 If we want to, we can structure the market differently. I want to talk about the financial sector. It's one of the areas where you have some of the largest sources of wealth for rich people in this country. And I'm going to also argue that this is a source of waste. We can actually make the economy more efficient by reducing the wealth that people draw from the financial sector. Okay, so I have six main points here. The purpose of the financial sector in a capitalist economy. Secondly, I see financial markets as being bloated and broken. They're not serving that purpose. Third, the idea of too big to fail and the bailouts that we had to the financial system back in the 2008-2009 financial crisis. Fourth, we could have greater competition and efficiency in financial services. We could have greater efficiency of government regulation of financial contracts. And last, I want to talk about hedge funds and private equity funds. These are where you have some people make enormous fortunes, not in ways that contribute to the efficiency of the economy. So in effect, by reducing waste, we would also go a long way towards reducing inequality. Why do we have financial markets? And just to be very clear here, financial markets serve very important purposes. So the two main ones, they allocate capital from savers to investors. So you have people that want to put money aside for their retirement, for their kids' education, to buy a house. People have lots of reasons to save. And while they're saving that money, other people could be using it. There's all sorts of reasons why people want to borrow. And the financial markets act as intermediaries there, from people want to save to people who want to invest. And we want that done as efficiently as possible. Second point, and this is something that I think confuses a lot of people, the distinction between efficient financial markets and an efficient financial system. So you'll often hear people talk about efficient financial markets. The idea is that you have the minimum of government interference that ideally would make the financial markets more efficient. What I'm focusing on here is the idea of an efficient financial system. Let's go back to the first point. What's the purpose of the financial market? Allocating capital from savers to investors. Well, in principle, we want that done with as few resources as possible. What I'd argue is that we have a financial system that's broken and bloated. We've seen a huge expansion in the financial system over the last five decades. And you're very, very hard pressed to point out what we've gotten from this. So somehow we're investing better today. Do we have better outcomes with our capital today than we did say five decades ago? The most obvious measure there would be productivity. Are we seeing more rapid productivity growth in the economy today than we did say in the 50s and 60s when we had a much smaller financial system? Well, the answer is no. We've actually seen much slower productivity growth. I focus here on the core financial sector. This is investment banking, securities and commodities trading. So this is literally just money going into the system being allocated to investment. That took up less than half a percent of GDP in the mid-70s. It's over 2 percent of GDP in the current economy. That's a difference of about $330 billion a year in the 2022 economy. That's an enormous increase in resources. And again, no obvious benefit in terms of capital allocation. Or if you like, do we feel more secure in our savings today? I think very, very few people would argue that given the volatility in financial markets in recent decades. Well, there's been research on this. There was a very good paper done by Cassetti and Karubiev. An inverted U-shaped curve between the size of financial markets relative to the economy and productivity growth. The argument was that when you have very underdeveloped financial markets, that when you think of a country that doesn't have a big stock exchange banking system, that it has slower productivity growth. Then you develop your financial market so it becomes easier to raise capital on the stock market or through banking system. So it's easier for firms to start out to expand. Then you saw more rapid productivity growth. But then when it grew even further as we have in the United States today in many other wealthy countries, then you saw slower productivity growth. And they looked at that more carefully and they said, well, where do you find the slower productivity growth as the financial markets grow larger? Well, the answer was sectors of the economy that require strong math skills, like computers, like engineering. Well, what would be the story there? They could make in many cases much more money in the financial industry than they can in computers and engineering. Well, in the financial industry, they're really not doing anything productive. Because let's say that we had this true price of IBM stock and we got there one second sooner because we have people with very sophisticated skills who are able to figure out what that true price is. What's the benefit to the economy? I don't know anyone who would tell you that's anything other than zero. On the other hand, if these people were working, developing better software engineering in different ways, well, they could be doing something productive. But I think that's a very plausible story about how the growth and the size of the financial sector has been a very direct drain on the economy. I also talk about inequality. What's going on with compensation per employee in the financial sector? There was always a gap in the financial sector compensation relative to the economy as a whole. So if we go back to 74, in 2020 dollars, the average employee in the financial sector got about 75,000. Now if we look into 20, the average total compensation in the economy as a whole, it's about 80,000 dollars. In the financial sector, it was almost 300,000 dollars. So we see a massive increase in the pay in people in the financial sector relative to the rest of the economy. It's a drain of resources. It's also generating an enormous amount of inequality because we have many people getting great fortunes from the financial sector. A few points here on how we treat the financial sector compared to other industries. So I and others have proposed financial transactions taxes as a way of reducing the amount of trading, the amount of resources going to the financial industry. Most things we buy in most states, they're subject to sales tax 5, 6, 7, 8%. Okay, well why don't we have sales taxes in the financial sector? Well, because the financial industry is very powerful. There's not a very good argument to my view against it. So the amount that I and others have proposed somewhere between 1 tenth and 2 tenths of a percent on stock trades. And you'd have a smaller tax on trades of derivatives and other assets. Comparing that to sales tax, that's very, very small. And I should also point out transactions costs have hugely plummeted over the last four or five decades. So if we bring in transaction costs and stock trades back to where they were, say in the mid-90s, early 90s. So it's not as though we'd be shutting down these markets. So what would a tax of, let's say, 1 or 2 tenths of a percent on stock trades do? It would raise somewhere close to half a percentage point in GDP. We've seen massive increases in trading over the last five decades, largely because the cost has fallen. So what would happen if we increased the cost of a trade by 1 or 2 tenths of a percentage point? Well, we'd probably see trading volume fall by roughly 50%. Now, what's really neat about that is that's roughly equal to the amount of the revenue that you would raise from the transactions tax. So in effect, what you're doing here is you're raising, say, $110 billion for the government. Where does it come from? It comes from the savings on trading. So we pay less money to the financial industry to carry out these trades, but we'd be paying that in taxes to the government. What difference does it make to most of us? It makes very little difference. So in effect, the full burden of the tax would be borne by the financial industry. We'd be eliminating waste in the financial industry. Now, would that affect the allocation of capital? Well, again, you could talk to people in the financial industry and they'll start yelling and screaming, well, if we did this, we would have less efficient markets. The market may be a little bit less efficient. Is that going to be bad for the economy? Are there all these bad investment decisions were made because the price of oil was $99.50 for one minute when it should have been $100? It's pretty hard to tell that story. So what we should care about is the efficiency of the financial sector as a whole. We're much better off with fewer resources being spent in the financial industry. And that means more for other things. Okay, the idea of too big to fail, that a financial institution could be so large that the political system, the political actors, the president, congress, whoever, they don't feel they could just let it fail. Okay, this is a very interesting concept that many economists poo-pooed until we got to 2008, 2009 financial crisis where we had some institutions fail. The collapse of the investment bank Lehman led to a huge financial crisis. And basically the decision was made by congress, by the Federal Reserve Board, by the president, that they would not allow other banks to fail. Okay, well, there's a market advantage to that. That if I leave money, if I lend money to an institution that's too big to fail, you don't care. Okay, so you don't care that J.P. Morgan is actually in really bad shape because you know if J.P. Morgan gets into trouble, that the government's going to come and bail it out, which means I'll get my money back. But that's a big advantage if you're too big to fail bank. You could be more careless in your lending policies. You don't have to be careful. We didn't have to do the bailouts. We could have let banks fail. There was no reason I think we'd have a second Great Depression. This was a myth that was perpetrated to prevent a serious discussion of alternatives. To my view, we had a great opportunity to downsize the financial industry in one big swoop, let the market work its magic. There would have been serious repercussions for the economy. There wasn't any way to dispute that. But we know how to get out of a Great Depression. So it was almost as though people forgot what happened in the first Great Depression. What finally got us out? We spent a lot of money on World War II. So had it been the case that we allowed the banking sector to basically unravel, we could have kept the financial system operating. We have the Federal Deposit Insurance Corporation, which we did not have during the first Great Depression. We have that as a result of the first Great Depression. And we could have then spent a lot of money to get the economy back on its feet. So this whole second Great Depression story, this was simply a scare story to justify bailing out the banks. We're talking about a situation where you have a very big industry, creates a lot of inequality, and relies in a really big way on the government. They want to pretend that they're just the free market. Sorry, that is not true. Let's get back to this idea, what do we want from the financial sector? Very important role. We want it to play this role using as few resources as possible. Well, it turns out that very often the government could do these services at a much, much lower cost than the financial industry. Social security is just a great example, because if we look at how much money we spend each year administering the social security system, it's about half of 1% of what's paid out in benefits. If you go, okay, well, suppose as an alternative, I want the same amount of money, my check of 1,000 a month, 1,500 a month, from a private 401K when I retire. Well, the administrative cost of the private 401K will be around 15% to 20% of what I'm going to get paid out. So we're talking about administrative costs that are 30 to 40 times as high. That's a really big difference. That's a lot of resources that are just totally wasted. One of the common comments or criticisms that the proponents of privatization will make is, well, that's a one-size-fits-all. And I always come back and go, yes, it is a one-size-fits-all, because social security, the whole idea is to give people core retirement income. And what you want there is one-size-fits-all. Suppose I decide, as many people do, and they're in a position to put more money aside. I want to put money in 401K even though I have my social security. I want to have something in addition. That's fantastic. That's what the financial system's for. That's where you don't have the one-size-fits-all. But the whole point of social security is to make sure that someone who's worked 20, 30, 40 years, when they retire, they're going to be able to have a decent core retirement income that they can count on. And government does that far more efficiently than the private sector. Okay, other ways we could talk about the government being more efficient than the private sector. We could have the Federal Reserve give everyone a digital bank account. Most of us have checking accounts, savings accounts at banks. Those accounts have lots of fees. They tend to hit lower income much more than people are upper income. Well, the cost of having those accounts actually are very, very low. I mean, they could charge some trivial costs, but it probably wouldn't even be worth making the billing. And that could save us tens of billions a year in bank fees. We don't do it basically because the banking industry is very powerful and they don't want us to do that. But that would be a way to have a more efficient financial system. Okay, efficiency of government regulation. So it's a common view to think that, oh, government regulation, we might be serving some purpose. We might be making it fair, but it's inefficient. We don't need government regulation, at least not in a very intrusive way. Well, in finance, we might think that. And that's because you could write deceptive contracts. Okay, we saw this in the housing bubble in 2002 to 2007 that led to the collapse in 2008, 2009. We had a lot of people who were buying variable rate, adjustable rate mortgages. But what these did was they had a lower teaser rate for the first two years and then they jumped to the market rate. So you had a lot of people that could afford the lower rate. They couldn't afford the rate that it would jump to. And the people who were issuing these mortgages didn't care because they were selling them in the secondary market. You'd have a company would issue the mortgage. They would then sell it to an investment bank who would then package it into mortgage-backed security and sell it all over the world. So you had a story where you had the issuers benefitting by an effect deceiving the borrowers. They disproportionately hit lower-income people, less educated people. For the simple reason there, these are people who are less used to reading contracts and they very often could push these contracts and get people to get contracts that are very bad for them. So that, to my view, is a very good argument for regulation. Okay, third point is this is actually an efficiency issue. So we're saying, okay, we're allocating resources across the economy. What's a good way to allocate resources? Well, why don't we have a lot of people trying to figure out how to design deceptive contracts then market them to people who won't understand them? That's not a good allocation of resources. So if you just say, okay, we're not going to allow that. Okay, you have to have standardized contracts. You can't try to come up with contracts that are deceptive or push them in deceptive ways. It's a clear case where government regulation, at least when done well, can be an efficiency gain. The last point, bankruptcy rules. This is, again, kind of an interesting story, at least to me, that we changed the bankruptcy rules back in 2005, made it much, much harder for people to declare bankruptcy and get rid of their debts. Okay, no one's saying you don't want any bankruptcy rules because, you know, it doesn't make sense to say someone's going to chase someone forever for bills that they can't possibly pay. So the question is, what are those rules? And what they did here was they made those rules much stricter and what was striking to me was that they applied them retroactively. So say I accumulated 40,000 in debt under the old bankruptcy rules. Well, suddenly there's new bankruptcy rules that makes it much harder for me to go into bankruptcy and to avoid paying the debts or to put it the other way, makes it much easier for the creditors to collect those debts. So that's not a free market story. That's the government basically acting as a bill collector. And again, if we think of the free market story, what we want is we want lenders to be responsible lenders and to not make loans to people who aren't able to pay them back. Well, instead, what you had here was you had a lot of lenders that made loans to people who weren't able to pay them back and they said, oh, well, let's change the rules. So it's easier for us to get money out of these people. That's not the free market. Okay, the last point I want to make is hedge funds and private equities. These are some of the richest people in the country. People like Mitt Romney, he has hundreds of millions of dollars. He's not even particularly high up in the list of private equity. There are others who have billions and billions or even tens of billions. So how do they get their money? Well, they have standard contracts and what had been kind of the standard in the industry were two and 20. So what this mean was that they would pay the hedge fund manager or the private equity fund manager 2% of the amount of money invested, say a pension fund invests a billion dollars with a private equity fund. Well, the 2% means that they're going to be paying them $20 million a year regardless of what the fund does. So they get $20 million off the top. That's every year regardless of what the fund does. Then they get 20% above a threshold. So this allowed many people to get very, very rich. On top of that, they get special tax treatment. I was amazed when I first heard about this. The idea of carried interest tax treatment. So if you're a teacher, you're a firefighter, you're taxed as normal income. The top tax rate currently is 37%. Okay, what if you're a hedge fund manager? Well, you get to pay taxes as though most of your income is capital gains. Well, the tax rate on capital gains for these people is just 20%. Okay, so they're actually paying a much, much lower tax rate. And when I first heard about this, I thought the person telling me it was mistaken. I looked it up, saw that they were right. And I thought, well, this is crazy. So I contacted a friend of my conservative economist. And I said, what's the justification for this? And he said, well, there isn't one. There's not an economic rationale. I think not anything that passes a laugh test. It's not gotten rid of because these are very rich and powerful people. But let's say I want to argue the case for hedge funds and argue the case for private equity. Well, the story I would want to tell is, well, these hedge funds are really, these are very insightful investors and they're able to find these companies that outpace the market and give them capital and it's good for the economy that way. And that would mean that they have exceptional returns. Well, it turns out they don't. The hedge funds typically underperform a simple mix of say 60% stock, 40% bonds. So that would mean that the universities, and here I'm thinking of Ivy League universities, Harvard, Yale, the other universities with really big endowments, rather than giving money to the people in the hedge funds, they would be much better off just saying, oh, we're just going to put in an index fund. We're just going to get a simple index fund from Vanguard where we pay a tenth of a percentage point rather than the 2% plus 20%. They would be better off doing that. Why do they give them money in the hedge funds? I'm willing to bet that you'd probably find that the people manage Harvard hedge funds are probably Harvard alums that have friends at the university. So basically you're making some people very, very rich, not because they're contributing to the economy, but because they have their friends in the right places. Same story with private equity. If you go back to the 80s, the 90s, and even to the first decade of this century, private equity funds tended to outperform the market. That's no longer true. So if you look back over the last 10 years, private equity have just done more or less even than 100 and 4 or 500. So if you just said, oh, I'm going to give this private equity fund a billion dollars, well, maybe instead I should just put a billion dollars from our pension fund into the S&P index fund, you'd have been just as well maybe even a little bit better with the index fund. So what does that mean? Well, people at private equity funds are getting a lot of money for, again, basically doing nothing. How do they do that? Well, they're very good with their public relations. They make a point of courting the pension fund managers, they're very sophisticated financial actors. In other words, these are not people with themselves, are big investors in financial markets. But what that means is some people get very, very rich, again, basically doing nothing for the economy. So my conclusion about this in the financial markets, we aren't benefited by having a massive financial industry with employing millions of people using up enormous amounts of resources. The other part of the story, it makes a small number of people very rich. So what we care about, and again, is a very narrow economic perspective. We want an efficient industry and we want, insofar as people are getting rich, to say they contribute to the economy. That's not the story of the financial industry today.