What would the United States look like without a financial industry? This question is the starting point of my recent paper, “Should Wall-Street Be Occupied? An Overlooked Price Externality of Financial Intermediation.” At first glance, the recent crisis suggests a grim answer to this question. As financial activity collapsed, the real economy halted. Lack of financing was associated with record-level unemployment, low investment, and overall reduction in economic activity.
Much of the thinking about the social value of finance has been framed in these terms: we know that finance is important because it performs many socially useful roles, and when financing “dries up,” the economy suffers. However, this logic is somewhat flawed, because the consequences of a shock to financing may be different from a permanent reduction in financing. Equating the two is similar to equating the mental state of someone who just got divorced with the mental state of someone who is single: disappearance is very different from absence, because presence creates dependence. Once you have a spouse, you become emotionally attached, as well as financially and logistically dependent. Once that spouse leaves, it may be difficult to re-adjust.
Finance has a similar attribute: a large financial system creates more dependence on finance. Assume that you want to buy a house, and need to take out a mortgage. You might say, “It’s a good thing that the financial system is here – without a mortgage loan, I could not afford to buy this house.” This statement neglects to take into account that without a financial system, the price of the house and your financing needs would be different. Just because you need a certain amount of financing in the current environment does not mean that you would need the same amount of financing in an environment with less abundant credit.
The key is that, if credit were less abundant, it would be less abundant for everyone: it might be harder for you to get a mortgage loan, but it would also be harder for the other potential buyers. As a consequence, the seller of the house would end up selling it for a lower price (note that a temporary disappearance of credit such as a financial crisis may not trigger the same price reaction, because prices take time to adjust and because sellers may prefer to wait until credit conditions recover). At the lower price, you would need less credit to purchase the same house.
What happened here? In the current environment, you need to borrow to buy the house. But, if we permanently reduce the aggregate amount of credit and allow sufficient time for prices to adjust, you suddenly need to borrow less to buy the same house! What is the source of this black magic?
Two things are going on. First, an observant reader might note that, while the reduction in credit makes buyers better off, the seller may be worse off because he has to sell his house at a lower price. So there is some “redistribution” from sellers to buyers. The second thing is more nuanced: the value of money increases. The value of a dollar can be measured, for example, by the amount of housing that a dollar can purchase. When credit is abundant, it takes many dollars to buy a house. When credit is scarce, fewer dollars are needed to buy the same house. This means that dollars are worth more! So, even though sellers get fewer dollars from selling their houses, these dollars are more valuable.
On some level, the financial system transfers dollars from people who do not need them right now to people who do. This increases the money in circulation and raises nominal prices; the purchasing power of money declines. This is somewhat analogous to a money-printing machine: the financial system takes “unused” dollar bills and brings them back into circulation. At a given set of prices, we might think of this as a very useful activity, because people would not be able to afford their purchases without these extra “borrowed” bills. However, if these extra bills were permanently out of circulation, the value of money would be higher and people would be able to afford the same things with fewer dollars.
Realizing that part of our need for finance is because of the abundance of finance suggests that we should rethink the tradeoff between the social benefits of financial intermediation and its costs (both in terms of the large resources spent on financial activities, and in terms of vulnerability to financial crises). Because of the inefficient dependence that it creates, an unrestricted financial system is too costly, and there is room for government intervention aimed at containing our dependence on finance.