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Other People's Money: Masters of the Universe or Servants of the People? by John Kay
AUTHOR John Kay lectured in economics at Oxford from 1971 to 1978, is visiting professor of economics at the London School of Economics, and is a regular editorial contributor to the Financial Times.
Other People’s Money deals with the state of the financial services industry. This matter is relevant to all, because no country can be prosperous unless it has a well-functioning financial system.
As a system, Kay notes, “I will show that its profitability is overstated, that the value of its output is poorly reported in economic statistics, and that much of what it does contributes little, if anything, to the betterment of lives and the efficiency of business.”
The beginnings of industrialisation and the growth in international trade happened at the same time as the development of finance in Britain and the Netherlands. This was necessary because finance contributes to a society and the economy in many ways.
It provides the necessary payment systems that trading requires, and matches lenders with borrowers. It enables individuals to manage their personal finances during their lifetimes and inter-generationally, and can help individuals and businesses manage the inevitable risks.
“Many good ideas become bad ideas when pursued to excess,” Kay explains. He goes on to show how the financial sector has grown in the last four decades through a process he describes as “financialisation”.
In the past, the bank manager and stockbroker knew his clients, and knew the companies he recommended to them.
Investment banks, similarly, had long-term relationships with the large companies they served. They also maintained solid relationships with institutions such as the insurance companies that aggregated the capital of small savers.
The central characteristics of the financialisation of Western economies over the past 40 years have been the shift from being the agent of clients to that of trading, from relationships with people to effecting transactions.
From the 1970s until the financial crisis in 2008, the financial sector grew in every way - size, income, sophistication and complexity.
The new financial markets no longer attracted those with little academic ambition but who excelled at client relations. By 2008 most senior executives held degrees from fine universities, and excelled at solving very difficult mathematical problems that were involved in pricing derivative securities.
The most successful graduates of Oxford and Cambridge and the Ivy League universities aspired to careers in the City or on Wall Street. “These cleverer people,” explains Kay, “managed things less well – much less well – than their less intellectually distinguished predecessors.”
What most people understand as the function of banking – lending to people and businesses - constitutes only about 3% of their total activity. The rest, in Kay’s words, “staggers the imagination”. Annually the value of the banking activities processed in Britain is £75trn, or about 40 times the national income.
Beyond its control - and understanding
The industry trades mostly “with itself, talks to itself and judges itself by reference to performance criteria that it has itself generated”. Most of these trades are conducted by computers silently trading with each other, and the trades are owned for less than the blink of an eye – literally. This is to be compared with the holding of equities for seven years, 50 years ago. The industry deals in products that have been proved to be beyond its control and even understanding.
Securities are claims on an asset. Derivative securities are claims on other securities, and so, logically their value depends ultimately on the value of the underlying securities. However, the assets underlying derivative contracts are three times the value of all the physical assets in the world. As such, finance has become a “good” in itself and the resultant process is the financialisation of banking.
What is the purpose of this activity and why is it so profitable?
Most people, including politicians and the public, and of course those in finance, seem to regard it as self-evident that governments and taxpayers have an obligation to ensure that the financial sector continues to operate in its existing form.
In similar vein, many believe that the extraordinary remuneration of financial businesses and their senior employees is deserved. The majority of people working in banking do not share in this success. “Our willingness to accept uncritically the proposition that finance has a unique status has done much damage,” Kay asserts.
In all the hundreds of articles about the finance industry written in recent years, very little attention has been given to the question: “Why is the industry so profitable?”
The reality is that finance is an industry like railways or retailing or electricity supply, and should be judged by the same principles. A large part of the growth of the finance industry is not the result of the wealth it has created, but rather the wealth created elsewhere in the economy.
The industry really does not require any more regulations. It is highly regulated as it is. What it does need is structural reform that would restore it to its priority tasks - meeting the needs of the real economy.
Kay’s work is a fascinating tour of a sector far more complex than is generally presumed. His insights and clarity of thinking make this book essential reading for anyone interested or participating in the finance sector. It ranges way beyond what is hinted at in this column.
Readability: Light ---+ Serious
Insights: High +---- Low
Practical: High ----+Low
* Ian Mann of Gateways consults internationally on leadership and strategy and is the author of Strategy that Works. Views expressed are his own.
