Why the Financial System Matters
The economy is like a game of musical chairs, and when the music stops, we don't want crooks and cheats to be the only ones who can find a seat.
Why is the financial system so important?
The purpose of the global financial system is simple, to enable the lifeblood of capitalism to do its job, to enable capital to go where it can get the greatest return for its owner. The system does that through a plethora of ever more complex arrangements and devices, financial and technological, though its fundamental character remains the same. The financial system has evolved to enable the safe movement of funds across boundaries, organizational or national. Paraphrasing Martin Shubik, money is a substitute for trust, in the world of trade. Money makes the world go round; the rest is detail, to be dipped into only if and when it helps to shed light on the problem we all have to deal with, which is how to make this system work for us.
To illustrate the significance of the financial sector, in the USA, for example, in 2006 it provided five per cent of private sector employment, but produced 8.1 per cent of GDP. The securities industry, although it contained only 0.65 per cent of private-sector employment, was responsible for 1.4 percent of US GDP. Any developed economy would be similar and the relative importance of the financial sector translates at the global level. However, these are only indicators of the sector's direct value, its indirect value to the global economy is much greater.
Because of what it does and how it does it, the global financial system is a de facto risk engine, moving risk along the value chain, across value chains, and through the whole economy, at local, regional, national and global levels. All of us can benefit from the opportunities the financial system creates and all of us suffer the consequences of the obverse of those opportunities, when risk – risk of loss, of failure, of fraud, of missed opportunities – becomes reality, as we have seen in recent months.
Ideally, the risk engine embedded in the financial system would operate as classical economists would like it to, blindly, omnisciently and impartially, like Adam Smith's invisible hand, using the information available to it to allocate risk where it is best dealt with, placing it in the safest hands or on the strongest shoulders. This is a Newtonian view of the world, with the ever reliable mechanical clock as its metaphor. All we humans need do is to wind up the clock, may be dust it occasionally, and it will do its job, creating order in an otherwise disorderly universe.
Alas, in reality the financial system is fallible, like all human creations. It is not a mechanical clock, nor even an atomic clock, which now keeps perfect time, aligning the macro world of people and planets to the micro world of atoms. Rather than a clock, it is more like any one of us; it is a macro reflection of the micro world of individual human endeavor. Information is always imperfect or incomplete, profit is not always the motive of the actors and the laws of economics have to interact with the even less rational laws of politics, they must accommodate cultural and social reality, the stage on which all human activities are performed. So, rather than a clockwork risk engine, delivering predictable and measurable results, the global financial system is more like the parlor game where players must find a chair when the music stops. Sooner or later, the music will stop and the player without a chair will be the loser.
Reality is becoming more and more complicated, by the way. It is estimated that in 1980, the book value of the S&P 500 companies was eighty per cent of the total value of market capitalization. As the first decade of the twenty-first century is closing, book values account for less than one third of the market capitalization of the S&P 500. Fundamental changes have occurred over the last few decades, redefining how economic value is generated. It is now safe to say that growth is driven primarily by factors other than land and capital. Rather, it is human capital and intellectual capital that matter, together with other intangibles, such as relationships, networks, reputation and environmental factors, such as regulatory frameworks. Yet, economic management is still firmly grounded in the industrial age and is failing to take this new reality into account.
As the 2007-08 sub-prime crisis and its aftermath have shown, the risk is not always placed in the safest hands or on the strongest shoulders. Rather, it lands where it will, when the music stops, when the bubble bursts, and people get hurt, economies get hurt, sometimes gravely or even fatally. When the financial system fails, economies fail and grief and loss often follow, sometimes accompanied by war and generalized disorder, as happened in the Weimar republic in Germany, between the World Wars, or in Yeltsin's post-communist Russia.
Because the financial system is the engine that keeps capitalism alive, and keeping nation-states from imploding, states have a strong interest in making sure that there are no failures or, at worst, that the damage is limited. For example, in developed economies there is an unspoken compact between the banks and the state: let us regulate your activities, perhaps a bit more than you might like, and we will keep you from failing. Banks increasingly perform functions akin to a water or power utility and are treated as such by government. The recent example of Northern Rock in the United Kingdom is a case in point.
Regulation is not merely another form of government red tape. It is pervasive in any western economy and is increasingly a topic of interest in developing economies. Global and national regulation is a powerful influence on business, especially in the financial sector, and is generally perceived by business as a hindrance or, at best, as a necessary evil. As rules change or new rules are made, there is a direct impact on the environment in which a business operates and sometimes on the business itself. As businesses struggle to comply with red tape, many see regulation and compliance as a threat to profitability and as a factor that discourages investment and damages competitiveness.
However, modern society cannot exist without regulation and the international financial markets and associated institutions could not exist without a regulatory framework. Only crooks and cheats prosper in an unregulated or improperly regulated market and the evidence is that properly regulated industries thrive to the advantage of most, rather than a few. Remote and recent history shows how, if not why, this is so.
Patrick Callioni is a former senior public servant, with the Queensland and Australian Governments, and is now the Managing Director of consulting company, Enterprise Intelligence Pty Ltd, which specialises in helping business to do business with government and vice-versa. www.enterpriseintelligence.net.au His book Compliance Regulation and Financial Services is available at Amazon
