Adair Turner, Chairman of the FSA (the SEC of the United Kingdom) is smart, articulate, and more aware than any senior regulator or finance official currently in power on this side of the Atlantic in my judgment. His 2011 Clare Distinguished Lecture in Economics and Public Policy on Reforming Finance is worth reading. In it, he discusses three interrelated ongoing responses to the financial crisis:
- A need to challenge the Anglo-Saxon model of financial capitalism;
- A need to question the rising scale of the financial sector as a percent of the total economy, and the apparently related rise of inequality;
- A need to rethink economics itself, particularly the free-market simplicities of rational expectations and the efficient market hypothesis.
I’d like to draw attention to just one subtle but critical insight Turner raises within this sweeping 30-page lecture, namely the issue of scale. Turner is not the first to question the aggregate scale of the financial sector as a proportion of the real economy in the lead up to the crisis, accounting for over 40% of corporate profits by some estimates. This phenomenon can also be seen in the astonishing growth of derivative contracts traded, debt securitizations of numerous varieties, and importantly, the growth in financial sector debt as a percentage of GDP (bank claims on other banks), which is up by a factor of 4 since 1980. Bank balance sheets today are dominated by such claims on other financial institutions. So the question of the scale of the financial sector, and the related question of its social value, is now firmly on the table. Turner then takes the scale issue further in his discussion of financial system stability from a regulator’s perspective, beyond the stability of individual firms. “Aggregate levels of debt and leverage in the real economy, and trends in those levels, are key determinants of financial stability.” This implies that even if (or hopefully when) we resolve the problem of too big to fail banks, “the total amount of credit extended to the real economy could be larger than optimal” and further, it is “the scale of new claims itself, which might require regulatory attention.” Most importantly, he focuses this question on individual markets, the subsystems of the financial system. He declares, “we many need to regulate leverage at the contract specific level within the market, rather than at the institutional bank level. The central question being how much equity and how much leverage, but now within markets rather than within specific institutions.” His reference to “contract specific level” refers in this instance to futures contracts in financial markets, but the idea is generalizable to all markets. This is a profound breakthrough with broad implications that run far beyond the macroprudential regulation of the financial system which is central in Turner’s thinking. It is a shift to thinking about systems, rather than individual institutions. And once we understand we are dealing with systems, it is only a matter of time before we begin to ask “what system?” Just as individual markets are subsystems of the financial system, which is the focus of the FSA and other financial regulators, and just as Turner and everyone else now understands the damage that boom/bust cycles in the financial system can cause to the real economy, so too does finance and the real economy impact the social systems, the regional ecosystems, and ultimately the entire geophysical system called the biosphere, within which our economy operates. It’s all one system! Turner has introduced the notion of limits in markets, not just in firms. This is new. This is in direct conflict with our naïve notion of “free markets” and even individual freedom. If there are scale limits to individual markets, how do we impose them? Who gets what share? And if there are scale limits, how do we differentiate which activities generate the most social welfare in order to give preference to such activities? Here are some examples of the choices our financial system will need to grapple with in a world of limits:
- Which gets preference, a pensioner’s investment in a long maturity fixed income investment or Goldman Sachs’ speculative trading interest (or any other speculator for that matter) in that same long maturity investment?
- General Mills’ investment in wheat futures to hedge the cost of next year’s cereal production or a pension fund’s desire to “invest” in commodities as an asset class uncorrelated with their financial assets?
- A private equity firm’s desire to tap bank debt capacity to do a leveraged buyout of a staid manufacturing firm in order to “enhance shareholder value” through outsourcing manufacturing to China or a series of small businesses needing that same bank debt capacity to fund their desire for incremental if unexciting low-margin growth in their regional markets?
Our natural instinct is to suggest that we let market participants compete for resources. However, we already know that “competitive markets” are not really truly competitive in many instances due to information asymmetries, hidden and not hidden subsidies, and a multitude of market power distortions and externalities that have lead to all kinds of unattractive social and environmental outcomes. We will learn that in a world of limits, such distortions will only accelerate, leaving even more unacceptable social and environmental outcomes if competitive market forces are left to determine the outcomes. We know in real life the importance of discipline to manage within limits or we face “systems collapse.” Too much ice cream and we get fat and sick. Too much speculation and we undermine financial system resiliency. Too many nuclear power plants near major earthquake fault lines and we put whole societies at unacceptable risk. Too much carbon in the atmosphere and civilization faces catastrophic climate risk. Systems behave like fractals. People, firms, markets, finance, economy, society, biosphere. All are connected. By introducing the notion of scale limits in financial markets, Adair Turner has, perhaps unwittingly, invited us into a whole new level of inquiry about finance and its proper place as a sub-system of the real economy, which in turn, by the laws of physics and chemistry, not theories old or new of economics, is bound by the geophysical limits of the biosphere.
