My previous argument in the Economist debate* was that the 3% of GDP that was made up of financial services in 1965 was clearly sufficient to the task, the proof being that the decade was a strong candidate for the greatest economic decade of the 20th century. We should be suspicious, therefore, of the benefits derived from the extra 4.5% of the pie that went to pay for financial services by 2007, as the financial services share of GDP expanded to a remarkable 7.5%. This extra 4.5% would seem to be without material value except to the recipients. Yet it is a form of tax on the remaining real economy and should reduce by 4.5% a year its ability to save and invest, both of which did slow down. This, in turn, should eventually reduce the growth rate of the non-financial sector, which it indeed did: from 3.5% a year before 1965, this growth rate slowed to 2.4% between 1980 and 2007, even before the crisis.
This bloated financial system was also increasingly deregulated and run with increasing regard for profit and bonus payments at all cost. Thirty years ago, Hyman Minsky could have told you that this would guarantee a major financial bubble sooner or later and at periodic intervals into the indefinite future. This unnecessary explosion in the size of the financial world has been a clear example of the potential for dysfunctionality in the capitalist free market system. I have not been a great fan of the theory of rational expectations – the belief in cold, rational, calculating homo sapiens; indeed, I believe it to be the greatest-ever failure of economic theory, which goes a long way toward explaining how completely useless economists were at warning us of the approaching crisis (with a half handful of honorable exceptions). But it would be a better world if their false assumptions were actually accurate ones: if only information flowed freely, were processed efficiently, and were available equally on both sides of every transaction, we would indeed live in a more efficient and probably better world. The problem that information is asymmetrical in the financial business is a serious one. One side of the transaction, say an institutional pension fund, is often at the mercy of the other, say the prop desk of a talented and mercilessly profit-oriented investment bank.
The problem of asymmetrical information is compounded by the confusion between the roles of agent and counterparty. I grew up in a world where stocks and other financial instruments were traded by the client with a high degree of trust in the agent. Millions of dollars traded on a word, without a tape recording. Somewhere along the way, without any formal announcement of the change, the “client” in a trade mutated into a “counterparty” who could be exploited. Steadily along the way, the agents’ behavior became more concerned with the return on their own trading capital than with the well-being of their clients. One of my nastiest shocks in 45 years was the realization one day in 1985 that we had been ripped off by our then favorite broker on one of the early program trades we were doing. We had supposed we had developed a trusting relationship. We had certainly done many incentive trades that were successful from our point of view. Perhaps, with hindsight, our strong incentives might have merely motivated them to rip off some other client.