One year after investment banking firm Lehman Brothers filed for bankruptcy protection, kicking off a week of massive shifts on Wall Street that was the beginning of the largest financial crisis in recent memory, Douglas Elliott participated in a live online chat to discuss the effect the financial crisis has had on the banking industry.
Douglas Elliott: Hi, this is Doug Elliott of the Brookings Institution. Welcome to our web chat. I apologize in advance that I won't be able to answer all your excellent questions, but I'll do what I can. Feel free to fire away when you're ready.
Laurel, Md.: Has Wall Street learned that it was too big?
I was just reading that during 2006(?) the financial sector earned one-third of all the profits of the S&P 500 companies, and that doesn't even include the finance arms of conglomerates like GM and GE. A small country like Switzerland can support an economy based on finance, but a major economy like the US can't make "nothing but money."
If this lesson has been learned, is it being implemented at the education level? In other words, are more of the brightest minds going into real sciences, and fewer into finance, than a couple of years ago?
Douglas Elliott: I share your intuition that the finance industry is larger than it would ideally be, but it is a remarkably hard thing to prove. First, profits in the sector are quite volatile, so you need to look at longer term averages. The industry has given back much of the excess profits that it earned in 2005 and 2006 by losing money subsequently. I suspect that a longer term average is more like 20% of the S&P 500's profits.
Second, no one that I know has a good way of measuring what size is right for any industry from a society's point of view. Confucius thought merchants were too important in China because they didn't create anything. Modern thinkers view merchants, broadly defined, as essential contributors to the economy. We may alter our view of finance over time and view a large finance sector as a good thing.
Again, I share your view. It's just hard to prove and because it's hard to prove it becomes hard to know what the right public policy is. Certainly it's difficult to persuade Wall Street to slim down when we have no analytical approach to convincingly show them what size they should be.
Detroit: Do you foresee a repeat negative effect of the banking industry on the stock market in the next few years?
Douglas Elliott: The banking industry is very important to the economy and it's still going through a turbulent period, with a lot more credit losses coming. So, I can't rule out negative effects on the market. However, I would be quite surprised if the effects are nearly as large as those we just experienced. Despite how things sometimes appear, the industry is being a lot more careful, financial risks are priced a lot more sensibly than a couple of years ago, and the regulators are much more focused on potential trouble.
My worry would be 10-20 years down the line if we don't reform financial regulation in the right way. Troubles this large usually take time to build up.
Boston: The US government has West Point, Annapolis and the Air Force Academy to train its next generation military leaders. As complex and fundamental as the financial system is to our country and citizens, why isn't there similar, sophisticated training for our financial regulators where the government finances, if not runs, the schools and the individuals sign a contract to work for four or more years for a regulating agency? Because of the incredible sophistication of the financial instruments and markets, is our only current option to rely on Wall Street veterans who either made their fortune or busted out to fill regulator roles (or very inexperienced younger regulators who get recruited away quickly by Wall Street firms)? This seems like an asymmetrical relationship right now with the government/citizens on the losing end...
Douglas Elliott: It's a great idea. Certainly we need to do something about the gap in sophistication between the regulators and the industry. The difference exists in most industries, but finance pays so much more than government that the problem is quite severe.
One thing we should certainly do is pay financial regulators substantially more. But, it's very hard to convince the public and Congress that "bureaucrats" deserve compensation at levels much higher than the average American earns.
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