The financial sector by its ability to create money is in a unique position to dictate which sectors get capital and which do not. This calculation is done on the basis of maximizing returns to the finance sector ignoring the larger needs of the economy. Apart from banks, stock, commodity and private exchanges have played a major role in this process. Once a company undergoes an IPO, the secondary market takes over and people in this market are basically trying to earn rental income. The stock market is supposed to play a role in efficiently allocating capital to needed sectors. What is the secondary market supposed to do? A similar argument goes for commodity exchanges.
Another problem with the financial sector is that it encourages a quantitative style of thinking. Risk is an integral part of finance. The projects that are lent money are not guaranteed to be successful. This risk needs to be measured in some fashion. The financial sector has come up with innovative measurement techniques for doing the same. Unfortunately, these techniques often have many assumptions embedded in them and not many people are aware of these. As a result, these techniques are used in an inappropriate fashion which results in an increase in systemic risk making the entire economy more volatile and fragile. Numbers are seductive. It is only too easy to look at a number and believe that it adequately captures a complex reality.
Debt is an integral feature of the financial system. Fractional reserve banking works by creating debt. History has shown that unless the level of debt (and the level of the associated interest) is controlled, there comes a time when the financial sector starts driving out other sectors. When that happens, the entire economy becomes susceptible to sudden shocks. When the globe becomes interconnected through high speed communication links, a shock in one part of the system gets transmitted to all other parts in the blink of an eye. In this fashion too, the financial system ends up weakening the overall system.
Finance also plays an important if largely unacknowledged role in fomenting environmental troubles. The problem again lies with quantitative assessments of risk and reward specifically the concept of time value of money. If a dollar today is more valuable than a dollar tomorrow, then it makes sense to take advantage of resources today even if in the long run the end result will be massive losses. If you cut down tree cover today because the lumber is more valuable today, then you will end up with soil erosion down the road which will result in far greater systemic losses.
Another factor: transparency is critical for the efficient and proper working of any financial system. However, in the recent past, there has been a major decrease in transparency of the workings of major financial firms. This has resulted in risks becoming hidden from view. In the end, we saw what happened in 2007 - 2008. The entire financial system seized up because there was no transparency.
The financial system today is broken. The existing paradigm has led us into a cul-de-sac out of which we can barely glimpse an exit. Staying in this situation is simply not an option. Some sort of a financial system is required to mobilize capital and deliver it where it is needed in an efficient and cost effective manner. The critical question today is what should replace the current paradigm?
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