The Role of Finance in the Economy: Implications for Structural Reform of the Financial Sector

15747 Words Jun 3rd, 2015 63 Pages
Martin Neil Baily
Douglas J. Elliott
The Brookings Institution
July 11, 2013

The Role of Finance in the Economy: Implications for Structural
Reform of the Financial Sector
Executive Summary
The U.S. financial system is critical to the functioning of the economy as a whole and banks are central to the financial system. In addition to providing substantial employment, finance serves three main purposes:
Credit provision. Credit fuels economic activity by allowing businesses to invest beyond their cash on hand, households to purchase homes without saving the entire cost in advance, and governments to smooth out their spending by mitigating the cyclical pattern of tax revenues and to invest in infrastructure projects. Banks
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In truth, it is very difficult to judge the right size of almost any industry and attempts at the use of central planning and other mechanisms to correct assumed problems of this nature have usually failed.
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Nonetheless, it is reasonable to assume that a sector will be too large if there are unwarranted economic subsidies flowing to it. This does appear to have been the case in the bubble and may still be the case, although such subsidies have been much reduced by a series of actions to remove government support and to force the financial industry to operate more safely.
However, we suspect the excessive size in the bubble period was considerably less than many argue and we believe it is important to be cautious in drawing policy conclusions as it seems impossible to prove whether the sector was or is too large and by how much. There are a number of important proposals to force major changes in the structure of the financial industry, including to:



Eliminate Too Big to Fail banks by forcing their break-up or downsizing
Limit the functions of banks à la Glass Steagall or the Volcker Rule

Banks that are central to our financial system, whether through sheer size or the critical nature of the services they provide,

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