NEW : Benjamin Friedman on overmighty finance

Harvard economist Benjamin Friedman asks a few questions in Thursday'sFinancial Times that are amazingly basic and unsettlingly unanswerable. And inadvertently (or perhaps not), Friedman, one of the eminences of American economics, reveals the limitations of the discipline as it's currently practiced.
In this case, Friedman isn't trying to forecast anything -- accurate prediction being the most obvious failure of economics in the current crisis. Rather he asks a seemingly simple question that is remarkable for not being asked before this. Why do we have such a large finance industry relative to earlier periods? Do all these bright Ivy types flocking to finance produce an aggregate benefit? Is a massive finance sector an efficient use of resources and does the costs that it accrues outstrip its gains? Sounds pretty
straightforward. In fact, we have no idea, which Friedman readily admits. Despite a headline on the column that suggests certainty (he undoubtedly didn't write it) -- "Overmighty finance levies a tithe on growth" -- Friedman himself lays out the situation and throws up his hands. "Does the increased efficiency our investment allocation system delivers meet that hurdle [of a net economic benefit]? We simply do not know."
Give him credit for honesty. If we don't know that, than we really don't have a clue about what to do with the financial system, either through the bailout or into the regulatory reform phase. We are, in the most basic way, as blind as Ben Bernanke and Henry Paulson in the frantic days around the collapse of Lehman Brothers Holdings Inc. Not that this simple-sounding question doesn't cover some difficult underlying issues, none of which have answers either. We are left to speculate. Could it be that a massive finance sector is necessary to squeeze out every ounce of growth from a large, complex and relatively mature economy, like a big turbocharger strapped to an old Cadillac? After all, what would occur if we permanently unbolted the mechanism of liquidity generation and financial innovation and tossed it away? (We tried it for a few months and almost expired.) This is analogous to Paul Krugman's suggestion earlier in the year that we simply roll back financial innovation to, say, the early '80s: What would happen to employment, corporate profits or growth? Clearly, the Obama administration was not prepared to take that leap into utter darkness and possible political destruction.
Could it be that such a large engine of liquidity is the price we pay for social and political "choices" -- actually, less political choices and more like tendencies -- that we've drifted toward over the past few decades, such as a massive, dysfunctional, private-public healthcare system or the increasing exposure of all Americans to market risk? Could it be that our propensity for bubbles is the result as much of political as financial choices? Does the economic system require greater jolts of adrenaline (that turbocharger again, to mix metaphors) to keep it growing at a rate that papers over underlying social and political problems we have no will to tackle? Are all bubbles equally bad?
These are questions not opinions. If Friedman doesn't know, then I haven't a clue. What these questions point out, however, is something that's been obvious since the economic punditry (and the faux-economists in their train) rose to full cry with the coming of the crisis: That this crisis is as much about politics, about the distribution of power and rewards, as it is about technical economics, like whether the stimulus will work or whether we're heading for a V, W or U recovery (the once-popular L seems to have been forgotten). And, again inadvertently, it points out where so much of the commentary has seemed half-baked. Economists like Krugman may write continually about politics, but the underlying discipline that provides credibility does not have a clue when it comes to what was still called in the days of John Stuart Mill "political economy." (Not that some haven't tried: Simon Johnson offered up his theory of a financial oligarchy, but that operated more at the level of provocative metaphor in the service of a set of specific policy prescriptions than as a complex view of the relation between finance and the real economy. At the end of the day, taking Johnson's oligarchy theory seriously only leads back to Friedman's question: Is such a large financial sector beneficial or necessary?) The question of the role of finance in our political economy is a matter of daunting technical complexities, but more damning, it involves soft and nonquantitative matters that simply don't fit the self-image of economics as a predictive science.
Friedman, in fact, may be a mild exception that proves the rule: His last book "The Moral Consequences of Economic Growth," explores the marshy territory that abuts quantitative economics. Still, since even Friedman, who at least has students to shape and colleagues to influence, is just asking the question now, it may be many years -- if ever -- before the dismal "science," which really does dominate policy and policymaking in the U.S., grapples with a meaningful answer. - Robert Teitelman

source : http://www.thedeal.com/dealscape/2009/08/benjamin_friedman_on_overmight.php