The opposite of real is fake and, after this tumultuous year, fake is how many now see the counterpart of the “real” economy, finance. Finance, however, for all the abuses and excesses, is not inferior to “real companies that make things”. A successful economy needs both.Subprime mortgages, monoline insurers, collateralised debt obligations, the collapse of Lehman Brothers, bail-outs for everyone from AIG to the Royal Bank of Scotland and one Bernard Madoff all tell us that financial regulation has not been working. Indeed finance is riddled, as it always has been, with gamblers using other people’s money, chancers taking risks but calling it genius, and worthy people following the crowd into collective insanity. Everyone is paying the price and regulation must be rethought.
There is a more extreme view, though, which points to the growth in finance as a share of output in rich countries and says the overmighty financial sector must become smaller, both to tame its capacity for disaster and to free resources and talent for more “productive” and “real” activities. This view is wrong.
It is mistaken in seeing finance as unproductive: it may not be tangible but its economic effects are. Financiers decide which investment projects best balance risk and reward and channel money to them: they offer ways to share intolerable risks, such as the house burning down; they allow the young to buy houses by borrowing from the old; and they make possible the exchange of goods without exchanging physical currency. If finance did not exist we would have to invent it – or find some communistic central planners to do the job instead.
Nor is financial innovation mistaken in principle. The logic of turning mortgages into bonds to disperse risks and make them tradable was reasonable; the fault was in using securitisation as a way to dodge bank capital requirements, multiply fees and dump bad loans on to others. Derivatives can be used to manage as well as to take risk. Self-certified or subprime mortgages, if extended to people with the capacity to repay after proper due diligence, should be a blessing.
It is not that finance is more prone to mania, fraud and collective error. Executives and visionaries drove the internet bubble just as much as venture capitalists; the Enron and WorldCom frauds hit (supposedly) real economy companies; US car companies have all invested in the same varieties of unpopular product. The difference is that the consequences when a financial institution goes wrong are so great. When WorldCom went under the world shrugged its shoulders; when Lehman Brothers failed the world fell to its knees. The danger of finance means it must be regulated, and regulated better – but it should not be proscribed.
Another approach is to ask whether having a large real sector makes an economy more resilient. Japan and Germany are both manufacturing powerhouses, yet they seem just as susceptible to this downturn, partly because they relied on finance-driven consumption abroad to provide demand for their exports. Developing countries, where the financial sector tends to be smaller, are suffering. Commodity exporters – how real is that? – may be in the worst position of all.
Some countries, such as Britain, which has hitched its prosperity most completely to the wealth generated by the City of London, may wish that their economies were more “real” in 2009. The idea that Britain’s economy can rely solely on finance – exporting banks and importing goods – is surely dead.
Finance and production are not alternatives but complements. The real economy relies on finance both for capital to invest and for consumers able to save, borrow and so shift their consumption in time. Finance regulators must act to address the clear and specific failures revealed this year. But that, not reining in finance for the sake of the “real”, should be their goal.
Copyright The Financial Times Limited 2008
