Viv Davies: Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. It's the first of November, 2011, and I'm speaking to Professor Wouter den Haan, of the London School of Economics, about his lead commentary in the current Vox debate, which centres on the question, why do we need a financial sector, and how much should we pay for it? Den Haan is of the opinion that whilst some activities in the financial sector are beneficial, others are less clearly so, and if appropriate regulation could curb excesses, whilst not affecting the value added of the sector, then resources could potentially be freed up for more socially useful activities. We also discuss the views of other economists on the value of the financial sector, including those of Andy Haldane and Charles Goodhart.

I began the interview by asking Wouter to briefly explain how the contribution and value of the financial sector is measured.

Wouter den Haan: So when we're trying to measure how much a country or a sector produces, then there are two steps. The first step is the easy step. That's just measuring how much is being earned in nominal terms. The second step is the hard question - that's how much is being earned in real terms. And even for regular products, that's not easy.

And so suppose a manufacturer sells a computer at a higher price. This could be just an increase in the price level, that's like inflation. Or it could be that the computer really has become better, and then this one computer actually means more computer, or at least more computing power. In the financial sector, that's even harder. And so if the financial sector charges more, is it just because their bargaining power has gone up, they receive more? Or is it really that they are producing more and better services?

Now on top of that, I have another problem of measuring the value added for the financial sector. It's that there's what we call a negative externality, and we've clearly seen that during the last financial crisis. The financial sector does activities for which it gets paid, but they have negative consequences for the rest of the economy.

OK, now regarding to the legislation part in your question, so in response to the legislation that has been proposed, the financial sector either says that this legislation will make it more difficult for them to do their tasks and it will hurt their profitability. But if it really is the case that the financial sector gets so much resources because their bargaining power has gone up, then if their profitability goes down because of new legislation, that may not be such a bad thing.

Viv: So how and why has the size of that contribution changed over time?

Wouter: So the numbers are absolutely stunning. And so in the US, just after the war, it's just that the share of gross domestic product, what we produce together, what was earned by the financial sector was two percent. And that has gone up to right around eight and a half percent. Just a stunning increase.

And then the question why, that's a really hard question to answer. For sure, the financial sector has taken on new tasks, and then it makes sense it gets rewarded for that. But I think the financial crisis has also made clear just that it is that part of this increase in what they earned was not because of the services they provided, but they just got bigger, part of the surplus.

Viv: Andrew Haldane from the Bank of England recently wrote of what he refers to as the “productivity miracle”e over the past few decades. He suggests that risk illusion rather than a productivity miracle appears to have driven high returns to finance, and that the recent history of banking appears to be as much a mirage as a miracle. Would you agree with that?

Wouter: So to some extent I definitely do. So a couple years ago, even institutions like the IMF, they were praising financial innovation and there was all these new great instruments that actually were supposed to reduce the risk. If that was true, then of course the financial sector should get rewards for that. What I think Andy Haldane rightly points out is that a lot of those products were overvalued. They were not really reducing the risk, at least not as much as we thought they were.

But what I hope to make clear in this debate is that there are also good aspects to all these new instruments that the financial sector developed, like mortgage backed securities and credit default swaps. There are positive aspects too. So it's important we don't jump to the other extreme and say the financial sector has no contribution at all. What I would like to figure out with this debate is what really are the positive aspects and what are the aspects which are overvalued.

Viv: So that brings me on, really, to the second lead commentary in the debate, posted earlier this week, was from Charles Goodhart. He argued that far from being socially useless, investment banks are critical to an effective economy, and that the idea that policymakers can safeguard retail banking alone is both mistaken and dangerous. What's your reaction to that?

Wouter: Yeah, the piece by Professor Goodhart is quite provocative. There are two parts to it. I think the provocative part is when he argues that even large companies need help dealing with the complex financial markets of modern times, like for example, in dealing with international transactions, and investment banks play a crucial role. So I'm not sure I would go that far.

But the other aspect of Professor Goodhart's piece, I do agree with. I think it's wrong for politicians to think that if they simply safeguard retail banks, then that's enough to make the financial sector safe. Institutions like Bear Stearns and AIG and Lehman Brothers, when you go back to the 90s, Long Term Capital Management, they were not retail banks.

But the collapse of these type of institutions can trigger havoc elsewhere in the financial sector. So I think the point that Professor Goodhart made that we shouldn't only focus on the safety of retail banks is a valid one.

Viv: So in a world where bankers' bonuses are still rising in spite of the critical state of many economies in Europe and around the world, how can we ensure that policymakers are engaged with these issues, and that regulation maintains and enhances the beneficial aspects of the financial sector, but at the same time curbs the excesses and what you refer to as the socially negative spillovers?

Wouter: Yes, that's a really difficult question. The financial sector is complex. I think no matter what kind of legislation is going to be imposed, the financial sector is going to be quite smart in trying to avoid it and do it its own way. So I think two things are important. The first thing is, we've got to make sure that the financial world is more transparent and there is more clarity.

So we avoid what we saw in the last decade, that the world had become so complex that we don't understand any more what's being traded, what the risks are, who is carrying those risks. I think if the financial world is more transparent, then I think the markets can do a better job in disciplining financial institutions that take on too much risk.

So part of accomplishing that, maybe, is that we have to make the financial world simpler, by maybe limiting the type of securities that can be traded. Possibly not all kind of obscure securities are really needed. It may also mean we have to limit the complexity of some financial institutions.

The second thing, and this actually is related, is that we have to solve the too big to fail problem. Like I said earlier, it's not just limited to retail banks. The policymakers have to have the possibility to take over a company and continue its operations while at the same time making sure its management and equity providers and debt providers are being punished if the company really took on too much risk.

So what happened in the past is these big companies, they knew they were going to be bailed out, and they took on more risk, and that's indeed what happened, with Lehman Brothers' being the exception. So I think that is a problem we have to solve. But if the world is more transparent and more simple, then I think the market can do a better job in disciplining large companies that take on risk, as long as it's known that the government will not bail them out.

Viv: So in conclusion, are you optimistic about the future of banking, and that the world can become more transparent and simple?

Wouter: Not anymore. When the financial crisis had just erupted, I thought this would be a great time for politicians to get their act together and learn from the past and build a new and better system. But if you see how politicians argue and are not capable of coming up with new and better plans, I've become a bit pessimistic.

Viv: Wouter den Haan, thanks very much.