Something's Rotten

EconTalk Extra
by Amy Willis
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Rana Foroohar on the Financial... Elizabeth Pape on Manufacturin...

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"You don't have to know anything about tier 1 capital to know something's rotten..."

The ratio of the financial industry's profits to its percentage of the overall economy has increased dramatically in recent decades, and has been pointed to by many as a cause for concern. That theme holds in this weeks EconTalk episode, in which host Russ Roberts welcomes Rana Foroohar of the Financial Times to discuss her new book, Makers and Takers: The Rise of Finance and the Fall of American Business. While Foroohar and Roberts don't necessarily agree on the solution, both are adamant about the problems this trend poses.

As usual, we'd like to hear what you think. Share your thoughts with us on what should be done to better discipline financial markets, the relationship between Wall Street and Washington, or your own experiences in the industry or regulatory sphere. As always, we love to hear from you.

1. What does Foroohar mean when she says the financial sector has gone from "greasing the wheels of Main Street capitalism" to becoming "the game in and of itself?"

2. Both Foroohar and Roberts bemoan the current cozy relationship between Wall Street and Washington, and to some extent, each agrees that the government's response to the 2008 financial crisis was necessary. But why does each think it was necessary, and how do their views on why characterize each's thoughts on the best way(s) to discipline the financial industry going forward?

3. How might it be possible for it to become culturally more difficult for bailouts to occur in the future? What would such cultural change look like?

4. What does Foroohar mean when she says, "What we have now is not something Adam Smith would recognize as a free market." What does she suggest as a solution to improve the financial markets for the benefit of the larger economy, and to what extent do you agree with her prescriptions?

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COMMENTS (5 to date)
Ralph Casale writes:

Two comments on the enjoyable episode. I do think I will pursue the book, which I have not read, to see if they are addressed within. Thank you for bringing it to my attention.

One item not discussed in regard to the government interaction with financial markets was FDIC. A simplified regulatory framework could come from adjusting that relationship. Too big to fail could become too big to insure via FDIC. Similarly a desire to meld conventional lending with investment banking could cost a firm this protection, or the protection could be priced (upwards) in relation to derivative ratios, leverage and/or other metrics. FDIC is an elephant in the room that few discuss, let alone consider as a regulatory tool (insurance) that could be more 'market oriented'.

The second is .... shrug. I don't recall. That is what listening in a car gets me.

Luke J writes:

Q1)

R. Epstein once (or twice) noted that that a lack of the rule of law leads to excessive compliance costs, and jobs. It seems a fitting analogy to the financial services sector, likely bloated due to overly complex regulation. Simplify the tax code and let's see what happens.

Luke J writes:

Q4)

Having read "...Wealth of Nations," and "How Adam Smith Can Change Your Life," I suspect Mr. Smith would have a measured (i.e. moderate) opinion of our economy, rather than an extreme yes/no position. I would expect him to be critical of some aspects and less of others.

That is after he recovers from the shock of being transported 240 years into the future.

Per Kurowski writes:

Allowing banks to leverage immensely with assets perceived as safe; so that they earned immensely high risk adjusted returns on equity on assets perceived as safe; was obviously a wet dream come true for bankers.

The problem though is that assets ex ante perceived as safe, like AAA rated securities, are exactly those assets that when they ex post turn up as risky, do cause major crisis. Assets that are perceived as risky, like loans to SMEs, do never create bank exposures able to put the banking system in danger.

The problem also is that allowing banks to leverage their equity differently for different assets, introduces a serious distortion in the allocation of bank credit that is also very dangerous for the health of the real economy.

“Makers and Takers” though touching base on many relevant issues ignores entirely this fundamental problem of risk weighing the capital requirements. In doing so Rana Forrohar has much company everywhere.

Here some questions you should make to any regulator that happens to come by. (Good luck!)

Mikko writes:

Q1) She means that
1) "greesing the wheels" is traditional lending where financing triggers production of some real world goods
2) "Game" happens between a gamer and a bank e.g. when ordinary people buy some complex financial instruments with minimal link to realworld goods.

Q3) Maybe financial industry should be polarized more clearly into two distinct buckets:
1) "Normal business" with no bailouts and minimal regulation. Its up to bank itself to build and maintain a trusted banking brand without support from regulator, state or central bank.
2) Property rights ensurer run by state or central bank. When I save money, stocks, certificate of land ownership, ... into these institutions I have full state backed guarantees for my ownership. I feel uncomfortable to propose state to enter yet another business but in this case it may be justified as other feasible solutions seem to be nonexisting.

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