2 July 2021

Support for this paper was gratefully received from the Korea Institute of Finance, which has published it here. Abstract The development and growth of the financial sector within the last 50 years has been justified on the grounds that new instruments and greater levels of trade result in a more efficient allocation of risk.  The experience of the Great Financial Crisis punctured this narrative, but much of the policy response has focussed on establishing new and more complex regulations.  This misunderstands the nature of risk and uncertainty in the financial system and the real problems of complexity that arise in these types of systems.  An analysis of the history of financial development highlights where socially harmful approaches have grown into destabilising practices. Keywords: Globalization, Finance, Financial Crisis, Financial Economics, Financial Markets JEL Codes: F65, G10, G14, G20 The rise of modern finance        Modern banks – and most other financial institutions – trade in securities, and the growth of such trade is the main explanation of the growth of the finance sector.  Lending to firms and individuals engaged in the production of goods and services – which most people would imagine was the principal business of a bank – is literally an insignificant part of their balance sheets. For British banks today, it amounts to about 10% of their total assets.[1]  For Korean banks, loans of all sorts to businesses have been declining as a proportion of bank loans over time.[2]  The assets of these banks consist mostly of the liabilities of other financial institutions, and conversely, the liabilities of these banks are predominantly owed to other financial institutions. The finance sector establishes claims against assets – the operating assets and future profits of a company, or the physical property and prospective earnings of an individual – and almost any such claim can be turned into a tradable security. ‘High-frequency trading’ is undertaken by computers that are constantly offering to buy and sell securities. The interval for which these securities are held by their owner may – literally – be shorter than the blink of an eye.  Competition to speed up the critical links in the global financial system – above all between Chicago and New York, but also across the Atlantic and over the pole to Tokyo – has reduced the time such communication links take to close to the physical limits established by the speed of light.[3] World trade has grown rapidly, but trading in foreign exchange has grown much faster.  The value of daily foreign exchange transactions is almost a hundred times the value of daily international trade in goods and services.[4]  The annual volume of payments processed in Britain is £75 trillion, about forty times Britain’s national income; in Korea, annual securities settlements are 35 times GDP.[5] Trade in securities has grown rapidly, but the explosion in the volume of financial activity is largely attributable to the development of markets in derivatives, so called because their value is derived from the value of other securities.  If securities are claims on assets, derivative securities are claims on other securities, and their value depends on the price, and ultimately on the value, of these underlying securities.  Once you have created derivative securities, you can create further layers of derivative securities whose values are dependent on the values of other derivative securities – and so on.  The value of such derivative contracts outstanding is three times the value of all the physical assets in the world.[6] What is it all for?  What is the purpose of this activity?  And why is it so profitable?  Common sense suggests that if a closed circle of people continuously exchange bits of paper with each other, the total value of these bits of paper will not change much, if at all.  If some members of that closed circle make extraordinary profits, these profits can only be made at the expense of other members of the same circle.  Common sense suggests that this activity leaves the value of the traded assets little changed, and cannot, taken as a whole, make money.  What, exactly, is wrong with this common sense perspective? Why we trade Perhaps the central insight of modern economics – the core of Adam Smith’s Wealth of Nations – is that trade can benefit both parties to an exchange.  Specialisation allows parties with different skills, different resources, or simply experience acquired through narrow focus, to deal advantageously with each other.  I keep a dairy herd, you have a coffee plantation. And together we can both enjoy milky coffee.  The wealth of nations resulted from the rejection of the mercantilist view – recently revived by Donald Trump – that trade was a process in which one party took advantage of the other. Modern financial economics treats risk as a commodity like milk or coffee.  People have different preferences and capabilities in their approach to risk and their ability to manage it, just as they have different tastes in food, or farm different kinds of land, or hold different agricultural skills.  Trade between them benefits both parties.  In this way, markets in risk enable the inescapable risks of modern life to be handled more efficiently.  If this analogy between risk and other commodities were valid, the standard tools of economics could be applied to the trading of risk.  This approach has been the basis of financial economics for half a century.  The metaphor has many attractions for those who work in financial markets, implying that the claims of market efficiency that are made for trade in milk and coffee are equally applicable to trade in foreign currency and credit default swaps.  The larger the volume of trade, the wider the scope of markets, the greater the benefits from free exchange in securities markets.  But you can have too much of a good thing.  That trade can benefit both parties does not imply that all trade does: and if not all trade is a process in which one party tricks the other into giving something away, some is indeed like that…  But three centuries after the great French economist Colbert provided a definitive exposition of the mercantilist doctrine, a different strand of thought in modern economics revived