What is the purpose of finance?

So what is the purpose of finance? Try that question over dinner and you will likely get a somewhat cynical reply, about its self-serving nature. Financial crisis after crisis, scandal after scandal have not helped to build a narrative that the finance serves any purpose than to serve itself. But that is far from the truth. Finance plays a pivotal role in our economy and in the debate for more inclusive growth within it.

Most would agree that the purpose of finance is to serve the outside world, “promoting investment, innovation and prosperity”. However the debate about what that might entail for the effective operation of finance has hardly begun. Search in the finance textbooks, and you will scarcely find one that begins with a clear definition of purpose, leave alone one which measures how well it is being fulfilled.

Insofar as we do have evidence, it is extremely sobering. One rigorous study, undertaken by Prof. Thomas Philippon, worked out over 130 years, the amount of money deposited in the care of the finance industry, and the amount that it had then invested in the outside word. (It excluded all the money that circulates within the industry itself). It then calculated the cost of this service, and how much more productive today’s industry was from that in 1880. It discovered no improvement whatsoever, and that the industry which finances the internet is no more productive than the one which financed the railroads. This is an astonishingly poor performance.

But it should not come as a surprise. For hundreds of years doctors treated their patients by bleeding them. It wasn’t until they started asking whether the procedure was fulfilling its purpose in curing the patient, that they realised that what they were doing was harmful, and the practice died away. By the same token, if we are to have a purposeful finance industry we need to debate what its purpose is, measure whether it is being achieved, and design our industry so that it is ever better.

That is the debate which the Pension Insurance Corporation is seeking to sponsor, Through a series of commissioned pieces of research from industry practitioners and academics it is looking at what the finance industry should be there to do, and why it finds it so difficult to achieve its purpose.

Here is an example. The purpose of a pension is to provide a reliable income from the time when someone retires to the day they die. (An efficient pension system will therefore be able to keep money safe, invest it appropriately, and critically allow us to share the risk of how long we will survive from retirement to death.) Today, in Britain, for those outside the public sector, there is no low cost way of buying a pension. Annuities are expensive, and their price unreliable.

It need not be this way. In Holland and Denmark, a perfectly workable system exists to provide private pensions. Yet in Britain, one of the global capitals of financial expertise, we lack an effective private pension system. That might be because, despite many positive innovations, policy makers have not thought clearly about the purpose of a pension, and hence we failed to build the institutions which will allow market forces to deliver on than purpose.

It is not just on pensions where we could do with a rethink. If the purpose of a stock exchange is to help companies raise money, and to allow ownership to change, even as the company continues for the long term, is that how they operate today? If the purpose of banks is to keep our money safe, while generating a surplus by lending it out to productive ventures, is that how they are currently financed? If the purpose of financial reporting and accounting standards was to help ensure managers run companies well and don’t abuse limited liability, is that how they currently operate? And if regulators were charged with helping the industry fulfil its purpose well, would that be consistent with the multiplying volumes of rules to which we are currently subject?

All this suggests we need a new starting point for our debate, from thinkers and academics, commentators and policy makers, regulators and practitioners.

If we did, the prize would be huge. Not least a catch up on the failure for over a century to deliver productivity gains which deliver for the outside world, and promote investment, innovation and prosperity.

Hari Man and David Pitt-Watson’s paper on the purpose of finance, ‘Why Finance Matters: Building an industry that serves its customers and society’, is available to download here