What They Do With Your Money: How the Financial System Fails Us and How to Fix It

Jon Lukomnik, Stephen Davis and David Pitt-Watson, authors of What They Do With Your Money: How the Financial System Fails Us and How to Fix It (Yale University Press, 2016), discuss their book.

Here is a question that should be important to anyone interested in the finance industry: “What is its purpose?”  If you can’t answer that question, you can’t judge is the industry is doing a good job or not.

Those issues of purpose and performance sit at the heart of our new book, What They Do With Your Money.

For most industries, purpose is obvious.  Ask someone the purpose of agriculture, and they will have no difficulty in telling you. Ask it about finance, and you are likely to be met with blank, and maybe cynical, faces.

Finance doesn’t create food, shelter or entertainment. It doesn’t weld metal into machines.  It doesn’t transport you here and there, or heat your home. But without it, none of those activities could happen at the scale needed by modern society. The industry enables prosperity and well-being. It is extraordinary important.

It has four key purposes. Keeping our money safe; facilitating payments, and sharing risk.  But perhaps the most important is what is known as “intermediation,” or, as the third Lord Rothschild put it, “taking money from point A where it is, to point B where it is needed”. From pooling savings to fund a mortgage, or helping build a factory, finance aggregates and distributes the capital needed for economic activity.

But the evidence on how well the industry performs its role is sobering. Today, the cost charged by the finance industry to move our savings from point A (in the real world), and invest them at point B, (also in the real world), is the same is it was 130 years ago.  In those 130 years, we have invented telephones, computers, and the internet, technologies which should have allowed better performance.  In almost every human endeavor, we have become more productive. But not in finance.

The issue we explore in our book is how this could possibly be the case. Financial markets are open and competitive, the industry employs clever people, who are no more or less upright than other citizens.  But in aggregate, finance has not served its customers well.  Why? There are a number of explanations, but they all boil down to one thing; this is not a system that is designed, practiced, regulated or even studied with “purpose” in mind.

For example, for markets to work, people need to know how much they are being charged.  Yet in the investment industry it is standard practice not to declare “hidden costs”.

Markets should offer us choice. But there are 79,669 mutual funds and unit trusts in the world. No one knows the optimal number, but everyone is pretty sure it’s less than 79,669. Why so many? It certainly doesn’t end up helping customers.

The number of financial intermediaries has grown exponentially.  One study identified 16 agents that shepherd your money to the eventual investment. And they all get paid. And much of the business of the finance industry is done with itself. British banks make about $7 trillion in loans each year. But only $2 trillion of that is with non-financial borrowers, or, as economist John Kay terms it, “businesses that do things”.  The remaining $5 trillion is intra-financial sector.

That lengthy chain of agents which affects cost also attenuates us from the ownership of the companies in which we invest. That is one reason that issues that most people should care about if their investments are to perform – like long-term profitability and sustainability – take lesser priority than issues the intermediaries care about, such as trading profits and short-term returns.

Investment institutions should be designed to invest; not just to trade.  Banks should be there to keep our money safe. Pension funds to provide an income from the time we retire to the time we die. That is not what is happening today.  If it did, the improvements could be extraordinary. For example, we calculate that a Dutch pension saver, who saved exactly the same as a British one, will receive a 50% higher pension, because the Dutch system is better designed to purpose.

Make no mistake.  Our current financial system is an extraordinary invention.  The services that it provides are essential to the way we live today. But it is under strain to fulfil its proper role. We need to address those strains, not by some grand plan, but by asking and addressing some common sense questions about what a purposeful system would look like.

That is what we try to do in What They Do With Your Money.

“What They Do With Your Money; How the Financial System Fails Us and How to Fix It”. Available at amazon.com or amazon.co.uk.