Haldane/Madouros: What is the Contribution of the Financial Sector?

Yves here. Andrew Haldane is the most important thinker, bar none, on the financial services industry today. This piece by Haldane and Vasileios Madouros, a fellow member of the Financial Stability team at the Bank of England. contains a key statement that needs to be drummed into policy makers and commentators: “Bearing risk is not, by itself, a productive activity.”

By Andrew Haldane, Executive Director, Financial Stability, Bank of England and Vasileios Madouros, Economist in the Financial Stability directorate of the Bank of England. Cross posted from VoxEU

Whilst few would argue that the financial crisis has not brought the real economy down with it, there is considerably less clarity about what the positive contribution of the financial sector is during normal times. This lead commentary in the current Vox debate on the issue focuses on the value-added of risk and government subsidies in national accounting, and makes an important distinction between risk-taking and risk management.

There is no doubting the financial sector has a significant impact on the real economy. Financial crisis experience makes this only too clear.1 Financial recessions are both deeper and longer-lasting than normal recessions. At this stage of a normal recession, output would be about 5% above its pre-crisis level. Today, in the UK, it remains about 3.5% below. So this much is clear: Starved of the services of the financial sector, the real economy cannot recuperate quickly.

But that does not answer the question of what positive contribution finance makes in normal, non-recessionary states. This is an altogether murkier picture. Even in concept, there is little clarity about the services that banks provide to customers, much less whether statisticians are correctly measuring those services.2 As currently measured, however, it seems likely that the value of financial intermediation services is significantly overstated in the national accounts, for reasons we now explain.

‘Excess’ returns in the banking sector3

The headline national accounts numbers point to a significant contribution of the financial sector to the economy. For the US, the value-added of financial intermediaries was about $1.2 trillion in 2010 – equivalent to 8% of total GDP. In the UK, the value-added of finance was around 10% of GDP in 2009. The trends over time are even more striking. For example, they suggest that the contribution of the financial sector to GDP in the US has increased almost fourfold since the Second World War.

At face value, these trends would be consistent with large productivity gains in finance. Pre-crisis, that is what the bald numbers implied. Measured total factor productivity growth in the financial sector exceeded that in the rest of the economy (Figure 1). Financial innovation was said to have allowed the banking system to better manage risk and allocate capital. These efficiency gains in turn allowed the factors of banking production (labour and capital) to reap the benefits through high returns (wages and dividends).

Figure 1 Differential in TFP growth between financial intermediation and the whole economy

Source: EU KLEMS and authors’ calculations. The EU KLEMS data are available online at www.euklems.net. For further detail on the database, see O’Mahony, M and Timmer, P M (2009), “Output, input and productivity measures at the industry level: the EU KLEMS Database”, Economic Journal, 119(538), pp. 374-403.

Notes: TFP estimates beased on the value-added approach and account for changes in both the quantity and quality of labour. A positive number implies higher TFP growth in financial intermedation relative to the whole economy.

But crisis experience has challenged this narrative. High pre-crisis returns in the financial sector proved temporary. The return on tangible equity in UK banking fell from levels of 25%+ in 2006 to – 29% in 2008. Many financial institutions around the world found themselves calling on the authorities, in enormous size, to help manage their solvency and liquidity risk. That fall from grace, and the resulting ballooning of risk, sits uneasily with a pre-crisis story of a shift in the technological frontier of banks’ risk management.

In fact, high pre-crisis returns to banking had a much more mundane explanation. They reflected simply increased risk-taking across the sector. This was not an outward shift in the portfolio possibility set of finance. Instead, it was a traverse up the high-wire of risk and return. This hire-wire act involved, on the asset side, rapid credit expansion, often through the development of poorly understood financial instruments. On the liability side, this ballooning balance sheet was financed using risky leverage, often at short maturities.

Risk-taking versus risk management

In what sense is increased risk-taking by banks a value-added service for the economy at large? In short, it is not.

The financial system provides a number of services to the wider economy, including payment and transaction services to depositors and borrowers; intermediation services by transforming deposits into funding for households, companies or governments; and risk transfer and insurance services. In doing so, financial intermediaries take on risk. For example, when they finance long-term loans to companies using short-term deposits from households, banks assume liquidity risk. And when they extend mortgages to households, they take on credit risk.

But bearing risk is not, by itself, a productive activity. The act of investing capital in a risky asset is a fundamental feature of capital markets. For example, a retail investor that purchases bonds issued by a company is bearing risk, but not contributing so much as a cent to measured economic activity. Similarly, a household that decides to use all of its liquid deposits to purchase a house, instead of borrowing some money from the bank and keeping some of its deposits with the bank, is bearing liquidity risk.

Neither of these acts could be said to boost overall economic activity or productivity in the economy. They re-allocate risk in the system but do not fundamentally change its size or shape. For that reason, statisticians do not count these activities in capital markets as contributing to activity or welfare. Rightly so.

What is a demonstrably productive economic activity is the management of risk. Banks use labour and capital to screen borrowers, assess their creditworthiness and monitor them. And they spend resources to assess their vulnerability to liquidity shocks arising from the maturity mismatches on their balance sheets. Customers, in turn, remunerate banks for these productive services

The current framework for measuring the contribution of financial intermediaries captures few of these subtleties. Crucially, it blurs the distinction between risk-bearing and risk management. Revenues that banks earn as compensation for risk-bearing – the spread between loan and deposit rates on their loan book – are accounted for as output by the banking sector. So bank balance-sheet expansion, as occurred ahead of the crisis, counts as increased value-added. But this confuses risk-bearing with risk management, especially when the risk itself may be mis-priced or mis-managed.

The upshot is a potentially significant over-estimation of the valued-added of the financial sector. The size of this effect is potentially very large. For example, Colangelo and Inklaar (2010) suggest that, for the Eurozone as a whole, adjusting for risk-taking would reduce the estimated output of the financial sector by about 25-40 % relative to the current methodology. If the same factor were applied in the UK, the measured contribution of the financial sector would suddenly drop to about 6-7.5% of GDP. That’s a measurement error of about £35-£55 billion based on 2009 data. The impact of this on overall GDP is likely to be smaller because half of the output of the financial sector is consumed by other businesses – so, while the measured value added of finance would drop, that of other sectors would increase.

Indeed, a banking system that does not accurately assess and price risk could even be thought to subtract value from the economy. Buyers and sellers of risk could meet instead in capital markets – as indeed they have, increasingly, following the crisis. The national accounts would capture such a transfer as a fall in GDP. But to the extent that capital markets are at present better able to price and manage that risk than banks, the opposite is actually true.

Implicit subsidies

There is a second, equally important, reason why the measured value-added of the financial sector in the national accounts may be seriously over-stated. We now know that the risk being taken by banks was not in fact borne by them, fully or potentially even partially. Instead it has been borne by society.

That is why GDP today lies below its pre-crisis level. And it is why government balance sheets, relative to GDP, are set to double as a result of the crisis in many countries.

But if banking risks are not borne by banks, they will not be priced by banks, or investors in banks, either. The implicit support of the taxpayer and society will show up as an explicit profits bonus to the financial system. Lower risk means lower funding costs, which in turn means fatter banking profits. If there are expectations that the government cavalry always stands at the ready, excess returns will be harvested both pre and post-crisis.

Elsewhere, we have sought to estimate those implicit subsidies to banking arising from its too big-to-fail status. For the largest 25 or so global banks, the average annual subsidy between 2007-2010 was hundreds of billions of dollars; on some estimates it was over $1 trillion (Haldane 2011). This compares with average annual profitability of the largest global banks of about $170 billion per annum in the five years ahead of the crisis.

Government subsidies – whether implicit or explicit – cannot be said to have added to economic well-being in aggregate. At best, they are a sectoral re-distribution of resources from the general taxpayer to the banks. If raising taxes or lowering government revenues has deadweight welfare costs, this transfer is actually welfare-reducing. That effect, too, is completely missed by existing statistical measures of the contribution of the financial sector.


If risk-making were a value-adding activity, Russian roulette players would contribute disproportionately to global welfare. And if government subsidies were the route to improved well-being, today’s growth problems could be solved at a stroke. Typically, this is not the way societies keep score. But it was those very misconceptions which caused the measured contribution of the financial sector to be over-estimated ahead of the crisis.

Risk-management is a legitimately value-added activity. It lies at the heart of the services banks provide. Today’s debate around banking and bankers has usefully rediscovered that key fact, amid the rubble of broken balance sheets and wasted financial and human capital. Investors, regulators and statisticians now need to adjust their measuring rods to ensure they are not blind to risk when next evaluating the return to banking.

For references and footnotes, visit the article at VoxEU

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  1. Blissex

    «There is a second, equally important, reason why the measured value-added of the financial sector in the national accounts may be seriously over-stated. We now know that the risk being taken by banks was not in fact borne by them, fully or potentially even partially. Instead it has been borne by society.

    That is why GDP today lies below its pre-crisis level. And it is why government balance sheets, relative to GDP, are set to double as a result of the crisis in many countries.»

    But this is an old and pretty banal argument! Nassim Taleb pointed out quite some time ago that OVER THE CYCLE financial sector profits are negative (because those profits are the illusion resulting from time shifting of risk, and eventually “risk happens”). Now businesses can well be adding value even if profits are negative, but for the case of the financial sector that raises many doubts.

    If one looks at the “most important chart in the world”…


    …it looks like both financial sector “booked” profits were entirely illusory and a consequence of enormously increased volumes of debt.

    Indeed GDP growth (of which FIRE profits growth has been a pretty large part) in countries like the USA and UK has been massively overstated for decades: probably in the past 30 years USA and UK GDP has not grown at all (and may well have declined) in real terms per capita. Indeed if one looks at the median and not the (per capita) average that has arguably at best remained constant, and the illusory growth has gone entirely to FIRE beneficiaries in the form of a massive redistribution of income (because all those illusory capital gains and bonuses have been monetized by the beneficiaries).

    The finance sector probably has been just an engine of redistribution of income, from non-FIRE businesses to FIRE businesses, in order to create fictitious employment in the latter.

    1. JazzBumpa

      So, to summarize:

      1) Over the last 30 years banking has devolved from a necessary financial function involved in the allocation of resources and management of risk to essentially non-value-added rent-seeking activities implemented through high risk practices.

      2) When the whole house of cards came tumbling down, the losses were socialized, while the criminals who perpetrated the underlying fraud walked off not only scot-free, but with huge bonuses.

      Did I miss anything?

      This is how we’ve been screwed for decades.

      1. Foppe

        Well, one thing that you missed was that, because of the turn to speculative finance/bubble blowing, it became politically possible to a. ignore the underlying issues with providing employment for most of the population in competition with 1 billion workers who work for next to nothing, and b. to allow much more outsourcing to happen as would otherwise have been possible, because of the fact that there wouldn’t have been so much Real-estate-fueled (temporary) employment (etc.). Because of the bubbles, nobody noticed that the underlying issue of deindustrialization of the US/UK (and productivity increases not being accompanied by wage increases for workers) was constantly getting worse, while those who did notice could be ignored very easily “because everyone felt that things were going well”.

        1. nonclassical

          some of us, listening on AFN in Germany, circa 1990 to political candidates (Cuomo) discuss why he wasn’t running,
          decided Ross Perot was accurate on the issue, and voted accordingly..

      2. 2little2late

        “Did I miss anything?”

        Is it entirely lost within this discussion that multi-millions have lost occupations that have been plied for generations and are now having their homes and savings taken away by the very same institutions that 1) caused this fucking mess to begin with, and 2) are seating themselves into positions of power globally with the goal of doing what exactly….solving mankind’s problems? Is there a punch line here? Is the whole fucking planet being punked?

      3. psychohistorian

        Nice summary comment JzB

        The only thing I think you may have missed is the rule-of-law which is now either ignored or made “legal” by the bought government folk for the global inherited rich that hire, fire and direct the puppets in the financial/FIRE sectors.

      4. F. Beard

        1) Over the last 30 years banking has devolved from a necessary financial function involved in the allocation of resources … JazzBumpa

        Yes that is the party line but what banks actually do is steal purchasing power from all and lend it to some for usury.

        And how do banks pull off such a scheme? Ans: via government privileges – aka fascism.

  2. MGK

    Not discussed, but equally important is the extreme efficiency of the financial sector with regard to labor input. In other words, it takes few employees within the financial sector to generate profits and its contrbiution to overall GDP compared to other sectors. Thus as the dependence on FIRE grows, unemployment will increase since per person, deals only get bigger over time.

    The US economy is constrained because we’ve migrated to making deals rather than making stuff. The only way for this to balance is to migrate labor to cheaper markets which is not going to happen.

    The painful reality is that beyond some threshold, FIRE as a component of the overall economy is detrimental to long term sustainability.

    1. ifthethunderdontgetya™³²®©

      It’s also illustrative of what an enormous error (for the rest of us) it was to approve all those banking mergers.

      Remember how often we we’re told we were ‘over-banked?’

      Prudent underwriting by banks who ‘knew their customers’ was replaced by lousy underwriting by too-big-to-fail banks (employing far fewer people) whose intention was to sell off the loans.

      And neither of our political parties is willing to do anything real about it, because they’re both in the bankers’ pockets.

      1. F. Beard

        Even “prudent lending” amounts to counterfeiting. Do not be surprised therefor if even “prudent lending” is unstable. For one thing, bank loans create the principal but not the interest for loans. For another, the debt typically compounds faster than real economic growth. For another, banks divide society into two groups – the “creditworthy” and the “non-creditworthy” with the “creditworthy” being privileged to loot the “non-creditworthy.”

        We don’t need banks. We need a risk-free money storage and transaction service but we don’t need banks.

        1. Calgacus

          F. Beard, we don’t need private banks, but we do need banking – lending, perhaps undertaken by the state, in a decentralized manner. Private currencies = private debt which is stable without being linked to the state, or the opposite, economies without private debt & lending are figments of the imagination that never existed and will never exist. A well-regulated private system, like the US had in the 30s – 70s is a reasonably close approximation to the ideal.

          If a private system is not making outsize profits, as today’s is, it is ipso facto not that different from a public system, not so far from the ideal. The problem is political instability even more than financial instability if banking is not done directly by gubmint bureaucrats – maybe on a JG! – which is what I would support. The political instability is that the banksters just buy the moronic government which creates them, and which is too stupid to remember that they are merely its tools.

          1. F. Beard

            we don’t need private banks, but we do need banking – lending, perhaps undertaken by the state, in a decentralized manner. Calgacus

            I don’t see the need for lending. If people have capital (including their talents and skills) then let them form or join a common stock company and let the common stock itself serve as money. In fact, anyone who accepted common stock money would become a member of that common stock company.

            Conventional money is an unnecessary intermediary between capital owners (including labor). I would not ban banking but certainly all government privileges for it should be abolished.

    2. rotter

      Im sure its implied in your comment wrt “the only way to fix”, but just in case not let me beat it over the head: Rather than deport millions of American workers to Maylasia and Tailand and Vietnam, lets shrink the christing financial industry (to a convenient wallet size) and rebuild our production capability. wealth = production, poverty = – production. It has to happen eventually anyway as transportation becomes more and more expensive, and the places to which manufacturing capital has to flee in order find a comfy level of corruption and worker destitution are too “libertarian” even with US millitary intervention (even for that gang). By then, government corruption and worker destitution in the US and Britain will be at SE Asian levels anyway, which is, no doubt part of the plan.

  3. Very Serious Sam

    “For the US, the value-added of financial intermediaries was about $1.2 trillion in 2010 – equivalent to 8% of total GDP. In the UK, the value-added of finance was around 10% of GDP in 2009”

    If one takes this figures face value, it would be interesting to know if the number of people working in this sector and their salaries are on the same level as the added values.

  4. Blue Tuesday

    > Nassim Taleb pointed out quite some time ago that OVER THE > CYCLE financial sector profits are negative

    Nassim is not an exaggerating: Cumulative bank losses exceed profits for as long back as there is data for.

      1. Blissex

        There are two reason why FIRE management are paid so much.

        * Banking is in effect a state function which is given a private mask (like weapons manufacturing and oil trading), mostly for international trade purposes. Banks have been forever an instrument or support of state policy. Bank management are richly rewarded for going along with the masquerade.

        * In the past 30 years stupid and greedy middle and upper class voters have demanded tax free and effort free financial capital gains for themselves (and lower wages for everybody else, but that’s another story) to fund the lifestyle they felt entitled to as WINNERS. As long as banks and brokers delivered the credit bubble that financed massive explosions in PE ratios for stocks and wage/price ratios for house, the petty rentiers who make the majority of voters were entirely happy for their benefactors to reward themselves as much as they wanted.

        The latter point is my usual one about how corrupt are most american voters, the “F*ck YOU! I got mine” class. Nothing new there, some of my usual quotes from J. K. Galbraith’s “The Great Crash 1929”.

        page 32 «One thing in the twenties should have been visible even to Coolidge. It concerned the American people of whose character he had spoken so well. Along with the sterling qualities he praised, there also displaying an inordinate desire to get rich quickly with a minimum of physical effort.»

        page 35 «The Florida boom was the first indication of the mood of the twenties and the conviction that God has intended the American middle class to be rich.

        But that this mood survived the Florida collapse is still more remarkable. It was widely understood that things had gone to pieces in Florida. While the number of speculators was almost certainly small compared with the subsequent speculation in the stock market, nearly every community contained a man who was known to have taken “quite a beating” in Florida. For a century after the collapse of the South Sea Bubble, Englishmen regarded the most reputable joint stock companies with some suspicion.

        Even as the Florida boom collapsed, the faith of Americans in quick, effortless enrichment in the stock market was becoming every day more evident.»

        page 68 «For now, free at last from all threat of government reaction or retribution, the market sailed off into the wild blue yonder. Especially after 1 June all hesitation disappeared.

        Never before or since have so many become so wondrously, so effortlessly, and so quickly rich.

        Perhaps Messrs Hoover and Mellon and the Federal Reserve were right in keeping their hands off. Perhaps it was worth being poor for a long time to be so rich for just a little while.»

        page 206 «Yet, in some respects, the chances for a recurrence of a speculative orgy are rather good.

        No one can doubt that the American people remain susceptible to the speculative mood — to the conviction that enterprise can be attended by unlimited rewards, which they, individually, were meant to share.

        A rising market can still bring the reality of riches. This, in turn, can draw more and more people to participate.»

        page 25 «Just as Republican orators for a generation after Appomattox made use of the bloody shirt, so for a generation Democrats have been warning that to elect Republicans is to invite another disaster like that of 1929. The defeat of the Democratic candidate in 1952 was widely attributed to the unfortunate appearance at the polls of too many youths who knew only by hearsay of the horrors of those days. It would be good to know whether, indeed, we shall some day have another 1929.»

  5. Brian

    I am not sure that an honest answer can be gleaned from the question. We lesser mortals have watched a repeat, with all the mistakes magnified, of the crisis of 1929-41. When the rules were abandoned, the risks became parodies of themselves. We have seen the same type of sickness rule the roost, and again, as if on cue, the destruction of the people upon whose backs the money was made, stolen, misappropriated, etc.
    I do not believe a rational or valid argument can be made for the “industry” of finance, for it would first need to be compared to the destruction of resources, environment, and smaller nations by the hundredweight, to gather everything of value to a few that produce no meaningful work.
    It is a form of gambling unlike a single person sitting down to try their weekly paycheck on the wheel, yet analogous. For the little person loses to the fix and their family suffers. When the thousands of vultures looking for their next meal go to their wheel, it affects millions of people, and the entire planet. It allows a disproportionate number of people unable to kick the habit to ruin others that have no such habit.
    It is much like religion isn’t it? There is no basis in fact for any precept, and the end result is the self satisfaction provided by the power or the money.
    Perhaps we will recognize it for the sickness that it is.

  6. patrick

    Banking is a necessary element in an economy – it is a utility – speculative finance is not. The two need to be divorced and everyone should be certain that risk takers will not be supported by the tax payer.

    1. F. Beard

      The two need to be divorced and everyone should be certain that risk takers will not be supported by the tax payer. Patrick

      All lending is inherently risky so you are implying the need for a risk-free money storage and transaction service that pays no interest and does no lending. I agree. Monetarily sovereign governments are the ideal institution to provide such a risk-free service since they cannot run out of money.

      If people wish to lend money then let them bear all risk in doing do.

      1. EH

        Your repeated comments imply an interest in Islamic banking, which you probably should look in to if you haven’t already.

        1. F. Beard

          My impression is that Islamic Banking obeys the letter of the anti-usury commands in the Koran but not the spirit.

          Not that the West has done better; the clear meaning of Scripture was twisted to allow usury so long as it was not “excessive” or collected from the poor.

          Strangely, the common stock company invented in 1602 made usury obsolete 92 years before the Bank of England.

          1. mansoor h. khan

            F. Beard,

            Please note that islam has no “official” institution or clergy or anything close.

            I believe the current form of islamic banking as commonly performed by major financial institutions (including in Iran) is a lie and just usury in disguise and not true to the teachings of quran and sunnah!

            Mansoor Khan

          2. skippy

            You can get a loan to buy some land, but, still have to pay rent on it, till the loan is payed off. Interest – usury is just…renamed….word games.

            Skippy…those with the the dosh, interpret, write the laws, go figure.

          3. mansoor h. khan


            Yes. Interest free loan is allowed. But in a bankruptcy situation the loan becomes an equity claim. The lien holder must share the proceeds and does NOT get his cut first. So if I purchased land for $10,000 and borrowed $2,500 (interest free) but was unable to pay but had paid back $500 then the land sold for $8,000. The lien holder would not get $2,000 but would get $1,600 only. The lien holder also suffers from the decline in value.

            This creates a different (a better more responsible) social relationships (which is the goal of quran and sunnah).


          4. mansoor h. khan


            “on ground does
            not even come close to working like that.”

            I have to agree with you on that. My brother in law says the same thing. Oh, it (islam) looks good on paper like Communism does but does not work in practice. My practicing elders tell me most of islamic history. Islam worked very well (700 to 1600?). Since 1600s then it has not worked as well as say the western way of life and thinking (overall).

            I don’t have a good answer to this discrepancy. Other than to say the “god works in mysterious ways”. Anyway, please keep your heart and mind open to new ideas.

            Thanks. Mansoor

          5. skippy

            @Mansoor, thanks for your personal honesty. Best wishes with your bridge building.

            Skippy…yep good time line for some things and not others… ha… what would the West be with out the Persians…plus.

          6. mansoor h. khan


            But I pray for more than just a bridge everyday. I pray that the creator of the universe guide me, you, america, and then humanity. My heart desires that the guidance be in that order but of course I will accept another order.


        2. Blissex

          It is not just Islamic banking: it is also Christian and Jewish banking as all three religions (as well as others) forbid usury in the clearest (and pretty drastic) terms (with a special case exception).

          1. mansoor h. khan


            This is not surprising. Since Abraham is the common father of Judaism, Christianity and Islam. My mother always says you do not what god knows and what he forbids is good for you.

            Since the Lehman Collapse I have been studying money, credit and banking and I was not at all looking at this from the religious angle but now I can see the disaster compounding interest currency system creates and this is not the first time.

            A co-worker who has read “This time is different” from Rogoff and Reinhart tells me that they have documented 800 of this stuff.

            But (god willing) the economic system (currency issuance as equity rather than debt) will happen and it will be major leap for humanity.

            There all kinds of implications of this change I won’t discuss here (see Clifford H. Douglas — social credit 1924).


  7. rf

    Deposit insurance is the true source of social risk in banking and creates the need to regulate and bail-out. Eliminate it and most of these problems go away. Would you keep all your money at Citi if you were afraid to lose it? nope. Its also a quick way to make the banks small but that would take out the rent seeking that washington and wall street love so much.

    On the value add from banking and finance – its kind of like arguing about how many different smart phones a consumer should have to choose from. Whats the value add of all the work that went into all these phone choices or breakfast cereal choices for that matter.

    The only reason this guy Haldane has to opine on the value is because of the monster created but the same entity(s) he works for. If a bank could fail in the woods and no one saw it would anyone care? If banks were like cell phone makers we wouldn’t give a crap.

    1. Anonymous Jones

      Having deposit insurance is the worst way to run a banking sector, except for all the other ways.

      1. F. Beard

        Who says we should even have a banking system of any consequence?

        A sovereign government, as the monopoly creator of its fiat, should provide a risk-free storage and check clearing service for that fiat that makes no loans and pays no interest.

        And if some people are not satisfied with zero interest then let them assume all the risks of depositing their money with a bank.

        It’s high time we have separation of State and Banking.

        1. Darren Kenworthy

          It is my impression that the Federal Reserve system already provides risk free storage and check clearing services to banks and other finacial services institutions at essentially no charge. This seems to be a corollary to your argument worth mentioning.

          1. F. Beard

            Yes. The banks deal with real money among themselves but as for the rest of us we are lent our own stolen purchasing power if we are considered “creditworthy”.

      2. rf

        The market is better at imposing discipline than the government. No way banks run high leverage if they need to fight for money.

        1. Hugh

          “The market is better at imposing discipline than the government.”

          Seems like you missed most of the relevant developments of the last 35 years. The market is just a black box that hucksters use to separate the rubes from their money.

    2. TK 421

      I don’t think deposit insurance is such a bad idea. The limit is, what, $250 K a person? That’s not a little, but it’s not enough to destroy the economy. We aren’t were we are today because banks failed and depositors had to be bailed out, but rather because financial speculators bet money they did not have and lost and demanded the government pay them back the money they lost but never had in the first place. Which the government did, because it was the speculators who paid for their campaigns. Yes they can!

      “Would you keep all your money at Citi if you were afraid to lose it?”

      Isn’t that like saying “would you buy health insurance from a company who might drop you at any minute?” In theory it’s nice, but reality lets us down.

      1. rf

        All I’m saying is deposit insurance, the fed, fnma/fhlmc allows the moral hazard that creates the need for bailouts and such. Look at MF Global, they failed, who cares. If market discipline controlled leverage we would care about banks. Government together with banks created the problem.

  8. voislav

    I think that the first paragraph of this piece sums up perfectly what is wrong with the economy today:

    “There is no doubting the financial sector has a significant impact on the real economy. Financial crisis experience makes this only too clear. Financial recessions are both deeper and longer-lasting than normal recessions. At this stage of a normal recession, output would be about 5% above its pre-crisis level. Today, in the UK, it remains about 3.5% below. So this much is clear: Starved of the services of the financial sector, the real economy cannot recuperate quickly.”

    So the normal situation is the one where we have debt-fueled growth. Now that the economy has become debt-averse, we are in real trouble because, oh shucks, our precious financial sector won’t be able to rape the rest of the economy like it did in the last 20 years. Forget about having a real economy then.

  9. R Foreman

    I just love the author’s nonchalant reference to a ‘financial recession’. Let’s be honest and call it what it is.. it’s a credit contraction. Banks loaned out too much, unpayable loans, so that excess lending has to be destroyed somehow (despite the establishment’s sincere efforts to reinflate the bubble). Now nobody really trusts that banks are solvent, and banks don’t trust anybody else to be solvent and pay back loans. Recession implies excess inventory beyond what the market will bear, and our current situation has little resemblance to that (unless you consider credit-based money to be inventory).

    Given a longer timeframe, nobody will trust that governments are solvent either, but long before that kind of bank run happens, we get upheaval that destroys the social contract.

    1. mansoor h. khan

      R Foreman,

      Banks don’t loan existing government money they issue new currency (i.e., counterfeit).

      It would be better to let them counterfeit and let them spend money in the economy debt free (let them live like kings). At least we would not have recessions and depressions.


      1. F. Beard

        It would be better to let them counterfeit and let them spend money in the economy debt free (let them live like kings). mansoor h. khan

        Yes but a better way is for corporations to spend their common stock as money.

        So why don’t corporations do that now? Why should they when the government backed counterfeiting cartel is available for them to borrow from?

        1. mansoor h. khan

          F. Beard,

          I am just trying to propose a transitional deal (a treaty – even if it is one sided) with the banking cartel.

          Future generations can move toward even more just solution.

          Baby steps!


          1. F. Beard

            Actually you are doing a good job of mocking our current system; it would be better if banks just spent money into circulation rather than lend it.

            But we already have an institution for spending money into existence – government.

        2. mansoor h. khan

          F. Beard,

          I mock to help the people break out of this “matrix”. So they can think about curreny/money correctly.

          Until the public’s thinking is correct (about how money works) the cartel will keep screwing us. That is how they rule: ignorance / lack of knowledge of the populace.


        3. jonboinAR

          You keep telling us where we need to get to. Now tell us how to get there, if you would. That’s the rub, right away, ain’t it?

  10. ftm

    Yves, more of this please.

    The economic contribution of current banking is grossly mis-measured and likely negative. Neoclassical theory is no help because in that world any level of debt can co-exist with any level and trajectory of output.

    Until we can coherently describe and measure what productive banks should do, we are going to suffer at the hands of the fools who run banks for their own aggrandizement.

  11. Linus Huber

    As psychohistorian says, the rule of law is important too.

    I just like to emphasize that the RULE OF LAW is the basis of the Western Economic Model. Not only has the rule of law been violated repeatedly over the past few years but in addition over the past maybe 30 years the financial industry’s lobbying efforts have been extremely successful to allow increased risk taking and to reduce reserves thereby increasing leverage. This resulted in distorted high profits allowing those bankers to loot the system via their compensation packages. Until those looters are brought to justice, the system is unlikely to heal as only REAL justice will make them stop their looting activities.

  12. allcoppedout

    I don’t see this as sophisticated analysis at all. My short sense of this is that the argument lacks the structured realism science demands. We need to know what financiers do at more basic levels and whether this could be more cheaply and reliably embodied in technology.

    1. Yves Smith Post author

      Economics is not science. Trying to come up with more precise results given how crappy any data about bank is (their balance sheets and income statements are a function of lots of assumptions, hence they are abstractions far more than those of make and sell companies) is illusory.

      This is a blog post, not a paper. Go read Haldane’s considerable body of work. By the standards of thinking by economists in this space, it’s very creative. And remember, he’s at the Bank of England, so he can’t be as blunt as he might like (and he has still been plenty blunt).

  13. mac

    It seems to me that this is a case of folks whose contribution is to “cheat each other and call it growth”, they contribute little.

    1. Lambert Strether

      I wouldn’t mind of they cheated each other; they enjoy that, let them do it.

      I do mind that they loot from the rest of us. As a commenter pointed out here the other day, if MF Global — and please remind me why Jon Corzine isn’t in jail — can simply st– move their customers’ money into their own accounts, is even my measley 401(k) safe? Well, no, it isn’t, which is why we should immediately privatize Social Security.

  14. RSDallas

    Why do we find ourselves talking about this? Like this person is the guru of all guru’s? Everything can be traced back to when the banks were allowed to function simultaneously as a trading house. PERIOD! This is a function of Washington folk and Washington ALONE!


  15. Hugh

    The financial sector is just a euphemism for kleptocracy. Looking at it like this, the question reduces to how much has kleptocracy subtracted out of the real economy in the last 35 years?

  16. LeonovaBalletRusse

    Yves, your brilliantly incisive commentators have worked out an incipient plan based on your incisive blog.

    Form your think tank and *get er done* post haste. If you turn your attention to the *euro*, you ought to be able to claim the English Lord’s prize as a side issue.

    Forget fatigue. Go for it: *Yves And Her Boys Crack the Nut*. Call the Think Tank *The Nutcracker Suite*.

  17. UnlearningEcon

    This is a great piece. But note this framing:

    ‘Whilst few would argue that the financial crisis has not brought the real economy down with it, there is considerably less clarity about what the positive contribution of the financial sector is during normal times’

    Thinking of this as ‘crisis’ time and pre 2007 as ‘normal’ time is a dangerous things to do, as it implies the crisis is just a temporary shock; noise, and we will be back on track soon. But the crisis is the necessary result of what happened during those ‘normal’ times and the crisis is nothing other than a continuation of the same forces.

  18. HS

    There are some circumstances where risk taking is productive. For risk taking to be productive, it requires that someone have a different assessment of the risks and profitability of an investment than the market. Someone who sees a great up and coming company (think Microsoft as a startup) allocates capital to a very productive use. This is a risk, but by taking it production goes up hugely.

    However, this is not what banks do. Its what venture capitalists and investment funds do. They take risks and profit by assessing actual risks better than others in the market. However, investment funds and venture capital are risky, and failure is an accepted possibility. By profiting from taking rather than managing risks banks are acting inappropriately. They betray their investors who are looking for security, and are putting their money in banks partially to avoid risk.

  19. isa

    And speaking of risk management, what is way better to hedge family’s finances against economic instability than opening a tax-free ISA savings account? It’s definitely a saver for the rainy day.

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