IAN McAULEY. The finance sector – value creation or value extraction?

Oct 29, 2018

The Government and the finance sector would have us believe that the finance sector makes a valuable contribution to our economy. But is it simply a bloated overhead? Economist Mariana Mazzucato, who will deliver the second John Menadue Oration in December, reminds us that its claimed role in “value creation” could be eclipsed by its actual role in “value extraction”.

At a time when reason and honesty are devalued in the political sphere, Australians have enjoyed a little Schadenfreude watching finance company executives squirm as Commissioner Hayne and the assisting counsellors confront them with simple questions with embarrassing answers.

Bankers, we learn, can suffer embarrassment. Some, perhaps, may even feel a sense of shame. But it’s highly unlikely that they are capable of reflecting on the more basic question of whether the whole finance sector is doing anything useful for society, or if it is simply a high-cost bloated overhead.

This question is beyond the Commission’s “letters patent” – its terms of reference. The Commission is specifically an inquiry into “misconduct”, rather than into the policy environment that has allowed such misconduct to dominate. Its interim report does touch on policy issues, specifically mentioning the pathetic behaviour of the oversight agencies, ASIC and APRA, but it judiciously avoids the question of government funding for these agencies (cut sharply by the Abbott Government). It points out weaknesses and compromises in the Future of Financial Reforms (enacted in 2012 by the Gillard Government), but we should remember that the Coalition Government would have significantly weakened these reforms but for strong opposition in the Senate.

The question not addressed is how Australia’s finance sector has become so large. How is it that over the last fifty years, the finance sector has doubled in size as a proportion of our economy – from 4.5 per cent of GDP to 9.0 per cent of GDP, over a period when tremendous advances in information and communications technology would have been expected to result in less costly ways of handling financial transactions and a leaner, more efficient financial sector? (Remember all those bank tellers, all those branches, all those cheques that had to be handled.)  Why, by the same measure, is our finance sector almost the largest among all “developed countries”? Germany’s finance sector is only 4.1 per cent of GDP, Japan’s 4.4 percent, Korea’s 5.5 per cent. Even the UK and the USA, the powerhouses of financial capitalism, have finance sectors that are smaller than Australia’s.

Some of the answer lies in the way we think about finance. We see it not as a necessary overhead to provide services for the real economy, but as a part of the real economy itself. To quote from a Treasury Paper:

Australia’s financial services sector is the largest contributor to the national economy, contributing around $140 billion to GDP over the last year. It has been a major driver of economic growth and, with 450,000 people employed here, will continue to be a core sector of Australia’s economy into the future.

We haven’t always thought of the finance sector in this way. In her recently-published book The Value of everything: making and taking in the global economy, Mariana Mazzucato, states:

Until the 1970s, the financial sector was perceived as a distributor, not a creator, of wealth, engaging in activities that were sterile and unproductive.

Of course we need a finance sector to facilitate transactions and to match savers with investors, but even in this latter function the sector’s role is overstated, because as Mazzucato points out, firms overwhelmingly finance new investment through retained earnings, bypassing the finance sector.

What Treasury sees as a contribution to the economy, she sees as an artefact of national accounting standards – standards that excluded finance from national accounts until the 1970s.

She points out that over the last fifty years economists and the governments they advise have taken on an idea of “value” that is based almost exclusively on the prices revealed in market transactions, without any regard to whether such exchanges relate to the way we may conceive “value” in our everyday lives. A financial advisor profiting from charging commissions for non-existent financial advice contributes to our measured GDP, but not even the cleverest witnesses appearing before the Commission could suggest that such behaviour represents “value” in terms of contributing to our well-being.

In fact, if as a result of the Commission’s findings, an incoming government trims the excesses of the finance sector, that will show as a negative contribution to GDP, demonstrating, once again, the dependence of such accounting measures on arbitrary definitions – a dependence unacknowledged by the Coalition Government.

Another manifestation of the absurdity of our measures of value has shown up in the headlines of the last few weeks, as house and share prices have fallen, with claims of billions having been wiped off our national wealth. But I suggest readers of Pearls and Irritations won’t have noticed any change in the comfort provided by their houses. The market price of their share portfolios may have fallen, but the companies issuing these shares still have the same assets as they had last week or the week before. The media seem to get far more excited by the artefacts of the paper economy than by developments that make a real impact on our wealth, such as destruction wrought by climate change.

If we could understand that numbers such as the “value” of the finance sector or the “value” of our housing and share portfolios are simply artefacts of accounting standards, they wouldn’t matter. We would disregard them in the same way as we (should) disregard media hyperbole and government spin.

But these numbers do matter, because people vest them with too much meaning. A belief that the increased market value of real-estate has been a gain in real wealth has led many people into high and unsustainable levels of debt (which doesn’t fall as real-estate values fall), and has allowed the Coalition to use this illusion to attack Labor’s modest proposals to remove some of the tax incentives contributing to the bubble.

In fact the capital-gains measures contributing to the housing bubble have their origins in Prime Minister John Howard and his Treasurer Peter Costello having been convinced by the finance sector’s idea of “financial dynamism”, which prompted the government in 1999 to amend capital gains tax provisions to reward short-term speculation while punishing long-term investment, sacrificing long-term investment in the real economy for the illusory benefits of greater activity in the finance sector.

In the coming months as a federal election looms the Morrison Government and its cheer squad in the Murdoch media will almost certainly engage in a Trumpian campaign of advocacy by numbers.

We will do well if we keep a level head and ask what any such numbers really mean.


Mariana Mazzucato is Professor in the Economics of Innovation and Public Value at University College London. She will be delivering the second Centre for Policy Development  John Menadue Oration on 11 December in Sydney (follow the hyperlink to reserve a place).  References to her work and explanations of the limitations of national accounts can be found in Miriam Lyons’ and my work Governomics: can we afford small government?.

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