DONALD TRUMP is fond of pointing out that the stockmarket has reached many record highs under his Presidency. It is a capricious measure to boast about, and one that may not fully reflect the concerns of those who voted for him and probably care more about real wage growth. And a look at the ratio of stockmarket capitalisation relative to GDP shows that this measure is close to a record high. And that led me to reflect on a sentence I wrote a few years ago: we are better at creating new claims on wealth than at creating wealth itself.
That sentence was written in the context of the huge rise in debt in the 40 years leading up to the 2008 crisis, and on the multiplication of obscure financial instruments that preceded it. It reflected the huge rise in the economic role of the finance sector, and the wages of those who work within it. But it also relates to the way that the authorities have helped economies recover from the crisis. One of the main tools was quantitative easing (QE), creating money (new claims on wealth) in order to buy assets.
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The motivation for QE was perfectly understandable. The financial pressure on banks was causing them to shrink their balance sheets, and thus the supply of credit to the rest of the economy; when that happened in the 1930s, the result was the Great Depression. Nevertheless, successive rounds of QE, accompanied by other forms of monetary stimulus, have resulted in very high asset values and ultra-low interest rates. What was initially sold as a short-term crisis expedient measure looks set to last longer than a decade.
Total debt levels in the economy have not fallen; the debt has been shifted away from the financial sector and onto the government (and via QE, on to the books of central banks). For as long as it stays on the books of central banks, the system is more stable but if QE is ever fully unwound, the system will be just as risky as before.
Creating money is the solution to a particular problem; a shortage of demand. It is harder to make the case for this at the moment when economies have been growing for a significant period, and when unemployment in both America and Britain is under 4.5%. Back in 2013, Mervyn King, then the governor of the Bank of England, warned that
there are limits on the ability of domestic monetary policy to expand real demand in the face of the need for changes in the real equilibrium of the economy. I do not believe that the present problems in the United Kingdom stem only from a large negative shock to aggregate demand. In common with many other countries, our problems also reflect the underlying need to rebalance our economy, requiring a reallocation of resources both within and between nations. It is not simply a question of boosting aggregate demand, but of helping to bring about a shift to a new equilibrium.
One of the great economic puzzles of recent years has been the slowdown in productivity growth across western nations. There are many potential explanations for this: the continued survival of zombie companies in a low rate era; mismeasurement of the gains from technology; new tech being less significant than older innovations (the Robert Gordon thesis); a preference among businesses to use extra labour when wages are low. And so on. Without productivity growth, long-term economic growth will be sluggish, especially given the ageing nature of western populations. And it is not clear how monetary policy can be much of a help.
The same goes for the frenzied activity of the financial sector. Finance has four important functions: operating the payments system; channelling funds from savers to the corporate sector; providing liquidity to the market by buying and selling assets; and helping the rest of society to manage risks, both financial and non-financial. So one can justify all the activity – the endless multiplication of funds and instruments or the frenetic trading activity – along these grounds. More liquid asset markets potentially lower the cost of capital; the creation of instruments such as derivatives allow risk to be allocated more efficiently, to those who have the appetites (and balance sheets) to handle it.
But that argument is much harder to make in the wake of the 2008 crisis. It turned out that the banks had not kept the risk off their balance sheets and the apparent liquidity of many assets was an illusion. In the wake of the crisis, the banks have shored up their balance sheets, in part by reducing the capital they devote to trading activities, with the result that, in a crisis, markets may be even less liquid than before.
We know that every time a financial asset gets trade, someone in the industry take a cut – a commission, a fee or a bid-offer spread. It is hard to calculate whether the gains made by the rest of society in terms of a lower cost of capital etc are more, or less, than the finance sector’s take. Many within the industry will point to the falling cost of trading. But that is offset by the number of times assets are traded; Thomas Philippon’s study found that the proportionate cut taken by financial intermediaries is as large as it was in the 19th century.
Winston Churchill famously said that he would “rather see finance less proud and industry more content.” A lot of people might be happier if the stockmarket was less buoyant and the average standard of living was more so.
The financial markets are not the whole economy