Finance is one of the easiest industries to be inherently distrustful of, and for good reason, too. The finance industry has been responsible for creating many major economic downturns. They have lost people their life savings and turned essential goods into speculative assets to be profited on.
Throughout this all, they've made billions of dollars and never clearly demonstrated the value that they've provided to society at large. But finance is a useful tool in any economic system that can genuinely do a lot of good. It can allocate resources effectively.
It can facilitate easy trade. and it can help people trade intangible future value for something that they need right now. Finance is not exclusive to capitalism either.
A good financial system is a crucial tool in basically any economic system and bad financial systems have been responsible for undoing a lot of alternatives. But it is just that, a tool, something that can be extremely useful or do a lot of damage, especially when it's allowed to grow beyond its usefulness. Today, the financial industry is one of the largest and arguably most influential systems in the world.
And between mega banks, hedge funds, private equity firms, sovereign wealth funds, and just regular people investing their money, we have arguably lost track of the role that this theoretically simple industry was supposed to play in our economies. It actually is surprisingly simple, but the manufactured complexity lumped on top of this whole system is a big part of the problem. And the only way to see that is to zoom out and properly understand what this whole thing is supposed to do and what it's not supposed to do.
So, what is the function of finance in an economy supposed to be? Is it still performing that role? and if not, what are the consequences of a finance industry that gets too large?
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So before continuing any further, it makes sense for us to establish the basic idea of finance. At its most fundamental level, the financial industry has forever been the intermediary between capital and the other factors of production, land, labor, and entrepreneurship. The finance industry takes money or wealth that's not been used and allocates it to productive economic activities to generate a return on investment.
In the case of land, the finance industry is in theory there to direct those investments of capital to where they could add the most value by taking savings deposits and using it to invest in property development, for example. Then there's labor, where the financial industry provides capital to workers so they can own assets through a mortgage and consume through things like credit cards. Here, the finance industry is trading present capital to workers in order to receive a share of the value of the workers's future labor.
And then there is the fourth factor of production, entrepreneurship, which dictates what is made with the limited resources of an economy. The finance industry in theory is supposed to regulate this factor of production by only providing capital to the ideas and businesses with the most potential to add value to the resources given to them. Say for example, there are two entrepreneurs who have an idea to cure cancer.
One is a trained oncologist with decades of experience and one is a high school dropout with no medical training. It's the finance industry's job to decide who gets allocated the limited resource of capital. When successful, entrepreneurialism is a source of invention that leads to the production of new goods and services which if successful can improve living standards for consumers, benefit society and generate profits for the entrepreneurs themselves who will share the returns with the financial intermediary who connected them with the capital to make these ideas a reality in the first place.
Now in practice, any capital investment usually funds some mixture of all three factors of production. And whilst entrepreneurialism offers good returns, it also tends to be the riskiest investment. So the financial intermediary obviously needs to perform due diligence.
Perhaps one of the most illustrative and organic examples of finance driving economic growth would be the industrial revolution in Britain from the late 18th century to the early 19th century where technological innovation and the shift to more efficient means of production radically increased economic output. New large scale enterprises required large capital inputs upfront to fund the construction of textile mills, steam engines, and mechanized equipment, which when put to use by an abundant labor force, would still take years to see any return on investment. This was only possible through access to financial capital in the first place which made it critical to industrial expansion.
But even at this stage, the financial industry was still pretty small and undeveloped with funding usually being sourced from wealthy individuals directly without a bank or investment fund acting as a middleman. As the finance industry grew, larger institutions formed and new markets emerged. Fast forward to the 20th century and financial intermediaries began to expand from investment in production to investment into consumption, which in a way was a logical move for them.
Why massproduce all of these goods if the vast majority of society can't afford to pay you for it? And so began the rise of consumer credit, which for the first time enabled consumers to live beyond the unnecessary constraints of their immediate income and savings. Credit for big ticket items such as cars, appliances, and furniture quickly became accessible in most capitalist nations during the roaring 20s.
Mortgages steadily became commonplace and as data technology evolved, finance for consumption became epitomized by credit cards during the 1980s. From 1950 to 2008, the US household debt, which measures how much credit consumers are taking on, grew from 24% of GDP in 1950 to 73% of GDP in the modern day. Now, not only is the finance industry allocating capital to the supply side of the economy, it's allocating capital to the demand side of the economy.
Now, this dual effect has driven real economic growth and improvements in living standards. But it's clear to see that the finance industry has evolved way beyond this historical account. And as the financial industry has grown in complexity, it's become difficult to see the value that many aspects of it actually provide for the real economy.
This concern is further driven by the sheer size and therefore power some of the largest financial institutions have grown to possess. Just take a look at the annual revenue of some of the largest finance companies. Some are generating totals that compare to the GDP of entire nations such as New Zealand or Portugal.
And whilst size may not matter in and of itself from so I'm told, it's safe to say that private interests of people in finance do not necessarily align with wider economic interests, which begs the question as to whether the financial industry has outgrown the net contribution role it's primarily played in the economy. This is a huge question to unpack and luckily we're able to sit down with Ra Faruhar to get her thoughts. Runner is the business columnist and associate editor of the Financial Times as well as the global economic analyst for CNN.
She had some concerning insights on the matter. So if you think about the traditional role of the financial industry, I kind of think of it like a an hourglass, right? And um you know, here are the savers up here and here are the um borrowers down here.
So people that need mortgages, people that want to start businesses. We've got all this savings up here and finance is supposed to be this kind of tiny part of the hourglass that is a help meet, you know, helping those two sides to reach each other productively. When I did my first book, Makers and Takers, in 2016, um, and I looked at the financial industry in depth, and if anything, things have gotten worse since then, only about 15% of the money that was sloshing around the financial system in America was going to that kind of productive investment into new businesses, into helping someone to buy a home, those sorts of things that really grow Main Street.
most of the the money 85% of it was just in this kind of closed loop of buying and selling of existing assets which again raises the price of things. It raises the price of housing. It raises the price of stock markets but it doesn't create anything new on Main Street.
What RER is talking about here is the transition that the finance industry has made away from long-term productive investments such as small business loans which are extremely rare nowadays and towards shorterterm trading and interest seeking from consumption. All over the world there are people in finance analyzing price movements and market data to execute trades that last as long as months and as short as a few nanconds. For foreign exchange markets, stock markets, cryptocurrency markets, and even commodity markets, short-term trading makes up a huge proportion of the total volume of trades.
While this provides liquidity to the markets, this level of short-term trading contributes little if anything to the real economy because it creates unreliable price fluctuations and it doesn't actually give publicly traded companies on the stock market any real capital to work with. Unlike long-term investing where both parties in a hypothetical transaction can win, speculative short-term trading is a zero- sum game. Total profits have to be matched by total losses and the only change that's occurred is the redistribution of value amongst the players.
And since it's a game built on an unequal playing field, it's actually driving inequality as untrained, uneducated, happygolucky, novel traders get financially skimmed by professional analysts and larger players who have more knowledge, experience, and informative tools at their disposal. This is especially the case since the CO9 pandemic, where millions of new traders enter the markets for the first time. It is well known that trading can be addictive and leads to negative outcomes for most inexperienced people who are drawn by the flashy adverts and the allure of quick cash by financial trading platforms whose only incentive is to maximize trading activity so that they profit from the fees.
Have you seen the 80% of traders lose money disclaimer that greets you when you're setting up a trading account? That's the financial industry's equivalent of the smoking kills warning found on a cigarette packet. Both are grim legally imposed reminders of the inherent risks yet too often ignored in the pursuit of short-term satisfaction.
Now you might say a game is a game survival of the fittest, right? But at the end of the day, nothing is made on the back of this type of speculative financial activity. No fiscal goods created, no services provided, and therefore value is not produced for the economy.
Investment legend Warren Buffett said it himself at the Burkshire Hathway annual meeting in 2022 when he declared that financial markets became almost totally a casino. The late Charlie Munger, Warren's right-hand man, went even further to say that civilization would have been a lot better without it. When referencing speculative trading, there are certain parts of the financial industry where you can tell that same story times 10 or times 20.
I would look at something like the commodities market, for example, and say, okay, yeah, you can go way back in history. You can go back to the Greeks and their olive presses and say, if you're an olive farmer, you might need some financial instruments to help you hedge the possibility of a drought or a poor harvest. Okay, that's that's a productive use of financial capital.
But is it a productive thing when 60 times of the trading uh in the commodities markets in certain kinds of minerals and and energy resources are being done just for the sake of financial trading versus say real hedging by farmers? And I would have to say no. Now, if you're thinking speculative short-term trading does not represent the financial industry as a whole, you'd be correct.
It's only one part of a wider system. But the core factor that enables institutional traders to profit without adding value also applies to essentially every other finance market in existence and that is information asymmetry. When one entity in a transaction has better information than the other, which means that they have a better understanding of the true value been exchanged.
For example, if a corporate executive knows about an upcoming deal that's going to increase a company's stock price, they can buy stocks before the information becomes public and before the higher price equilibrium is established. This information asymmetry between the corporate executive who is buying the stock and the seller who is blind to the near future value of the stock gives one party an advantage which they can exploit to take profit from the market. Now this example is the definition of illegal insider trading.
But elsewhere in the financial markets information asymmetry is a perfectly fine way to make profits. Take high frequency trading where algorithms with super fast connections are accessing information before anyone else. This is all done in the space of microsconds but it adds up.
Research in the quarterly journal of economics found that highfrequency trading costs the equities market alone $5 billion US a year. This represents attacks for all other market participants and is literally automated rent extraction. In the case of consumers, information asymmetry could be in the form of insurance products that you overpay for because there are subtle details in the terms and conditions that reduce the size or chance of a payout.
And ultimately, what these examples show us is that as the finance industry becomes increasingly complex, the information gap between the industry and the average Joe grows. whether that's trading, insurance, credit or any other financial market. This creates more room for the finance industry to extract value from transactions instead of assisting in the creation of new value.
Consequently, the financial industry has increased its dominant position in the global economy and its concentrated profitability is extracting value in other less obvious ways as well. The latest global graduate survey shows finance to be the leading prospective industry for graduates, having become more preferable compared to the last year, whilst education, healthcare, and government has become less preferable. As a result, human capital is diverting away from occupations that produce high marginal benefits to society, such as medical research, construction, teaching, or civil service, causing talent gaps and less effective governance and lower efficiency.
These graduates could work on the development of solutions to energy storage, medical research, and space exploration, or the development of bots that can buy stock for $213. 72 on one exchange and sell it for $213. 73 on another.
Of course, an oversized financial system is not just a problem simply because much of it is pointless. problems are further compounded by the disproportionate benefit it has for people who already have wealth. Most of the equities, the stocks, the bonds, um even the housing market in America is owned by the top 10% of the population.
So about 85% for example of the entire stock market is owned by the top 10% of the population. That gets even more concentrated when you go into the 1% the. 1%.
So, the Carl icons of the world are benefiting tremendously. I'm benefiting um because I have a large stock portfolio, but the average American still gets most of their money from a paycheck. It's about income.
It's not about asset wealth. And yet, over the last 40 years, the entire nature of our economy has changed in ways that encourage asset wealth at the expense of income growth. A recent report by McKenzie Company found that asset price inflation has created $ 160 trillion US of paper wealth globally, which is mostly benefiting the wealthy by definition.
Just take a look at the house price to income ratio in most developed countries. In most places, it's been rising for at least the last 10 years, most notably in Portugal, which we've explored in a recent video. If you'd rather look at more liquid financial assets, it's the same story.
Since 2010, US stock markets have grown three and a half times quicker than median wage growth. This is great for the owners of financial assets, but for the majority of people in the economy who source their income from labor and have low levels of investable savings, there's been little benefit. Now, finance is an easy scapegoat for all of our economic problems because, well, even finance bros don't like finance bros.
The reality is that the industry does have a function. It's there in theory to be the lubricant that makes investing, transacting, saving, and conducting business easier. It moves risk from people who don't want it to people that are happy to accept it for the potential of a reward.
And even for consumers using credit within reason, it can help to ease out budgeting and make the consumption of the goods and services we enjoy a little bit more seamless. The poison, as with most things, is in the dosage. A good engine needs oil to run, submerge the whole thing in it, though, and it's going to seize up.
Unfortunately, there's no natural stop on the finance industry. And if it can't make money by providing value, it will make money from extracting value. Now, of course, this can be addressed with regulations, but to do that, we need to first acknowledge that it has clearly gone too far to begin with.
Now, our full interview with Rana, as well as several other worldleading economists and industry insiders, is available on Curiosity Stream as part of our new featurelength documentary. There will be a link in the description to sign up and watch that, as well as an extensive library of other world-class documentaries. Thanks for watching, mate.
Bye.
