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Should Wall-Street Be Occupied?

Maya Eden's picture

What would the United States look like without a financial industry? This question is the starting point of my recent paper, “Should Wall-Street Be Occupied? An Overlooked Price Externality of Financial Intermediation.” At first glance, the recent crisis suggests a grim answer to this question. As financial activity collapsed, the real economy halted. Lack of financing was associated with record-level unemployment, low investment, and overall reduction in economic activity.

Much of the thinking about the social value of finance has been framed in these terms: we know that finance is important because it performs many socially useful roles, and when financing “dries up,” the economy suffers. However, this logic is somewhat flawed, because the consequences of a shock to financing may be different from a permanent reduction in financing. Equating the two is similar to equating the mental state of someone who just got divorced with the mental state of someone who is single: disappearance is very different from absence, because presence creates dependence. Once you have a spouse, you become emotionally attached, as well as financially and logistically dependent. Once that spouse leaves, it may be difficult to re-adjust.

Finance has a similar attribute: a large financial system creates more dependence on finance. Assume that you want to buy a house, and need to take out a mortgage. You might say, “It’s a good thing that the financial system is here – without a mortgage loan, I could not afford to buy this house.” This statement neglects to take into account that without a financial system, the price of the house and your financing needs would be different. Just because you need a certain amount of financing in the current environment does not mean that you would need the same amount of financing in an environment with less abundant credit.

The key is that, if credit were less abundant, it would be less abundant for everyone: it might be harder for you to get a mortgage loan, but it would also be harder for the other potential buyers. As a consequence, the seller of the house would end up selling it for a lower price (note that a temporary disappearance of credit such as a financial crisis may not trigger the same price reaction, because prices take time to adjust and because sellers may prefer to wait until credit conditions recover). At the lower price, you would need less credit to purchase the same house.

What happened here? In the current environment, you need to borrow to buy the house. But, if we permanently reduce the aggregate amount of credit and allow sufficient time for prices to adjust, you suddenly need to borrow less to buy the same house! What is the source of this black magic?

Two things are going on. First, an observant reader might note that, while the reduction in credit makes buyers better off, the seller may be worse off because he has to sell his house at a lower price. So there is some “redistribution” from sellers to buyers. The second thing is more nuanced: the value of money increases. The value of a dollar can be measured, for example, by the amount of housing that a dollar can purchase. When credit is abundant, it takes many dollars to buy a house. When credit is scarce, fewer dollars are needed to buy the same house. This means that dollars are worth more! So, even though sellers get fewer dollars from selling their houses, these dollars are more valuable.

On some level, the financial system transfers dollars from people who do not need them right now to people who do. This increases the money in circulation and raises nominal prices; the purchasing power of money declines. This is somewhat analogous to a money-printing machine: the financial system takes “unused” dollar bills and brings them back into circulation. At a given set of prices, we might think of this as a very useful activity, because people would not be able to afford their purchases without these extra “borrowed” bills. However, if these extra bills were permanently out of circulation, the value of money would be higher and people would be able to afford the same things with fewer dollars.

Realizing that part of our need for finance is because of the abundance of finance suggests that we should rethink the tradeoff between the social benefits of financial intermediation and its costs (both in terms of the large resources spent on financial activities, and in terms of vulnerability to financial crises). Because of the inefficient dependence that it creates, an unrestricted financial system is too costly, and there is room for government intervention aimed at containing our dependence on finance.


Submitted by David J. McKenzie on
This blog post simplifies the results of an already simplistic model presented in the paper, and therefore pushes an argument that seems irrelevant for most developing countries. As the paper itself shows, once you allow for heterogeneity in producers and for capital supply to not be inelastic, financial intermediation both leads to an increase in the size of overall production in a country, and a reallocation of capital from less to more productive producers. So some financial intermediation is better than none. However, the paper then claims that there is still the possibility of too much financial intermediation since it involves a cost, and each individual who borrows doesn’t take account of the fact that part of his or her actions are to bid up the price of capital for others. But to move from this theoretical result to suggesting that there is room for government intervention to restrain access to finance is many steps too far – once one introduces all the other frictions of reality that constrain access to finance into the model, it seems much more likely that most countries are in a situation of far too little financial intermediation still – unfettered and excessive access to finance is hardly the concern of most developing countries the World Bank deals with.

Submitted by Maya Eden on
Thanks for this comment. I agree that the problem of "too much financing" seems more relevant in developed economies than in developing ones. However, I think that this mechanism might be highly relevant for thinking about the social returns to financial development in a general equilibrium framework. Many studies look at micro-interventions and suggest strikingly high returns to financing in developing countries. The general equilibrium model suggests that this type of exercise overstates the returns to finance, as it essentially holds prices fixed. In environments in which funding is highly scarce, the demand for inputs is constrained so equilibrium prices are depressed. Consequently, people who are lucky enough to receive financing can go a long way with a few rupees. However, once access to finance increases on an aggregate level, we should expect input prices to rise, which would result in much more modest returns to financing. Whether or not there are positive returns to increasing access to finance on a large scale remains an open question, especially given the high costs associated with overcoming the various "frictions" you mention.

Submitted by Anonymous on
Even if we limit our discussion to housing and its utilities with/without financing, more in-depth research is necessary. From gereneral intuition, housing without financicng can not be imagined wheter it is in developing countries or in developed countries. What is making matters more complicated is that the problem in developing countries is that even scarce financing is preoccupied by small number of people, which not only bids up the price of housing but also makes other majority of people want to easy access to more financing opportunity. In that sense, at the developmental stage, enhancing the level of access to finance can increase overall returns. It's just from my intuition.

Submitted by Maya Eden on
Thank you for this comment. I very much hope to see more in-depth research on the many issues that this price externality raises. The point you raise regarding the potential distributional implications of this price externality is an important one. When aggregate credit is scarce, the "lucky ones" who have access to financing can realize high returns given the low equilibrium prices. Your intuition is correct that allowing for broader access to finance may change the distribution of surplus. Whether this distributional change is favorable or not depends on who benefits more from more access to credit (it is likely to benefit those who have better access to credit, and hurt those who remain credit rationed). Regardless, the price externality will benefit the owners of the "constrained goods" - for example, if access to credit increases the demand for land, this will lead to an appreciation in the price of land which will benefit land owners. I hope to see more research on these important issues.

I enjoyed reading the blog and the paper. Certainly, recent events in the US lend some credence to the notion that there could be such a thing as too much finance (although most likely not in the case of most developing countries). However, even if we believe that the amount of finance needs to be limited, what really worries me is the mechanism the paper invokes to guarantee that in the end consumers could have access to the same goods as with a larger amount of finance. Essentially, all the adjustment has to happen through prices and in reality we know that in many situations prices are very sticky. Plus we observe in practice many countries where the the financial sector shrank considerably (take Argentina after the 2001-2002 crisis) and where dollar prices for houses (the example mentioned in the blog) went down only temporarily even though credit never recovered to the pre-crisis prices.

Submitted by Maya Eden on
Thank you for this comment. I absolutely agree with both points that you raise: first, price adjustments are often very slow and painful - so there is an argument for bailing out the financial system during crises, even if the "long run" goal should be reducing the economy's dependence on finance. This should be done gradually in a way that is mindful of transitional costs. Second, the Argentinian example raises a broader point regarding the relevance of this mechanism in a small open economy framework (where "dollar prices" matter). In a small open economy, the extent to which domestic credit can affect the price index is naturally more limited. To realize the entire welfare gains, reduction in financing should be done in an internationally coordinated fashion.

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