In the 19th century, U.S. Supreme Court Justice Samuel Miller complained about the "united, vigorous, and selfish effort of the capitalists" to protect their interests. Their suits had "shaken my faith in human nature.… They engage in no commerce, no trade, no manufacturing, no agriculture. They produce nothing."
The Federal Deposit Insurance Corporation's Center for Financial Research and the Journal of Financial Services Research recently invited papers for their 10th Annual Fall Research Conference with the following theme:
Financial services are intermediate inputs that provide benefits to society when they contribute to economic growth and raise standards of living. As a share of GDP, financial services have grown from 2.5 percent in the 1940s to almost 8 percent today. During this period of growth, few questioned whether the finance sector created social benefits commensurate with its share of GDP. Following the crisis, many are re-examining the linkages between the financial sector and sustainable growth. Government policies, moreover, are likely to alter the existing balance between finance and the real sector. Many market failures have been identified as a source of skewed incentives that inflated a credit bubble.
Talk about standing history on its head! Middlemen of all types, including financial, have always been objects of a popular hatred that politicians and regulators have sought to exploit. The present is no exception. In his first Inaugural Address, Franklin Roosevelt said the Great Depression occurred
Primarily … because the rulers of the exchange of mankind’s goods have failed, through their own stubbornness and their own incompetence…. Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men…. Faced by failure of credit they have proposed only the lending of more money [we wish]…. They know only the rules of a generation of self-seekers.
The money changers have fled from their high seats in the temple of our civilization. We now restore that temple to the ancient truths. The measure of the restoration lies in the extent to which we apply social values more noble than mere monetary profit.
We know that the Great Depression was one of the greatest government failures of all time: wildly fluctuating monetary policies (inflation during and after World War I followed by severe deflations) of the Federal Reserve (a government agency created in 1913), which finally abandoned its responsibilities.
Overlooked by populists and politicians, as well as in the theme of the FDIC’s conference, is that intermediaries do produce things – particularly the transport of goods and money from suppliers (including lenders) to users (including borrowers), activities that include the production and use of information, which, contrary to the attitudes of regulators, is not free. We must remember that financial intermediaries exist because of transaction costs, including the costs of information, and that they compete for profits by producing and selling information and other transaction services – just as manufacturers pursue profits by buying inputs, transforming them into tangible products, and selling them. Economist Robert Clower wrote in his compelling fashion:
The trades that take place in a market economy ultimately are determined by the quantity and distribution of natural and human resources and by individual tastes. This is true regardless of the manner in which trade is organized. In the absence of market-making firms, however, … vast quantities of resources would be diverted away from directly want-satisfying production and consumption activities into tiresome and inefficient search and bargaining chores…. [T]he firms that make and operate our numerous retail, wholesale, manufacturing, and service markets are the visible fingers of the invisible hand -- the fingers that coordinate the countless activities of people in every modern society.
The conference call’s suggestion that the growth of intermediary services as a share of the economy is recent also flies in the face of history. Industrial and financial revolutions, old and new, have been inseparable (Goldsmith 1954; Carter 2006). The coiner of the term, Arnold Toynbee (1884), wrote:
The essence of the Industrial Revolution is the substitution of competition for the mediaeval regulations which had previously controlled the production and distribution of wealth.
The conference call’s reference to market failures is also misguided. Market failures may occur – although the tendency of economists to attribute failure to the latter when theory and practice do not conform is suspect – but the recent crisis was the result of the responses of households and firms to government-promoted adverse incentives – including the promotion of packages of subprime mortgages by Government Sponsored Enterprises, official endorsements of ratings, too-easy and then too-tight monetary policy, and dependence on prospective bailouts under the Greenspan put and Too Big To Fail – reminiscent of the mercantilist/pre-industrial era that Adam Smith (1776) criticized.
The U.S. financial sector has always been heavily regulated in the belief that financial intermediation is costless (and therefore useless), so that, for example, bank portfolios are as easily understood and even managed by remote, inexperienced, and part-time overseers without meaningful incentives, as by full-time professionals whose livelihoods are at risk. This attitude was responsible for the creation of the FDIC in the 1930s as part of an attempt to resolve bank problems resulting from (1) official restrictions on bank structure (mainly anti-branching laws) and (2) the erratic monetary problems of the Federal Reserve (referred to above) by means of what might be the classic adverse incentive – deposit insurance without independence of risk or risk-based premiums (which are even today inadequate).
Instead of seeking more regulations (and engines of government failure), the conference organizers should address the connections between finance and growth, including the development of financial services in an increasingly specialized economy, and the elimination of regulations and their institutions, including the FDIC. But then they would be out of a job.
George J. Benston and Clifford W. Smith, Jr. 1976. “A transactions costs approach to the theory of financial intermediation,” Journal of Finance, May.
Susan Carter, et.al., eds. 2006. Historical Statistics of the U.S. Millennial Edition. Cambridge Univ. Press.
Robert W. Clower, 1994. “The fingers of the invisible hand,” Brock Univ. Review, April.
Raymond Goldsmith. 1954. The Share of Financial Intermediaries in National Wealth and National Assets, 1900-1949. National Bureau of Economic Research.
Carter H. Golembe. 1960. “The deposit insurance legislation of 1933: An examination of its antecedents and its purposes,” Political Science Quarterly, June.
Adam Smith. 1776. An Inquiry into the Nature and Causes of the Wealth of Nations. Strahan and Cadell.
Arnold Toynbee. 1884. The Industrial Revolution. Rivington’s.
John J. Wallis and Douglas C. North. 1986. “Measuring the transactions sector in the American economy, 1870-1970,” in S. Engerman and R. Gallman, eds. Long-Term Factors in American Economic Growth. Univ. of Chicago Press.
Robert H. Wiebe. 1967. The Search for Order, 1877-1920. Hill and Wang.