Saturday, November 29, 2014

Starving the Squid

BERKELEY – Is America’s financial sector slowly draining the lifeblood from its real economy? The journalist Matt Taibbi’s memorable description in 2009 of Goldman Sachs – “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money” – still resonates, and for good reason.

Back in 2011, I noted that finance and insurance in the United States accounted for 2.8% of GDP in 1950 compared to 8.4% of GDP three years after the worst financial crisis in almost 80 years. “[I]f the US were getting good value from the extra…$750 billion diverted annually from paying people who make directly useful goods and provide directly useful services, it would be obvious in the statistics.”

Such a massive diversion of resources “away from goods and services directly useful this year,” I argued, “is a good bargain only if it boosts overall annual economic growth by 0.3% – or 6% per 25-year generation.” In other words, it is a good bargain only if it collectively has a substantial amount of what financiers call “alpha.”

That had not happened, so I asked why so much financial skill and enterprise had not yielded “obvious economic dividends.” The reason, I proposed, was that “[t]here are two sustainable ways to make money in finance: find people with risks that need to be carried and match them with people with unused risk-bearing capacity, or find people with such risks and match them with people who are clueless but who have money.”

Over the past year and a half, in the wake of Thomas Philippon and Ariell Reshef’s estimate that 2% of US GDP has been wasted in the pointless hypertrophy of the financial sector, evidence that America’s financial system is less a device for efficiently sharing risk and more a device for separating rich people from their money – a Las Vegas without the glitz – has mounted.

This is not a partisan view. Bruce Bartlett, a senior official in the Reagan and George H. W. Bush administrations, recently pointed to research showing the sharp rise in the financialization of the US economy. He then cited empirical work suggesting that financial deepening is useful only in the early stages of economic development, evidence of a negative correlation between financial deepening and real investment, and the withering conclusion of Adair Turner, Britain’s former top financial regulator: “There is no clear evidence that the growth in the scale and complexity of the financial system in the rich developed world over the last 20 to 30 years has driven increased growth or stability.”

Four years ago, during the 2008-9 crisis, I was largely ambivalent about financialization. It seemed to me that, yes, our modern sophisticated financial systems had created enormous macroeconomic risks. But it also seemed to me that a world short of risk-bearing capacity needed virtually anything that induced people to commit their money to long-term risky investments.

In other words, such a world needed either the reality or the illusion that finance could, as John Maynard Keynes put it, “defeat the dark forces of time and ignorance which envelop our future.” Most reforms that would guard against macroeconomic risk would also limit the ability of finance to persuade people to commit to long-term risky investments, and hence further lower the supply of finance willing to assume such undertakings.

But events and economic research since the crisis have demonstrated three things. First, modern finance is simply too politically powerful for legislatures or regulators to restrain its ability to create systemic macroeconomic risk. At the same time, it has not preserved its ability to entice customers with promises of safe, sophisticated money management.

Second, the correlations between economic growth and financial deepening on which I relied do indeed vanish when countries’ financial systems move beyond banks, electronic funds transfer, and bond markets to more sophisticated instruments.

Finally, the social returns from investment in finance as the industry of the future have largely disappeared over the past generation. A back-of-the-envelope calculation of mine in 2007 suggested that the world paid financial institutions roughly $800 billion every year for mergers and acquisitions that yielded about $170 billion of real economic value. That rather poor cost-benefit ratio does not appear to be improving.

Back in 2011, I should have read Keynes’s General Theory a little further, to where he suggests that “when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” At that point, it is time either for creative thinking about how funding can be channeled to the real economy in a way that bypasses modern finance, with its large negative alpha, or to risk being sucked dry.

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    1. Portrait of Keith Roberts

      CommentedKeith Roberts

      Expanding slightly on GA Pakula's comment, I would add that the growth of finance seems to me linked to its increasing ability to attract capital--that is, in the broadest sense, to increase the supply of credit. Of course, this view does not negate DeLong's argument that the financial sector has cost vastly more than it returns. The validity of that claim depends on the empirical research he mentions. It would be useful to have a summary of those articles.

        Portrait of Keith Roberts

        CommentedKeith Roberts

        The Phillippon and Reshef article concludes that up to 50% of the sector's earnings were rents in recent years, suggesting inefficiency and monopolization; in effect, I think, an overshooting by the sector based largely on its outpacing regulation--much as the bandits of the Old West outpaced the sheriffs, for a while. Cecchetti and Kharoubi measure credit levels against economic output over 5 year periods, and find that when outstanding credit exceeds about 90% of GDP, growth rates slow. It's not clear to me, however, that this correlation reflects causation. Again, nobody can plausibly claim that, unlike any other economic sector, finance never gets ahead of demand. It clearly has, does, and will continue to do so, just as do steel, computer, or clothing production.

    2. CommentedIngolf Eide

      It's easy to confuse two separate matters in this discussion, I think:

      - As GA Pakela notes, for the average user the range and quality of financial services has improved out of sight in recent decades. Partly because of deregulation but probably even more because of advances in technology.

      - At a macro level, it's a different story. In the last few decades the financial sector has almost certainly been a net drag on the economy, as DeLong suggests. No great mystery as to why. The sector's extreme growth simply mirrors the growth in credit and money. When a fiat money system is deregulated and is still underwritten by a combination of central bank and government guarantees (both implicit and explicit), malignant growth is guaranteed. It's only a question of how long it takes.

    3. CommentedJose araujo

      I think the article is lacking in some sort of conclusion or what is causing the problem.

      I think what DeLong exposes, is the reflection of the problems we are having in governance models that were at the heart of the financial crisis and subsequent recession we are experiencing today.

      We still have not found an answer to the agency problems we have created, where the agent is almost completely uncountable to the principle.

      Agents are maximizing their own profits, they don't care about the owners of the money. They have developed a system where they are protected from the fall and have a big incentive to take risk when things are wrong so they can collect the profits, and that what caused the crisis.

      Now, money is so abundant that they don't have to perform, they just have to avoid screw-ups to continue to make money.

      On the last crisis, when financial markets were stalling money was transferred to real assets ( the Milken principle), but today edge funds and bank managers don't have to do it, they don't have to take maximize their clients profit, just park the money in bonds.

    4. CommentedR Lubman

      What an utterly trivial opinion!

      Do you not understand that the most specialized economy in the world needs a large finance sector, and it developed only because it was needed to intermediate resources among a large number of economic entities?

      The finance sector greases the wheels for US business to earn high returns on foreign equity investments. It also allows foreigners to purchase US debt instruments, USD based, at low rates. Where would the US be if there wasn't this huge positive carry coming into the country every year?

      You stated on your blog that you couldn't have forecast what has happened in the past 5 years. Keep looking to Rolling Stone for your economic wisdom and past will be prologue!

    5. Commentedjesus alfaro

      It's true you cannot be forced to buy a financial product. Neither to buy a car or a phone, but you usually do not get hurt by buying a car or a phone. Markets do not protect you when buying financial products neither as individuals nor as taxpayers

    6. CommentedPaul A. Myers

      The tax code is a major culprit: deductibility of interest and non-deductibility of dividends makes an uneven playing field to the advantage of Big Finance.

      Look at the Senate Finance Committee -- and despair!

    7. CommentedJason Krishnan

      What role does tax regulation have in managing the financial sector's relationship with the real economy? In terms of current initiatives in this regard, the UK's levy on bonuses, and the EU's financial transactions tax come to mind.

      To Mark Pitts' comment, "Yes, finance has grown enormously. So has the computer industry. So what?" I would respond that the AOL acquisition was a good example of what happens when the "computer" industry is over-funded.

    8. CommentedKen Fedio

      The more disturbing realization of all is that G&S simply makes markets regardless of the value of assets therein: commodities, stocks, real estate, they are worth whatever they want them to be, and they defeat traditional valuation metrics at their whim.

    9. Commenteddonna jorgo

      so CAPITALISM GLOBALISM ,MONOPOLISME. no one have human sens .
      yes money smell ..they wanted to modificated ..changed ..or destroy start something GS ruls....
      thank you

    10. CommentedProcyon Mukherjee

      A great article by DeLong; of all the travails that financialization brought in, it is the lingering doubt that it did not solve the very basic problem of allocating capital for productive use of the society as is evident in the BIS paper 69 which has shown that “if output per worker is plotted against the share of employment in finance, there emerges a point where both financial development and financial system’s size turn from good to bad beyond a point (that point lies at 3.2% for the fraction of employment and 6.5% for the fraction of value added in finance). Based on 2008 data, the United States, Canada, the United Kingdom and Ireland were all beyond the threshold for employment (4.1%, 5.7%, 3.5% and 4.5%, respectively). And the United States and Ireland were also beyond the threshold for value added (7.7% and 10.4%, respectively)”. Thus we have a problem of stranded capital if too much is following to little economic change. It is also true for global finance and de-globalization pushes back the problem to the original, one of stranded capital and its inability to ‘push’ beyond a point.

      The financial markets helped by Central bank advances have amassed assets that have compounded annual growth rate of 9% (even after the painful adjustments), whereas the world economy has not even grown by 3%. This apparent dysfunctional arrangement had raised the doubt that financial markets instead of propounding systemic stability, consumer protection and risk mitigation practices to benefit large sections of people may have actually not served the lofty goals of bringing financial service access to greater majority of people, who go through the pains of adjustment more than the larger institutions; in providing the balance between serving
      those sections who have less knowledge of the products on offer that could advance credit and could be actually used judiciously through a mode of smoothening consumption (not excessive leverage), the larger focus had shifted to misallocation of resources to housing and consumer credit at an alarming rate which is not sustainable. People who need to keep their financial savings in safe custody actually succumbed in this process with large scale erosion of their net worth. But more importantly the competitive efficiency of the global
      financial markets whose benefits should have flown unequivocally to the larger sections of the society actually petered to an excessive financialization that made
      some of the sovereign back-stops insufficient. The question of sovereign insolvency, which was never in doubt, has become a very common word and the
      moral hazard has multiplied its preponderance in recent times.

      The linkage of financialization and commodity market volatility is one recurring item that does not bode well as is evident in the seminal paper, "Financialization, crisis and commodity correlation dynamics", which states the following, "Results point to increasing integration between commodities and Financial markets. Higher commodity returns volatility is predicted by lower interest rates and corporate bond spreads, US dollar depreciations, higher expected stock volatility and Financial traders open positions. We observe higher and more variable correlation, particularly from mid-sample, often predicted by higher expected stock volatility. For many pairings, we observe a structural break in the conditional correlation processes from the late 1990s."

    11. CommentedMark Pitts

      The squid we have to starve is big government.

      We can all choose to minimize our use of financial products.

      But whether we like it or not, about a third of GDP is consumed by the various levels of gov't.

    12. CommentedMark Pitts

      Only an real-world-ignorant academic/government economist would think bond and equity issuance, market making, M&A, mortgage products, risk management tools, insurance, etc., are not useful services in an advanced economy.
      Yes, finance has grown enormously. So has the computer industry. So what?
      There is apparently no limit to an academic's burning envy of the successful.

    13. CommentedG. A. Pakela

      The financial sector cannot force you to buy their products, so I do not understand how it is sucking us dry. When I started my career three decades ago, the ability to invest using an IRA or 401k was limited to higher cost mutual funds that pocketed over 1% of your assets annually in fees. Today, you can own the entire U.S. stock market for less than .1% and the entire international stock market for about .2%. Up until recently, it was possible to receive interest on checking account balances, that is until the Fed started sucking savers dry!

      The financial industry was far more expensive and opaque for the average investor back in the halcyon 1970s, where so many Keynesian academics came of age.

        CommentedMark Pitts

        Exactly right G.A. Don't forget the days when the gov't regulated interest rates. Then, everyone earned a negative rate of interest, all to the benefit of the gov't. "Buy government bonds" is now know to be a gov't hoax to take advantage of ignorant trusting citizens.