28 June 2016

Financial System and the Economy: America Vs Europe

What is a financial system? It is a system that supplies money for economic activities - like buying a tractor, building a factory or starting a company. What is the need for a financial system? Only rich people have money. So a financial system is needed to provide money to ordinary people for economic activities.

The financial system is to the economy what the circulatory system is to the human body. The body needs blood to function - and the circulatory system supplies it. Similarly, the economy needs money to operate - and the financial system supplies it. Banks are the best-known part of the financial system. The stock exchange is another. There are many more.

In 2003, Raghuram Rajan and Luigi Zingales (professors of finance at the Chicago School of Business) wrote a book called "Saving Capitalism From Capitalists". In it, they argued that the best financial system is a free/unrestricted financial system - like America's. 5 years later, the 2008 American Financial Crisis happened - the worst financial crisis since 1929 (which had caused the Great Depression of the 1930s). Most economists blamed America's unrestricted financial system for this crisis.

In 2014, Raghuram Rajan wrote a 10-page afterword titled 'Lessons from the Great Recession'. In it, he talks about the recession that the financial crisis caused - rather than the financial crisis itself. Further, he blames the recession on long-term economic and political trends - rather than the financial system. He is slightly casual both about the financial crisis itself and the unrestricted American financial system that caused it.

The sub-title of the book is 'Unleashing the power of financial markets to create wealth and spread opportunity'. The authors argue that a free/unrestricted financial system (like America's) is the best financial system because it supplies the maximum money to ordinary people and small companies. On the other hand, they argue that an unfree/restricted financial system (like the European countries) supplies money only to rich people and big companies.

If this argument is correct, then America must perform better than the European countries. Is this so? America's per capita income is higher than all the European countries, yes. But the authors argue that America's free/unrestricted financial system is the best for supplying money to poor people and lifting them out of poverty. So we should look at the income of the poorest 10% of the people. And in this, America is one of the worst among the industrialised countries.

The authors may argue that the poorest 10% in Europe have a higher income due to government handouts. Then let us look at upward mobility - the degree to which the poor can come out of poverty. In this also, America is beaten by:
a) North Europe (Norway, Sweden, Finland, Denmark)
b) West Europe (Germany, France, Holland, Belgium)
c) British colonies (Canada, Australia, New Zealand)
Only South Europe (Spain, Portugal, Italy, Greece) is worse than America.

The authors may argue that this is not due to the financial system, but the larger economic system. To this, we can make two points. The first point is trivial and technical. Yes, the financial system is not an independent system. It is only the sub-system of a larger system - the economic system. But in that case, it is the performance of the system that really matters, and not the performance of the sub-system. What is the use if the sub-system works well, but the system does not?

The second point is more fundamental, about philosophy. Every country has a philosophy, and it builds all its systems (political, economic, financial, etc) on the foundation of that philosophy. No country builds one system on one philosophy, and another system on another philosophy. America is no different. And it has built both its economic system and its financial system on the same philosophy - Darwinism (ie, natural selection and survival of the fittest; or 'every man for himself, devil take the hindmost'). So it doesn't make sense to praise the financial system but criticise the economic system when both are built on the same philosophy. (Another view: You cannot expect the financial-economic system to treat ideas, products, services and industries in one way - and people in another way)

But these criticisms aside, "Saving Capitalism From Capitalists" is a very informative and interesting book about the financial system and also about economic history.

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