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.