Financial Services and Innovation

In my last post, I mentioned the City Hegemony Thesis of Britain’s economic decline. Today, I will compare a few main ideas from this theory with trends in the US. The CHT argues Britain’s global expansion in the 19th century created a large and powerful financial services industry (the City) which ultimately damaged domestic development. London was at the center of an empire which, especially after WWII, maintained its influence mostly through finance. As a result, the City flourished and gained significant influence over the government, using this influence to insure favorable free trade and laissez-faire policies. The UK went from being a center of economic innovation to one of financial innovation.

Economists have questioned whether the free market policies pushed by the City were the best policies for the UK. These policies meant capital moved efficiently to where it received the highest return with the lowest risk. Though this benefited global economic development, it hurt industry because capital was moving to sectors that did not facilitate real growth within the UK.

Here in the US, a similar thing has happened. We have lost the true purpose of the financial services industry. The main purpose of financial services, the reason these firms exist, is to provide financing and allocate capital. Financial services have built a completely new business model. If one includes the financing arms of industrial companies like GE and GM, financial earnings have represented 40% of recent S&P earnings (before 2008)! Capital is no longer a driving force of innovation but a method of speculation and arbitrage.

In the UK, the City’s allocation of capital neglected domestic industry and innovation. In the US, capital pushed mortgages and housing prices rather than innovation. Ever since the dotcom bubble, fund raising for private equity (top) and venture capital (bottom) has diminished.

Same trend for IPOs:

But Hedge Funds have boomed:

That’s not to say the growth of the financial services sector is necessarily a bad thing. Even financial product innovation can be a positive force if they were traded on exchanges rather than OTC. The most negative development has been the structural innovation. Financial firms should return to their core competencies and stay there. Investment banks should do less speculating and more underwriting. Commercial banks should do less investment banking and return to borrowing at 3, lending at 4, and golfing at 5. Speculation should be the business of hedge funds; their systemic risk is much lower since they aren’t too big to fail. (Some would argue LTCM was an exception, but what made LTCM a systemic risk was the action of its counterparties, the investment banks.)

Financial services need to recognize they have a responsibility beyond their shareholders. For example, the Lex column this Wednesday displayed a graphic showing the differences between financial recessions and normal recessions.