The financial sector has grown massively since the 1970s, whether size is measured in terms of the volume of transactions, the number and remuneration of highly skilled professionals, the share of corporate profits, or, most importantly, the political power of the finance capital. As Frase observes, referencing Felix Salmon, the huge returns extracted by this sector distort the distribution of income for the economy as a whole. The market return on any activity must be adjusted for the cut taken by the financial sector. This fact makes the attempt to assign ethical status to marginal productivity academic, in the worst sense of the term.
Taking this further, any strategy for the Left that yields more than modest changes in the distribution of income, wealth and power, must involve a direct conflict with the financial sector, and must imply a substantial contraction in the size, wealth and power of that sector. A necessary condition for such a strategy to be feasible is the premise that the incomes flowing to the financial sector come at the expense of the rest of the economy, and in particular, at the expense of working people.
Conversely, if the financial sector makes a contribution to the economy that is commensurate with, or greater than, the incomes flowing to that sector, then a policy that substantially reduces the size of the financial sector is likely to harm the rest of the economy. In principle, it might be possible to redistribute income from the financial sector through progressive taxation, without greatly changing its operations. In practice, however, the political futility of such a strategy is obvious. As long as the financial sector commands its current resources, and is viewed as an essential contributor to prosperity, it will easily defeat proposals for higher taxation.
First, some distinctions. Obviously, a capitalist or mixed economy cannot function without money and other financial instruments. But during the Bretton Woods era, the financial sector was much smaller and less powerful than it is today. The question is whether that expansion of the financial sector since the 1970s has generated net benefits for the rest of society.
The set of “retail” financial services supplied to households and small businesses (insurance, savings and checking accounts, housing, personal and business loans, credit cards) has not changed much since the Bretton Woods era. In addition, technical progress has automated most routine interactions with banks, to a greater extent than has happened with most other service industries. The size of the retail banking sector, relative to the economy as a whole, does not appear to have changed greatly.
The real transformation has been in corporate and international finance — “Wall Street” in shorthand (in the UK, “the City”). The growth in the volume and complexity of financial transactions since the breakdown of the Bretton Woods system in the early 1970s has been staggering.
In the Bretton Woods era, and even in the globalized financial economy of the 19th century, most financial transactions were directly related to trade in goods and services, or to capital investments. By contrast, in the current era of financial capitalism that began in the 1970s, the volume of shares traded every day on the New York has risen from 15 million in 1971 to 4 billion today. Average share prices have risen by a factor of 20 or more, so that the total value of shares traded is around 10,000 times higher than it was. Other financial markets, some of which barely existed before the 1970s, have grown even faster.
Even more striking has been the emergence of a bewildering variety of complex instruments, generically referred to as derivatives. The gross value of outstanding derivatives rose to $600 trillion (about 10 times the annual output of the global economy) in the years leading up to the financial crisis. While some derivatives markets collapsed in the last crisis, many have continued to expand; the market as a whole has remained about the same size as in the leadup to the crisis.
The financial services sector as a whole accounts for more than 20 percent of US GDP, and this share has grown by around 10 percentage points since the 1970s. Additional expansion has taken place in the business services sector, encompassing law and accounting firms and other outgrowths of a financialized economy. Overall, it seems reasonable to conclude that Wall Street in its various forms accounts for around 20 percent of total US income, a share comparable to that of the US government.
Is the financial sector making a contribution to society commensurate with its returns? The evidence is overwhelmingly against this proposition. We can look at a variety of tests.
First, there is the relationship between individual rewards and performance. Within the financial sector, those who have reached the top of successful firms have become spectacularly wealthy as a result. Jamie Dimon of JP Morgan (currently the subject of at least five separate investigations for misconduct) is a typical example, with net worth estimated at $400 million.
However, the rewards for those who have led enterprises to destruction have been as great or greater. Dick Fuld of Lehman Brothers walked away with $500 million, and Jimmy Cayne of Bear Stearns was left with $300 million to pursue his true passion, professional bridge.
Next we can look at how well the sector has performed its core functions: risk management and the allocation of investment.
The central claim advanced in support of the financial sector was that it could do a better job of managing household and business risk than could the inflexible structures of the social democratic welfare state, represented in the US by New Deal institutions like Social Security.
This claim was supported by the supposed “Great Moderation” in economic volatility, a reduction in the variability of Gross Domestic Product observed in the US between the early 1980s and the early 2000s.
In fact, even during the Great Moderation, reductions in aggregate volatility concealed what Jacob Hacker described as the “Great Risk Shift,” from business and government to workers and households. Employment became less secure, even in the public sector and in profitable firms that would previously have avoided layoffs except as a last resort. Defined benefit pensions were replaced by defined contribution schemes in which individual workers and their families bore the risk of market fluctuations. The spectacular collapse of 2008 revealed the Great Moderation as an illusion. In the process, tens of millions of households saw their savings wiped out. Household wealth fell by 25 percent during the crisis, and has recovered only marginally since then.
Meanwhile, those at the top were increasingly immune from risk of all kinds. The proportional volatility of income is no higher for senior managers than for workers in general. But as the income distribution has become more unequal, this means that there is less and less risk that someone in the top 1 percent of the income distribution will experience an income shock sufficient to push them out of this group.
Another critical aspect of risk relates to movements in exchange rates. The push towards financial liberalization began with the breakdown of the Bretton Woods system of fixed exchange rates. The promise was that, once exchange rates were set by trade in financial markets, they would be determined by the underlying conditions of absolute and comparative advantage in the production of goods and services, and by differences in inflation rates. Since differences in inflation rates have generally been small, and changes in patterns of comparative advantage are usually gradual, it was expected that market-determined exchange rates would be relatively stable, contrasting with the sharp devaluations (of as much as 20 or 25 percent) occasionally forced on governments during the Bretton Woods era. This stability would, in turn, help to stabilize national economies.
In fact, the reverse has been the case. Exchange rates have gyrated wildly even in the absence of significant changes in fundamentals. For example, the Australian dollar traded at $US1.10 when it was first floated in 1983, before falling below 50 cents and then rebounding all the way back to $1.10. The current rate is around $US 0.90. These fluctuations have had catastrophic effects on trade-exposed sectors like manufacturing.
The other core function of the financial sector is the allocation of investment. During the social democratic era, most long-term investment in infrastructure was undertaken by the household sector. Investment in housing took place within a tightly regulated retail banking sector. With Keynesian macroeconomic management ensuring sustained near-full employment, and with control effectively in the hands of managers rather than shareholders, corporations could finance much of their investment from retained earnings. Short of catastrophic failure, financial markets had little say in investment decisions.
Financial deregulation was supposed to change all that. Public enterprises were privatized on the assumption that profit-maximizing firms would avoid wasteful projects. Mortgages were securitized and became tradeable financial assets. The rise of hostile takeovers and the theory of shareholder value meant that each quarterly earnings report provided an opportunity for markets to make judgements on corporate investment strategies.
These developments were supposed to provide a stable and rational framework for investment. In fact, the opposite was true. The expansion of the global financial sector has produced a series of bubbles so massive as to put past bubbles to shame.
The result has been the misallocation of investment on a scale unprecedented in the history of capitalism. The Dot-Com bubble alone saw the dissipation of a trillion dollars in wasted investments. Losses from projects started during the housing bubble and then abandoned are hard to estimate, but probably comparable in magnitude.
The rapid growth in incomes accruing to the financial sector has been accompanied by slow growth or stagnation in incomes for the rest of society. Moreover, aggregate income growth over the entire period of market liberalism, including the current recession, has been weak. The rise of Wall Street has left the rest of society with a diminished share of a smaller (more precisely, slower-growing) pie.
It is occasionally argued that the disastrous impacts of financial market crises in the developed world, and in many developing countries, need to be set against the decades of strong growth in India and China, which have lifted hundreds of millions of people against poverty. But these countries are notable for the degree to which liberalization of markets in goods and services has been accompanied by continued financial repression. Even so, there is no guarantee that they will remain immune from financial disaster as the inexorable growth of the financial sector extends ever further. Already China has a large, and apparently unstable, shadow financial sector linked in opaque ways to the state-regulated official sector.
All the evidence suggests that the expansion of Wall Street and its counterparts has come at the expense of society as a whole. What lessons should we draw from this?
First, consider the implications for the debate about incomes and marginal products. The top 1 percent of the income recipients, accounting for more than 20 percent of total US income, are predominantly employed in the financial sector or in senior corporate management. The earnings of senior corporate managers, and Chief Executive Officers in particular, are driven in large measure by financial market valuations and the associated capital gains. If financial market valuations are unrelated to social value, the same must be true of the earnings of financial corporations and CEOs.
The conclusion that the earnings of the top 1 percent do not reflect contributions to social value has implications for the entire distribution of income. Incomes in the top 1 percent shape relative incomes for the rest of the top quintile of the income distributions. To take an example close to home for the author, the wages of academic economists are higher because of the “outside option” of working in banking or finance. But many middle managers contribute massive effort in return for relatively modest salaries precisely because their jobs give them an outside chance of the glittering prizes at the top of the hierarchy.
The top 1 percent of income recipients receive about 20 percent of total US income, and the next 19 percent another 40 percent or so. If 60 percent of total income is allocated in ways that bear little relationship to the social value of work, the same is true, in aggregate, of the remaining 40 percent. Most obviously, if the share accruing to the top 20 percent of income earners is larger than the contribution of this group to social value, the opposite must be true of the share accruing to the remaining 80 percent.
But the conclusion that incomes do not reflect social contributions is not confined to the absolute level of wages. It even extends to the relative wages of workers in the bottom 80 percent of the distribution. It may be true, in some cases, that the relative wages of different workers reflect the relative market values of the goods and services they produce after managers and capital owners have taken their cut. But when the magnitude of this cut is unrelated to social contribution, and actually constitutes the bulk of total value, the value of the residual paid to those actually engaged in production is not related to social contribution, either. The dominance of the financial sector distorts all prices and wages in the economy, not just those directly related to the activities of the financial sector.
The implications for political strategy are equally important. Despite the catastrophic failures of capitalism in the 2008 crisis and thereafter, political outcomes for the Left have been disappointing, to put it mildly. Social democratic parties have put the preservation of financial sector stability ahead of the interests of working people and the need for public services. Far from being rewarded for this display of “responsibility,” they have lost votes in all directions: to more radical parties on the Left, to the xenophobic right and even to the mainstream conservative parties, to whom they have effectively conceded the policy debate.
This is the outcome of political strategies that are badly wrong in both substance and rhetoric. The rhetorical error has been to reject populist appeals and class division, and instead to project, with limited success, an image of responsibility and technocratic competence. This is an absurd pitch to offer when it is evident to all that the system is failing and that the technocrats who managed it have nothing to offer in response except an unjustified faith in austerity. In these circumstances, it is scarcely surprising that voters find more appeal in parties that put the blame on easily identified outgroups such as immigrants.
The answer here is simple. Instead of seeking the approval of the financial sector, the Left, including liberals and social democrats, should identify this sector as a primary source of our current problems. Bank-bashing has been a reliable source of votes ever since banks existed, and the conduct of the financial sector entirely justifies a sustained bashing. Rather than being scared of accusations of “class warfare,” the Left should embrace it, remembering that “they only call it class warfare when we fight back.”
The unexpected, if temporary, success of Occupy Wall Street provides one model. But even within US party politics there are some signs that such a strategy can be effective. The campaign to stop Obama’s planned nomination of Larry Summers as chairman of the US Federal Reserve, which focused critical attention on his role in financial deregulation, is one such example.
Bad as they are, the rhetorical errors of the center-left are less significant than their failure to offer any coherent alternative to austerity politics. For the most part, they have not even been willing to defend the Keynesian demand management advocated by most credible macroeconomists. The fact that the main academic advocates of austerity have been utterly discredited has not moved them.
Beyond changes in short-term policy, any serious attempt to stabilize the macroeconomy and return to sustainable improvements in living standards must involve a drastic reduction in the size and economic weight of the financial sector. Attempts at regulating derivatives markets have proved utterly futile in the face of massive incentives to take profitable risks, backed up by the guarantee of a government bailout.
The only remaining option is to separate these markets entirely from the socially useful parts of the financial system, then let them fail. Publicly guaranteed banks should be banned from engaging in all but the most basic financial transactions, such as issuing loans and bonds and accepting deposits. In particular, banks should be prohibited from doing any business with institutions engaged in speculative finance such as trade in derivatives. Such institutions should be required to raise all their funds directly from investors, on a “buyer beware” basis, and should never be bailed out, directly or indirectly, when they get into trouble.
It is also critical to end the tax privileges currently received by financial operators, such as the “carried interest” deduction in the US and, more generally, the concessional treatment of capital gains. In the absence of such concessions and of the protection implied by government bailouts, much of the existing financial sector would not be viable. This is all for the better. The resources currently consumed by the sector could be put to much better use in health and education, or in the real productive activities of the private sector.
A thirty-year experiment with financial liberalization has proved, beyond any reasonable doubt, that the growth of Wall Street has come at the expense of society as a whole, and that the earnings it generates are not justified by a contribution to social value...
Sunday, November 17, 2013
"Wall Street Isn't Worth It"
Economist John Quiggan @ Jacobin: