How To Really Cut Finance Down To Size

By Joseph Calhoun

I posted a link earlier to an article by Matt Yglesias, Cutting Finance Down To Size, which references an article by John Quiggin who argues that Wall Street Isn't Worth It. Yglesias uses this quote as a lead in:

The only remaining option is to separate these markets entirely from the socially useful parts of the financial system, then let them fail. Publicly guaranteed banks should be banned from engaging in all but the most basic financial transactions, such as issuing loans and bonds and accepting deposits. In particular, banks should be prohibited from doing any business with institutions engaged in speculative finance such as trade in derivatives. Such institutions should be required to raise all their funds directly from investors, on a "buyer beware" basis, and should never be bailed out, directly or indirectly, when they get into trouble.

Why did Yglesias choose this passage to cite? He skips the most interesting part of Quiggin's article. Quiggin, quite elegantly connects the dots between the end of Bretton Woods and the rise of finance:

The real transformation has been in corporate and international finance - "Wall Street" in shorthand (in the UK, "the City"). The growth in the volume and complexity of financial transactions since the breakdown of the Bretton Woods system in the early 1970s has been staggering.

In the Bretton Woods era, and even in the globalized financial economy of the 19th century, most financial transactions were directly related to trade in goods and services, or to capital investments. By contrast, in the current era of financial capitalism that began in the 1970s, the volume of shares traded every day on the New York has risen from 15 million in 1971 to 4 billion today. Average share prices have risen by a factor of 20 or more, so that the total value of shares traded is around 10,000 times higher than it was. Other financial markets, some of which barely existed before the 1970s, have grown even faster.

Even more striking has been the emergence of a bewildering variety of complex instruments, generically referred to as derivatives. The gross value of outstanding derivatives rose to $600 trillion (about 10 times the annual output of the global economy) in the years leading up to the financial crisis. While some derivatives markets collapsed in the last crisis, many have continued to expand; the market as a whole has remained about the same size as in the leadup to the crisis.

As Quiggin points out, the growth of derivatives is a direct result of volatile exchange rates. Quiggin also points to the rise in inequality during the floating exchange rate era something I've argued is also a direct result of severing the link of the dollar to gold. The paragraph before the one Yglesias cites is this one:

Beyond changes in short-term policy, any serious attempt to stabilize the macroeconomy and return to sustainable improvements in living standards must involve a drastic reduction in the size and economic weight of the financial sector. Attempts at regulating derivatives markets have proved utterly futile in the face of massive incentives to take profitable risks, backed up by the guarantee of a government bailout.

Well, yes, quite right Quiggin. So why doesn't he advocate the obvious solution? Why can't Yglesias and other "liberals" connect the dots here? Why do they believe they can come up with a perfect set of regulations that will solve a problem with a much simpler solution?

Many of the problems with our economy have developed during the period of floating exchange rates that arose after the end of Bretton Woods. Derivatives use has risen because it had to - companies face a much more volatile operating environment (from a blog post I wrote back in 2010): 

During the period of the pure gold standard from 1880-1913 (when the Federal Reserve was established) the standard deviation of commodity prices was roughly 4.5. During the free float period from 1914-1926 the standard deviation at least doubled (there are differences depending on which commodity index is used). During the Bretton Woods era from 1945 to 1971 commodity price volatility was reduced again to a standard deviation of about 8. Since 1971 volatility has again risen to about 15. (Cuddington & Liang)

If you want a more stable operating environment that reduces the footprint of the financial sector, the answer is obvious - stabilize the value of the dollar. I would argue for a gold standard but if someone can find an alternative that works as well or better, I'm all ears. We know the gold standard would cut the finance sector down to size. More rules will not get the job done because, as Yglesias points out, companies need to be able to hedge and they will find a way to do it. So why don't liberals advocate this oh so obvious solution? I guess they think there is some advantage to floating exchange rates, something for which the evidence is sorely lacking. Or maybe they just like telling people what to do.

Joseph Calhoun is CEO of Alhambra Investment Partners in Miami, Florida. He can be reached at

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