What Finance is for, and How it Veered off Course

Wall StreetBy John Kay

Foreign Affairs

Over the last 30 years, the finance sector has placed itself at the centre of political, economic, and business life. Today, finance is the most powerful industrial lobby and a major provider of campaign funding. News bulletins report daily on what is happening in “the markets”—by which they mean securities markets, not shopping malls or supply chains. “Business news” is largely news about stock prices, and when news about output, employment, or products is released, the media turn to Wall Street for an assessment of its significance.

Business policy is likewise conducted with an amount of attention to Wall Street that would have been inconceivable two generations ago, and the chief executives of modern companies proclaim allegiance to the promotion of “shareholder value.” Economic policy, too, is conducted with a view to what “the markets” think, and households are increasingly forced to rely on those same markets for their retirement security. Finance is the career of choice for a high proportion of the top graduates of the top schools and universities.

A country can only be prosperous if it has a well-functioning financial system, but that does not imply that the larger the financial system a country has, the more prosperous it is likely to be. Financial innovation was critical to the creation of an industrial society; it does not follow that every modern financial innovation contributes to economic growth. Many good ideas become bad ideas when pursued to excess.

The central characteristic of the recent process of financialization in Western economies has been a shift from relationships to transactions. The traditional bank manager—whether he (it was always he) was a titan of finance, such as JP Morgan, or a community figure of the kind epitomized by George Bailey in It’s a Wonderful Life—would base his decisions on his personal knowledge of his clients. The stockbrokers of yesterday would be personally familiar with the companies they recommended to customers they knew. Investment banks maintained long-term relationships with large companies. They would have similar connections with institutions, such as the insurance companies that channelled the capital of small savers into infrastructure and business investment.

The world of finance today is dominated instead by trading, and trading is a principal source of pay and profits. Fifty years ago, there was one large speculative financial market—the stock exchange. The volume of trading in it was, by modern standards, modest: the average holding period for a share was seven years. The stock exchange was also the place where government bonds were bought and sold, but the bond market was sleepy in the extreme. Thirty years ago, activity was shifting to the trading floor of investment banks. Today, the screen is the source of information and the basis of trading: an increasing fraction of trade is conducted by computers silently transacting with each other.

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Picture: Andrés Nieto Porras from Palma de Mallorca, España (Donde el dinero ficticio se hace real) [CC BY-SA 2.0 (http://creativecommons.org/licenses/by-sa/2.0)%5D, via Wikimedia Commons

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