Here We Go Again: How Much is Too Much?

This comment is going to leave me subject to a lot of criticism because it (a) defies conventional wisdom, and (b) currently evokes strong feelings in a specific direction. Nonetheless, I am going to proceed anyway. Tyler Cowen writes:

I see two big and very real problems: slow income growth for many income classes and a problem with excessively high returns to finance at the very top.

This isn’t really about Tyler, but rather about the fact that he is among a group of individuals who are so self-assured about this point. Once more I would like to ask, “what are the optimal returns to finance?” The conventional wisdom is that the financial crisis proved that we had invested too heavily in finance, those who worked in finance were overpaid, etc. But how do we know how much is too much? The conventional wisdom seems to suggest that we can define “too much” in the same terms as pornography — we know it when we see it. But this is ludicrous. Even if one is willing to concede that it is somehow obvious that the returns to finance were excessive, it is still necessary to understand at what point these returns exceed optimality. Unfortunately, those who are most self-assured that the returns to finance were too large have offered no criteria for such an assessment. The financial crisis in and of itself is purportedly evidence.

A serious analysis would begin by understanding what is actually being done in finance. A popular view that I hear in the punditry is that we invested too much in finance and not enough into actually making things — whatever that means. As I have talked about before, financial intermediaries do create things. They transform illiquid assets into liquid liabilities. To the extent to which these liabilities are information-insensitive (Gary Gorton’s term), these liabilities can be considered “safe.” Ricardo Caballero has made the case that the world has a shortage of safe assets. If Caballero is correct, then the world of finance could play a significant role it mitigating that shortage and potentially create large welfare gains.

If one wants to talk about the optimal returns to finance, it is first necessary to understand the size and the scope of welfare gains created by financial innovation. Doing so requires an understanding of the purpose and the role of financial intermediaries and an explicit framework for determining optimality. Once that is done perhaps Tyler and the others will be proven correct that we need a smaller financial sector. Perhaps not. Until then, however, let’s have a moratorium on declaring something to be “too much” without having an explicit objective measure as to what is optimal.

6 responses to “Here We Go Again: How Much is Too Much?

  1. why not talk about how many camels can fit through the head of a pin??

    what nonsense.

    The question of income distribnution is one of relativity. If the median income of a nation is say $40,000 per year– should there be anyone in the income group who earns $40,000 in one day –such as Mitt Romney? and if there is people who earn that much should we tax that inome at a progressive income tax rate with a surtax for those earning a million in one year (or almost $4000 per work day)??

    the second question is should we even allow activity that can earn a $40,000 in day — if that activity can cause societal problems –hardships or even deaths??

    We throw the Willie Sutttons (bank robbers) into jail because of they way they earn their living is socially undesireable and many innocents can get severally hurt, or even shot during the robbery and get away. Why not jail the innovators of financial assets who knew they were dumping this garbage onto the pension funds of millions of workers???

  2. As economies and nations become wealthier, they throw off more investable income. Capital becomes abundant, maybe too much so.

    So, there is more demand for the management of capital. With such large pools of capital sloshing around, it is not surprising some cut off huge portions for themselves and that a mandarin class of money managers emerges.

    Ever I have supported consumption taxes. But I am beginning to wonder. What if we have capital gluts? What if people keep saving even with rates at zero as they have retirement, college, security issues?

    Desperation for yield soon trumps prudence.

  3. Ha! I agree, but good luck convincing anyone.

  4. The financial sector receives a very large public subsidy in the form of a TBTF guarantee , which probably makes the sector larger than it would be absent this subsidy. Is this optimal ?

  5. pce,

    That depends on what the optimal size of the financial sector is, doesn’t it? For example, if the financial sector was too small without TBTF, then one could justify such a subsidy. What you are saying is that TBTF makes the financial sector larger ceteris paribus. That is something different altogether and I think that is something that we agree on. Note also that I’m not advocating TBTF, but rather making a broader point that if you are going to say something is too big or too little, there should be some objective criteria by which to make those claims.

  6. Pingback: » Innovation through regulation

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