The financial services business in the past 25 years has been repeatedly deregulated, and has benefited from immense advances in technology, all in the interests of greater efficiency. Yet its employment has increased, as has its share in value added terms in the U.S. economy — from 4.55 percent of the economy in 1977 to 7.90 percent of the economy in 2004, according to Bureau of Economic Analysis figures. To become vastly more efficient without becoming cheaper is quite a trick; how has it been managed?
Proponents of the modern financial services industry will at this point quote various economic laws about willing buyer/willing seller, and enter into paeans of rhapsody about the extraordinary sophistication of entirely new product areas such as securitization and derivatives. I would be the last to deny that the people involved in these areas are clever; many of them have PhDs from good schools and in one notorious case, the hedge fund Long Term Capital Management which collapsed in 1998, two of the advisors had Nobel prizes. All these people are fearfully well paid, lauded in the financial press and respected by all but the ardently anti-capitalist left. Yet like the small boy who spotted that the Emperor’s new clothes didn’t exist, and that he was in fact naked, I feel an irresistible compulsion to ask: are these people actually adding value?
Take derivatives, for instance, in which I participated in a modest way in the 1980s. Total outstanding volume in derivatives contracts is currently around $300 trillion, more than 5 times the entire Gross World Product. Yet in national accounts, where risk aversion is ignored, derivatives, unlike conventional investments are a zero sum game. When a derivative contract is opened, it starts producing profits for one side and losses for the other, of equal amounts; for every winner there is a loser. Thus banks make a profit on derivatives only at the expense of their investors and corporate clients, who may successfully hedge a risk but have paid a price to do so. The net gain in national wealth is zero, since the risks being “hedged” unlike the hurricanes and death of conventional insurance are two-way – for each loser in a derivatives price movement there is a winner.
Further, since Gross World Product is less than $60 trillion, it is difficult to see where there could be $300 trillion of risks to hedge. To the extent that Wall Street is engaging in frantic derivatives trading, it is merely carving itself a larger slice out of the world economic pie, not making the pie itself larger. The cost of clients’ derivatives activity is hidden in movements in bond, share, commodity and foreign exchange prices
It seems at first sight inexplicable that a huge market could exist, many times the size of the risks it is theoretically there to hedge, rewarding many thousands of traders at a princely level and even more thousands of back office staff at a more modest level, without itself producing any tangible value. Of course, the salaries and bonuses of the participants are included in output, and indeed the revenues from derivatives operations must be sufficient to cover those salaries and bonuses, otherwise the market wouldn’t exist, yet the output of the sector is entirely hidden. A large number of people have made a very good living indeed without increasing anybody’s welfare but their own.
The same applies to the mergers and acquisitions business. Studies have shown that on average mergers and acquisitions reduce the value of the companies being merged, as well as causing disruption to the careers of their employees. There are two beneficiaries. One is the top management of both companies, which either receives a large payout, in the case of the seller or gets a bigger empire to run, in the case of the buyer. The other is the investment banker advising on the deal, who reaps large fees and hence bonuses at the end of the year. Again, transactions which on average add nothing to output nevertheless benefit the incomes of a small group of insiders, primarily in the financial services business.
Wall Street analysts and investment managers, similarly, add little value. Studies since the 1970s have shown that the average return on actively managed funds is lower than the return of the market as a whole. Analysts, on the other hand, are very largely producing “buy” recommendations on the stocks they cover; apart from the conflicts of interest involved, there is little value to a compass which always points towards the bows of a ship, no matter in which direction it is traveling. Funds themselves have steadily increased their portfolio turnover, thus increasing the costs in brokerage and bid/asked spread to their investors without any significant improvement in returns. There is thus little or no economic benefit to all this expensive activity, beyond investment in a passive “index” fund or, better still, investment by a modestly paid 1950s Boston investment committee, which could hardly ever agree on any trades, and therefore incurred no costs beyond the excellent lunches at its monthly meetings.
In the consumer finance area, the last 30 years have seen an explosion in the credit card business, with lines of credit being offered in the mail to all but the technically bankrupt and the currently incarcerated (the dead get many such offers until, after several years, their names are culled from the mailing lists for non-responsiveness.) As a result, consumers’ debt service payments have risen to an all time high, more than double the percentage of their income of 1980. Since money consumers are paying in excessive interest charges and late fees is money they don’t have to spend, this again represents additional output that is of little benefit. In this case however those consumers who are insouciant about credit, and regard their credit cards as free money on which they can safely default, an ever growing group, are happily living off subsidies from the interest paid by the rest of us. At most, this is redistribution not creation of wealth.
Finally, we come to the plethora of new investment products created since 1980, such as the leveraged buyout fund, the private equity fund and the hedge fund. Hedge funds in particular have enjoyed explosive growth since the late 1990s, as liquidity has been high and the returns available in the stock markets have appeared unexciting. Notable in all three types of fund is a scale of fees to the fund managers far above those available from conventional funds. Not notable is any evidence of superior returns to investors over and above those available in the stock market – for example the rate of return on private equity investments in the long bull market since 1982 has been somewhat below that available from investing in the Standard and Poors 500 share index. These funds are thus not adding value, they are simply adding cost in two forms, higher remuneration for the fund managers and occasional bonanzas of wealth for the management of target companies.
Breaking down the value added between the various financial sectors, between 1977 and 2004, the banking and credit intermediation sector grew considerably faster than the economy as a whole, rising from 2.39 per cent of the economy’s value added to 3.96 percent, a rise of 66 percent in its share compared with the overall financial services business’s rise of 74 percent. Set against the explosion in credit cards, the lending business has suffered from two trends, a further relative decline in corporate lending, the main financial services business in the 1950s but already in decline by 1977, and the increasing securitization of home mortgages, another business involving large fees to Wall Street and very little benefit to the consumer.
The insurance business, the least affected by Wall Street brilliance, has increased its share of the U.S. economy by only 26 percent, from 1.82 percent to 2.30 percent.
The securities business has shown the most spectacular growth. Only 0.31 percent of the U.S. economy in 1977, it has exploded to 1.46 percent of the entire U.S. economy, growing its share by 371 percent. Investment banks, tiny (in terms of capital – smaller than the London merchant banks) partnerships before 1970, multiplied their capital 1000-fold and devoted it to gigantic trading operations, replacing client-oriented partners with deal-oriented traders whose average remuneration was a substantial multiple of their predecessors’ (not 1000 times it, but there were many more of them.)
Finally the fund management and custody business, a minuscule 0.02 percent of the U.S. economy in 1977, has shown even more spectacular growth from its low base, rising to 0.19 percent of the economy, a growth of 845 percent in its share.
Free marketers and friends of Wall Street will be grinding their teeth at this stage and enquiring how, in a free market, Wall Street can consistently, year after year, add it its remuneration and that of top corporate management without providing value to its customers at least comparable to the value being added.
The answer is quite simple: Wall Street is rent seeking, cutting itself a bigger slice of the economic cake without itself increasing the size of the cake, an activity defined by public choice economist Gordon Tullock. Wall Street is the gatekeeper for the allocation of resources in the U.S. economy, and hence is able to extract monopoly rents by exercising this function. If you want to raise money you have to go to Wall Street, there is no longer any viable alternative. The savings and loans, which made home mortgages to local residents, were bankrupted by the high interest rates and inflation of the late 1970s. The local banks, which lent to local businesses and maintained independence from money center banks, were taken over by behemoths after the 1994 repeal of the 1927 McFadden Act, which had prohibited interstate branching. The small, service oriented investment banks, and their London cousins the merchant banks, metastasized into gigantic trading operations through a lengthy process that began with the abolition of fixed Stock Exchange commissions in 1975 and ended with the 1999 repeal of the Glass-Steagall Act. Local moneylenders which provided finance to consumers were driven out of business by the ubiquitous credit card.
By controlling the finance process, and providing luxuriant rewards to the corporate management who are nominally its most important customers, Wall Street has succeeded in substantially increasing its share of the U.S. economy, and will continue doing so. It is helped by a complaisant Federal Reserve providing endless liquidity through excessive money creation, which is channeled by Wall Street into ever rising securities and asset prices. Gross Domestic Product increases year after year, but the average U.S. worker who is not involved in Wall Street never gets any richer – the Census Bureau statistics on personal income tell you this and for once, they don’t lie.
Wall Street’s grip on the U.S. economy, and its allocation to itself of U.S. resources, can be broken by only one thing, tight money and a bear market. This will produce losses on the trading desks that for so many years have shown profits, it will dry up the supply of “funny money” for private equity, leveraged buyout and hedge fund investment, it will sharply reduce house prices and hence the volume of home mortgage financing, and it will turn the credit card business, already dangerous, into a pit of uncontrollable losses.
Wall Street will resist this unhappy event with every means at its disposal. Indeed it has already fought off one such episode in 2001-3 with the help of a friendly Fed creating liquidity and a helpful administration cutting taxes (this economic bailout will be damaging in the long run, but today’s trading-oriented Wall Street cares little about the long run.). This time around, consumer price inflation, even as massaged by the Bureau of Labor Statistics, is creeping ever upward, as is the Federal budget deficit, so no such “cure” will be available.
Of course, the rest of us will suffer too, unemployment will rise and the value of our houses and our pensions will decline. But it will be worth it, to remove the vise-like grip of Wall Street on our economy, return the financial services business to its proper modest place in the scheme of things and make Wall Street “big swinging dicks” and their cousins in corporate top management earn their living, like the rest of us, by making and selling something that benefits the economy as a whole.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.