises, or even in the expansion of existing enterprises, means concentrating your risk and incurring extreme illiquidity. In such a world productive people and enterprises dominate, while finance is merely a tool.

But as economies expand and produce ever-greater and ever-more-widely-dispersed wealth, demand for lower-risk uses of excess capital arise. Stock and bond markets are organized, allowing investors to provide capital to companies while enjoying diversification and daily liquidity. Because money and profits are so important to people, innovation in the financial sector is richly rewarded, with new products permitting ever-lower risk, removing friction from transactions, and in general maximizing the free flow of capital across the society.

But as the financial sector grows and gobbles up resources and talent, the rest of the economy begins to suffer. Useful financial innovation morphs into unproductive innovation that merely lines the pockets of financiers. Valuable developments like mortgage-backed securities (MBS) evolved into impenetrable collateralized debt obligations (CDOs) that mutated into synthetic CDOs on which credit default swaps (CDS) were sold and so on. These “innovations” produced huge profits for the financial sector, but they served no useful purposes and many unproductive ones, e.g., allowing poor-credit, low-income individuals to buy homes they couldn’t afford. When the mortgage market collapsed in 2008 the entire global economy collapsed with it.

A powerful financial sector also becomes a vehicle for almost continuous fraud. In my own corner of the financial world – financial advice – financial firms have made billions of dollars of fraudulent profits via conflicts of interest. Elsewhere in the financial sector, phenomena like information asymmetries, corrupt cultures, over-complexity and rent-seeking behavior result in the kinds of dishonesty we read about every week in the financial press. In the paper cited above, Professor Zingales appended to his essay a list of fines imposed on financial firms just in the years 2012 – 2014. The list runs to two small-font, densely-spaced pages and totals almost $140 billion.

All modern free market economies suffer from over-financialization, but nowhere is the virus as virulent as in the UK. London is the second largest financial capital in the world, after New York, but London dominates England in ways that New York could never hope to dominate America. A full 26% of the entire population of England resides in metropolitan London, while a mere 5% of Americans live in metro New York.

There is no mystery behind London’s prominence as a financial center. Its location on Greenwich Mean Time means that when the markets open in London the Asian markets haven’t yet closed, and when the markets close in London the US markets have already opened. English common law, an independent judicial system, enforcement of contracts, support for free markets and a stable parliamentary democracy all ensure that financial activity will tend to congregate in London.

That may be terrific for London and its highly compensated financial workers (and its vast infrastructure of financial handmaidens, especially lawyers and accountants), but it’s terrible for the rest of the economy. As the London financial sector continues to grow, the oxygen is sucked out of other UK industries. It was easy, before the Brexit vote, for non-Londoners to foresee a day when all the jobs in England would be in London, while the rest of the country would consist of dark and empty factories and offices, their former employees on the dole.

By leaving the EU the UK will at last be free to exercise control over its own financial sector. Whether it can be controlled, and how that control can be imposed without destroying the essential uses of finance, are matters about which no one knows much of anything. But at least the possibility of control will be there, and thus the potential for a stronger, better-balanced and more sustainable British economy.

Next up: Waking Up on the Wrong Side of History, Part 4

Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.

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