Financial Regulation and Economic Growth

The election has once again focused attention on financial regulation, with the suggestion that excessive regulation is choking off economic growth. Financial regulation can certainly keep money from going to productive activities, but generally financial regulation has the opposite goal – keeping money from going to unproductive activities.

Wall Street finances the manufacturing and service activities that grow our economy. But financial companies aren’t formed to grow our economy – they are formed to earn money for their shareholders, just like any other company. There are only so many productive activities to be financed, only so many building loans or stock offerings. So Wall Street spends a lot of time thinking about other ways to make money. One of the easiest is to create financial instruments that allow investors to make or lose money based on things they don’t actually own.

Wall Street calls these financial instruments “derivatives”, because they derive their value from someone else’s financial activities. An Oil Future, an option to buy oil in the future at a fixed price, derives its value from the price companies are willing to pay for oil in the future. An investor makes money if the price of oil goes above the option price. A Credit Default Swap, essentially a form of insurance on bonds you don’t own, derives its value from the price people are willing to pay for a bond at some point in the future. An investor makes money if the bond price drops below the price specified in the Credit Default Swap.

Speculators buying and selling different kinds of derivatives were one of the primary causes of the Depression. In the 1930 the United States began building a financial regulatory structure that greatly limited Wall Street’s ability to buy and sell derivatives other than in situations in which there was a clear economic need, for instance food manufacturers buying wheat futures to protect against future wheat price increases.

Wall Street has spent the last eighty years looking for ways around these regulatory restrictions. Beginning in the late forties Wall Street used a regulatory exemption for small groups of wealthy investors to create Hedge Funds that operated outside the government’s financial oversight. In the early nineties Credit Default Swaps were introduced and Wall Street convinced regulators that investment banks should be allowed to buy oil futures even though they didn’t buy oil. In 2004 regulators greatly increased regulated banks’ ability to participate in derivatives markets.

Derivatives generate economic activity, but they don’t actually grow our economy. A builder that borrows $150,000 from a bank to build a home and then sells that home for $200,000 adds $50,000 in additional wealth to our economy. A derivative is wager between two investors on the future price of something that the investors don’t own. There is no economic output and no wealth created – the profit that the more clever investor receives is money lost by the less clever investor.

While this is great for the clever investor and generates fees for Wall Street, it actually channels investment away from productive economic activity. On Wall Street there is something called “Yield Envy” ” – financiers get jealous if their peers have bigger returns. Making money by investing in companies that sell products and services generally takes a long time and produces moderate returns. Making money by betting that bond prices will drop next year can generate fantastic returns very quickly. Because wagering – speculation – can offer far bigger returns it tends to draw capital and talented people away from productive economic activities such as financing manufacturing growth. This isn’t just idle economic theory. According to the Commerce Department investment in manufacturing equipment by U.S. Companies actually dropped for several years after the Bush Tax Cuts, while almost a trillion dollars was invested into hedge funds that speculated on oil futures and housing bonds. Bad activity drove out good, and our economy suffered.

Again making it harder for investors to make money on things they don’t own will cost Wall Street tens of billions of dollars in fees and profits, and will undoubtedly cost politicians hundreds of millions of dollars of Wall Street campaign donations. But it won’t choke off economic growth. Instead, limiting the ability of Wall Street to make money through speculation will actually increase the investment in real economic growth, and will be good for our country.

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