On Saturday, The Baseline Scenario's Simon Johnson returned to the question of modern finance and financial innovation. Johnson's original post last week presented the thesis that finance has grown too large and too innovative, thus creating diseconomies in the real economy. He admitted, however, that the evidence for that thesis was thin; in fact, he cited studies providing only circumstantial evidence on both sides of the issue. Indeed, that to me is what was most striking about this fundamental debate: The economics profession had never really gotten around to studying the relationship between the financial and the real economy enough to provide policy that's based on much more than past practice, a dislike of well-paid bankers or the new conventional wisdom.
Johnson's first post spent some time on the sketchy evidence. In his second, apparently buoyed up by the response, he abandons that skepticism, declaring not only that modern finance is too large but also that it has effectively taken over the government. This is a return to one of Johnson's favorite arguments, that the banks constitute a kind of oligarchy that calls the shots, what he's now calling "state capture."
The problem here is that Johnson has no more evidence for this than he did the first time. And he bulldozes through any skepticism by erecting a straw man, noting that as "the Lehman anniversary approaches, defenders of the financial sector struggle into position." Struggle into position? What are they, overweight fighter pilots? He then purports to summarize the pro-finance position with three points: "We need finance to make the economy work; financial innovation delivers value, although it's not perfect (what is?); don't kill the goose that laid the golden egg."
I'll speak for no one else: Those three statements are exactly as hypothetical and exactly as unproven as Johnson's meme of bank state capture. We have no idea, in both cases. It's true, just as Johnson believes in a bank oligarchy and in the notion that finance has sucked the life out of the real economy, a multitude of economists still believe all or part of these three main points. But we're at the point where we need to make policy. Say Johnson is correct and finance is too large, a position many share and given the reality of too-big-to-fail an obvious regulatory problem. But Johnson is not talking individual banks; he's talking finance as a sector. What's the optimal size? How far should we shrink it down to achieve the kind of real growth that will reduce unemployment and drive incomes across the board? The question becomes even knottier with financial innovation. What should we get rid of? What should we keep? Johnson can scoff at the notion that some innovation produces value, but how do we draw the line to preserve the good and eliminate the bad? Should all securitizations go? Should we try Tobin taxes, as the U.K.'s Financial Services Agency's Adair Turner suggested recently, that hammer speculative trading, if we could ever distinguish that from fruitful investing?
The closest thing to an empirical economic argument is Johnson's notion that we should now go back and "recalculate" economic growth, subtracting all the bad mortgages and loans and losses. How would that work exactly? Can't a bad loan or a bubble leave at least a residue of "real" value despite it gong bad? Google Inc. (NASDAQ:GOOG), after all, was started in the midst of the dot-com boom. Should we just declare the value it has generated since a mere mirage? Again, the issue here to me isn't that such a recalibration shouldn't take place, it's why haven't the tools been developed to make it a meaningful and ongoing project, and one we can develop policy on a rational basis? Technological innovation is another one of those areas that neoclassical economics has long struggled to fit into its calculations.
A former chief economist at the International Monetary Fund, Johnson has been an insightful observer of international economic affairs. How would that Johnson imagine convincing leaders from around the world (and you'd need them all, or at least most of the G-20) to take the steps necessary to significantly shrink finance, beyond the kind of new capital rules being discussed at the G-20? So far no one's listening. Are the world's most developed economies going to take a blind leap into the dark?
The fact is, faced with an empirical vacuity, Johnson himself leaps into a more satisfying political argument that requires no evidence. This may make many of his regular readers happy, but it takes the argument in a whole new direction. If Johnson is right, then why do voters allow this to occur? What does it say about American democracy and about the American electorate? What it says is that they're just as dumb (or dumber) than those masses of emerging nation voters who at least may lack the democratic means to break a bank oligarchy (or it says, perhaps more realistically, that voters tolerated growing size for years in exchange for some services that they desired like ATMs and credit cards, a tolerance that may now be growing thin). And given that the tide now seems to be flowing away from the state capture theory, at least in terms of policy, what hope does Johnson hold that any significant steps will be taken? Or does he just want to indulge in the prophet gig?
Robert Teitelman is editor in chief of The Deal.