The Dysfunctional Financial Sector

After the 1929 Depression, when the economic theory entered a new era with the Keynesian revolution, which was called the "French Revolution" at the time, some anti-crisis measures were tried to be taken through regulations with the lessons learned from the crisis. However, with the neoliberal wave of the 1980s, almost all of these regulations were destroyed.

Especially in the 1990s, a rapidly growing financial market emerged with the support of technology.

In the 1990s, there was a lot of research on the effects of changes in financial markets on macroeconomic balance. This was a very popular topic in the academic world at the time. The articles clearly explained the role that the financial sector should play in the economy, but developments diverged from the ideal world described in the articles over time.

Today, articles questioning the social benefits of financial markets have become popular. The article titled "Does Finance Benefit Society?" written by Luigi Zingales is important.

Why do financial markets exist? Let's take a look at the following items:

1. The first basic function of financial markets is to provide a payment system. The role of money transfer, which is a result of the exchange of goods and services in the markets, is undertaken by financial markets.

2. Financial markets mediate the channeling of household savings to firms in need of investment projects or working capital financing. This mediation is achieved by offering a wide range of financial products to savers and those in need of credit.

3. Financial markets serve to provide liquidity in the economy through the purchase and sale of financial assets.

4. A very important task of financial markets is to provide physical and financial risk management services to households and firms.

As the growth in the financial market far exceeded the growth rate of the real economy, general economic efficiency decreased. This situation was especially valid for the USA. In periods when the financial sector grows very rapidly, qualified labor is concentrated mainly in the financial sector. Because, in order to attract the labor needed with rapid growth, the financial sector offers satisfactory wages. Thus, the labor force that has the power to provide high efficiency is distributed unevenly between the real sector and the financial sector.

The rapidly growing finance sector has to collateralize itself within the credit mechanism. Over time, as a result of rapid growth, real estate collateral, which is seen as the most solid collateral, begins to come into play. This situation begins to create an inflation in real estate market prices parallel to the growth in the finance market. At this point, a rapidly growing finance sector and a rapidly growing real estate sector become the locomotive of the economy.

The real estate sector is a sector where there is no technological development and no increase in productivity through innovation. Therefore, the growth momentum that started with the finance sector continues with the real estate sector accompanying it, and a model emerges where the credit mechanism works between the finance and real estate markets and is disconnected from the real economy.

As the resources in the economy are directed to an area where there is no technological development and therefore no increase in productivity, such as the real estate sector, the use of resources in investment areas where technological development is provided is out of the question. Indeed, American technology companies, which mediated the very high productivity increases with the effect of rapidly growing technology investments in the 1990s, have lost this power today.

Instead of acting as an intermediary, the financial sector is turning into a market that tends to monopolize through excessive profits. The result is financial institutions that are "too big to fail." Their rescue becomes a necessity when financial bubbles burst. Because if they are allowed to fail, there is a risk that the social cost will be much higher than the social cost incurred.

By bailing out giant financial institutions, the losses of these institutions are transferred to the balance sheet of the public sector, but the profits remain with these institutions. The ones who bear the losses in the balance sheet of the public sector are the taxpayers. That is, society. The ones who take the profits in financial institutions are the CEOs and other top executives who earn about 300 times the salaries of the average American citizen. These developments are at the root of income inequality in the US.

Instead of being a tool for saving and accumulating wealth in the long term, the financial sector has become a field that encourages speculation, resembling a casino. Thus, the functions predicted by economic theory and the course of financial markets have become disconnected. Naturally, economic theory has also been "dumbfounded" in explaining these developments. Although some explanations have been attempted with behavioral economic models, it is ethically impossible for theory to defend the current wreckage. Theory can only clarify the situation.

As a result of the moral erosion in financial markets, between January 2012 and December 2014, financial institutions had to pay $139 billion in fines to legal institutions in the US. These fines were born out of activities such as the Libor scandal and currency fixing operations. The last news we read in the newspapers on this subject was the $2.5 billion fine imposed on Deutsche Bank.

Debt does not present an equation where the sum of the price paid by the borrower and the profit of the lender is zero. There is collateral, and as a result of bursting bubbles, both the borrower and the lender are destroyed together. As of 2015, we see that the amount of debt before the crisis has not been melted. Global debt has only been transferred to the balance sheets of public sectors.

The Miller-Modigliani theorem states that the market is indifferent to how a firm is financed. That is, the market does not care whether a shareholder or a bank finances a firm. The observation is correct. However, in any negative situation, in one case, an individual and their environment, and in the other case, society in general, suffers economic damage.

Now, let's ask again. Does the financial sector provide any social benefit? The findings of scientific studies have given a very clear answer for the last 40 years: no! Therefore, the financial sector needs to be restored to its proper functions.