Finance and the Economy

I’ve had a recurring rant for a few years now, that I’ve been happy to deliver over a coffee or a cocktail. The short form goes something like this:

“Financial institutions don’t produce anything. Instead, they act as catalysts – enabling other entities to be more productive than they otherwise would have. Because of the existence of banks who will offer loans, I can start a small business and stock the shelves. That additional productivity has real monetary value and so banks and finance houses have a perfectly valid slice of the economy from which to extract their profits.

Here’s the crux: Everything is fine as long as the productivity gains associated with the existence of banks exceeds the money that those banks extract from the economy. However, we need to keep in mind that banking does not actually produce anything. When banking, trading, hedging, or scamming come to be seen as actual productivity – then we have a critical error in our judgement that will eventually come crashing down.

Neither banks nor stocks nor funds actually produce value. So long as the finance system is an enabler of increased productivity, all is well. However, when the finance system comes to be seen as a growth engine for the creation of wealth, in and of itself, that is when problems start.

I never had numbers to quantify my impression that we were treating the stock market not as a catalyst but as a growth engine. Paul Krugman’s column today gives me those numbers. Apparently finance was less than 4% of the economy during the 40’s, 50s, and 60s. At the peak of the recent bubble, finance was 8% of GDP.

Let me say that again: We had 8% of our GDP that simply didn’t exist. The “P” in GDP stands for “Production.” Over 20 years, 8% … math math math … yup. That’s the problem.

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