Some debates seem to be going on forever. One of them is devoted to the role of financial services, and, depending on where we are in the economic cycle, this debate might get more or less heated and bitter. What is it that finance contributes to the society? Is it adding value or is it just self-serving? Can more regulation introduced by the government change the way it behaves?

The various aspects of this discussion and the arguments have been nicely summarised by Luigi Zingales from the University of Chicago Booth School of Business who, among other things, explains how the public opinion affects and shapes the finance (a full text of the paper is available here).

In many respects finance is not dissimilar to health care – both provide a service that everybody needs, but very few understand and both depend heavily on trust. In both sectors the governments have intervened on a large scale thus limiting the natural market forces and causing both sectors to lobby hard to direct this intervention to their advantage. But in terms of social prestige there is a huge gap and historically finance has been seen primarily as a rent-seeking activity by the society. (The term “rent-seeking” in economics is usually defined as the use of resources to obtain an economic gain from others without reciprocating any benefits back to society through wealth creation.)

Although the views expressed by the uneducated masses often get sneered upon, the public perception is actually very important for the proper functioning of finance. The argument goes something like this: For finance to operate in a competitive and an arm’s length manner (in which it can truly benefit the society) it is necessary to have a prompt enforcement of contracts. When there is a case of strong public anti-finance sentiment such enforcement becomes difficult. In absence of public support only those financiers that are earning rents can afford to pay for political protection which is necessary to have the contracts enforced. As a result, what could be called the “bad finance” (the non-competitive and non-arm’s length) is the one that survives and prevails making the public anti-finance sentiment even stronger.

One of the reasons for its low public prestige, according to Mr Zingales, is that the social benefits of finance are less visible, whereas the large and sometimes rapid accumulation of wealth that is often associated with finance clearly is. The paper refers to George Soros who in 1992 shorted British pound on a massive scale and almost single-handedly forced it to leave the European Exchange Rate Mechanism. The result that was actually beneficial to the UK economy has been much less visible and is rarely acknowledged, whereas Mr Soros’s profits from this operation, which exceeded USD 1 billion, are well remembered. This creates envy and resentment and causes a public dislike towards finance even in the best of times. In periods of crisis or in cases where fraud is detected such resentment easily turns into rage endangering the contract enforcement and leading to even more rent seeking. In other words, this is a vicious circle.

The common response by the government to prevent this (and, in fact, the government’s response to almost any problem) is to increase supervision and regulation. But, given the nature of the problem and the forces at work here, this might not be the solution.

Sincerely,

Aivars Jurcans
editor@mergers.lv