Whether or when a financial sector can grow so big it interferes with society's health has been a burning question since the crash of 2008 and the Great Recession that followed.
It's rare for a leading economist, especially one from deep inside the finance sector itself, to weigh in with a resounding "yes!" But that's the conclusion of University of Chicago economist Luigi Zingales, who states bluntly that there's nothing in theory or practice "to support the notion that all the growth of the financial sector in the last 40 years has been beneficial to society."
He's taking aim at banking, insurance, the stock market, and commodity and derivatives markets, and he's unhappy at how easy it is to hit his targets. "From Libor fixing to exchange rate manipulation, from gold price rigging to outright financial fraud in subprime mortgages, not a day passes without news of a fresh financial scandal."
Zingales' report will be published this summer in the Journal of Finance, but it was delivered in January as his valedictory lecture as president of the American Finance Assn. The organization is made up of "the economists and related disciplines who study finance in-depth," observes Timothy Taylor, managing editor of the Journal of Economic Perspectives, who spotlighted the Zingales lecture on his blog, Conversable Economist.
Zingales joins numerous other critics who have sounded off since the recession about our out-of-control financial industry. Taylor also points us to Stephen Cecchetti of the Bank for International Settlements, who wrote in 2012 about how the explosion of credit in the pre-crash era threw the economy off-kilter while producing its own self-destructive feedback loop:
"Finance's large rewards attract the best and the brightest," Cecchetti wrote. "When I was a student, my classmates dreamed of curing cancer, unifying field theory or flying to Mars. Those in today's cohort want to become hedge fund managers....Is this the most efficient allocation for such scarce resources? I doubt it."
Zingales has two main goals in his lecture, entitled, "Does Finance Benefit Society?" One is to underscore that there is much about the financial sector in developed economies that is wasteful, crooked and socially destructive. The other is to warn his fellow economists that their own credibility is on the line if they don't recognize that truth.
Worse, finance professors are part of the problem, he says. They instill in their students the mindset that financial gain is the only legitimate goal: "We teach our students how to maximize the tax advantage of debt and how to exploit any arbitrage opportunity. Customers are often not seen as people to respect, but as counterparties to take to the cleaners....We inadvertently do teach people how to behave and not in a good way."
Academic finance experts have sold themselves out by rationalizing behavior they know to be wrong. "We should be the watchdogs of the financial industry, not its lap dogs."
The danger, Zingales says, is that the failure to recognize the vices perpetrated by the finance sector allows its virtues to be overlooked. Manipulation, fraud, and repeated scandals encourage the public to mistrust all financial transactions and lead to increased, and increasingly complex, regulation.
That atmosphere, in turn, encourages rent-seeking--the pursuit of business advantage via political influence, which lowers the quality of the entire sector. "Only those financiers who enjoy rents can afford to pay for the heavy lobbying," Zingales states. "Only the noncompetitive and clubbish...can survive."
The reality that the financial sector, in its proper role, "fosters growth, promotes entrepreneurship, favors education, alleviates poverty and reduces inequality" gets lost because of public disdain.
An overly large, aggressive, and heedless finance sector becomes an end in itself, rather than a servant of the productive sectors of the economy--manufacturing, construction, retailing, and education, among others. That's an unsustainable balance, because it produces more anti-finance sentiment than is healthy.
That's what the United States faced after 1929, Zingales warns, "and it faces this risk again today."