Tuesday, March 1, 2011

What exactly is the function of the financial sector?

An interesting article by Professor Bill Black on the fundamental flaws of the financial sector.  Prof Black makes the argument that the sector is too large and it basically sucks the life out of the real economy.

His arguments are pretty strident, and in most cases rather unsubstantiated, but still thought provoking.   It reminded me of a discussion that I had with a forestry Professor who lives down the street from me.  He asked me what I thought should be the correct size of the financial sector.  I couldn't give him a specific number, but I did note that we may have an oversized financial sector due to some government policies.

The two policies that come to mind are the mortgage interest tax deduction and the implicit guarantee of too big to fail banks.   The interest tax deduction subsidizes home ownership and boosts the mortgage backed securities market, while the too big to fail guarantee causes banks and other financial institutions to get too large and, in effect shift some of their risk to the federal government.

Abolishing the interest tax deduction and imposing size related capital requirements on banks would go a long way to remove these distortions.