Column : Big finance must read Adam Smith

Written by Michael Walton | Michael Walton | Updated: Sep 17 2009, 02:41am hrs
It comes to something when the President of the Federal Reserve Bank of Kansas City warns of the dangers of financial oligarchy and the Chairman of the UKs Financial Services authority questions the social value of some of finances activity. Both happened in the past month. There are big failures in financial markets! Oligarchic influence is part of the problem! A year after the collapse of Lehman Brothers is a good time to consider these issues.

The nature and depth of the financial crisis was a huge surprise to (almost) everyone. But the underlying phenomena are familiar to anyone working on developing economies. It is mainstream to recognise that financial markets are thick with failure, that crises happen, and that concentrated interests are a big influence on policy.

Lets look at the crisis through this prism. With the benefit of hindsight, it is clear that there were big market failures, notably in the development of products that amplified and obscured risks, alongside techniques to offload these onto the nave and unsuspectingthat included sophisticated investors. This induced moral hazard on a grand scale, with powerful incentives for excessive risk-taking, since those taking risks could spread or avoid the costs. Those who sold, offloaded or sanctioned these products did extremely well. This caused big real distortions, pulling talent and innovative effort into finance, such that the sector accounted for around 30% of profits in the US before the crisis.

The powerful financial lobby was an important influence on the deregulation that underpinned these changesalong with prevailing currents of thought. Lehman Brothers was just one beneficiary, enjoying large profits, giving obscene bonuses, and accumulating big risks. Like others, it efficiently transmitted these risks throughout the system.

When the music stopped, with the souring of the US subprime market, there was a collective act of revelation that the assets were of much, much lower quality than they seemed. Lehman was insolvent.

Now the action got interesting. For the US government and Fed let Lehman go bust! Here was surely a policy victory against moral hazard, and, moreover, involving a pillar of the financial system.

This didnt last long. The costs were massively higher than expected, to the extent that anything was expected in those days. The systemic effects were so extensiveowing to the extraordinary scope and complexity of counterparty riskthat the whole financial system practically froze up. Saving the system was much more important than moral hazard, and an extraordinary and impressive array of monetary, financial and fiscal action saved the world from either a short-run financial catastrophe or the Second Great Depression.

I think it is highly likely that the crisis resolution was regressive: some of the wealthy lost their shirt (and a very few may go to jail), but the financial sector as a whole benefited from major gains in the upswing and imposed an immense fiscal cost in the downturn: of the order of 40% of GDP in the US, a cost that will be paid by lower spending and higher taxes. Unemployment has risen sharply, while the share of financial profits in GDP has actually risen in 2009, and bonuses are back.

The drama is continuing to unfold. Two things happened. First, it became universally acknowledged that something had to be done on the regulatory front. But second, the underlying structure of the system has remained intact, with actually increased dominance of large financial firms, and the return to high profits, helped by cheap money and low competition. Moreover, finance remains intricately linked to the political system, with financial institutions amongst the most important donors to congressional campaigns. The banking lobby is vigorously campaigning against regulation it judges to be burdensome, even against the seemingly highly socially useful consumer products legislation, that would screen and provide warning labels on complex and risky financial products. This illustrates a common story: high levels of market concentration can shape the design and implementation of the very regulation designed to correct market failure.

Better regulation and curtailing influence will be complex in design, but what matters are the principles. The most likely short-run action will be on higher capital requirements. A good idea, but unlikely to fix problems of moral hazard, diversion of talent into finance, and future crisis risks. Lehmans measured coverage of first tier capital was healthy before the crisis. Breaking up large banks could be fiendishly difficult. But the power of big finance is surely an issue that needs to be grappled with. This isnt a left-wing preoccupation. Adam Smith was as concerned with the distorting influence of concentrated interests as he was insightful of the power of decentralised markets.

The author is at the Harvard Kennedy School, the Institute of Social & Economic Change and Centre for Policy Research