Does Finance Create Wealth?

What’s the role of the financial sector in an economy? I came across this question the other day while vetting something (what I cannot say) and the answer was, believe it or not, “to create and maintan economic wealth”.

Stuff like this drives me bonkers.

There’s this perception, especially in the media, that finance and especially the stock market is a way of creating wealth. Sorry but that simply isn’t true, except in a narrow sense for the go-between – the banker, the insurer, the stock broker etc. The economic textbook answer of course is that the financial sector functions as an intermediary: between investors and companies, between borrowers and lenders, between buyer and seller.

Since the intermediary earns fees for this service, from an economic viewpoint this is viewed as income which can be accumulated as wealth. But the actual flow of funds that the intermediary handles does not of itself constitute wealth creation, even if one side or the other makes a profit off the transaction.

How come? Let’s take a stock market example. Say you buy shares in company A for RM1.00 a share, and later sell it for RM1.50. You’ve made a trading profit of RM0.50, and have obviously increased your wealth.

But does the aggregate wealth of the system rise? No, it doesn’t – you’ve got counterparties in each buy/sell transaction. Somebody received your RM1.00 in return for the “A” company shares, and somebody paid you RM1.50 for those same shares. In short, this is a zero-sum game – no wealth is created, it’s just passed around.

So where does this idea of finance creating wealth come from? Because the perception is that share prices tend to go up over time (at least, if you’ve invested in a good company) – hence, the monetary value of shares held by investors likewise go up.

So wealth is created right? Not exactly. Shares are nothing more than a claim on the assets and value of the business of a company. If the value of the company goes up, then the underlying value of the claims represented by the shares of the company will also go up, which usually means the share price also goes up.

But here’s the key point – wealth creation has occurred at the company level, not in the stock market. If the underlying value of a company stays pat, then anybody making a profit trading in the shares of that company did so at someone else’s expense, since the value of the claim represented by those shares has not changed.

Corporate finance exercises, M&A exercises - it doesn't make a difference. Changes in share prices due to these exercises occur because the real and/or perceived value of a company has changed. Again, the change in wealth and value have occured at the company level, and share prices just reflect that.

Zero-sum game. The same thing occurs in banking and insurance, if not quite in so straightforward a manner.

That’s why bubbles are so damaging. Because the difference between reality and perception get so large, somebody (usually the professionals) makes an obscene profit, and somebody (usually the sucker retail investor) takes massive losses. And the aftermath of bubbles typically sees underlying values fall as well, so everybody takes a further hit.

So does finance create wealth? No, nyet, nada, non, nein!