J. Bradford DeLong
Upon What Meat Hath Our Financial Sector Fed to Grow so Great? J. Bradford DeLong U.C. Berkeley December 23, 2010
Mike Konczal: Cowen and others on Leverage, Financial Market Regulation  Rortybomb: [Paul Volcker said in 2007:] I had another comment I was going to make. You won’t be able to resolve it for me but I’ll raise it anyway. It strikes me that when one looks at the banking system, never before in our lifetime has the industry been under so much competitive pressure with declining market share in many areas and a feeling of intense strain, yet at the same time, the industry never has been so profitable with so
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much apparent strength. How do I reconcile those two observations?... I’d recommending splitting the argument into three questions: 1. 2. 3.
Why is the financial sector so big? Why is the financial sector so profitable? and Why is the financial sector so risky?...
Greta R. Krippner argued convincingly that the increase in the financial share of the economy isn’t the result of the modern corporation splitting off internal financial work.... Being short on volatility isn’t sufficient for these [three] problems, and may not even be necessary.... The quote at the top is from this paper by James Crotty, which finds “If Financial Market Competition is so Intense, Why are Financial Firm Profits so High?”, which finds the reasons [to be]: rapid growth in the demand for financial products and services in the past quarter century; rising concentration in most major financial industries that makes what Schumpeter called “corespective” competition and the exercise of market power possible (thus raising the possibility that competition is not universally as intense as Volcker assumed); increased risktaking among all the major financial market actors that has raised average profit rates; and rapid financial innovation in over-the-counter derivatives that allows giant banks to create and trade complex products with high profit margins.... [L]everage is one key, but thinking of leverage in two dimensions – how much and how “sticky” it is, how not subject to panic it is – is another. As Wallace Turbeville wrote: Bank runs by depositors have become a thing of the past because of the FDIC. The problem is not that the deposits are callable loans. It is that the derivative-embedded credit between banks and industrial companies are actually complexes of callable loans. Bank customers withdraw
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deposited funds when they become insecure. With trading, counterparties demand collateralization of all out-of-themoney risk when insecurity sets in. That’s what happened to Lehman and AIG, and Enron before them, as well as some lesser known institutions. A bank run now happens at the trading level…Jimmy Stewart will no longer have to plead with his bank’s depositors. It will be someone like Jamie Dimon pleading with fellow bankers and corporate CEO’s.
As Steve Cohen and I are trying to write: Over the past thirty years we performed a kind of cosmetic surgery on our economy. First is what was sold as liposuction but turned out to be muscle removal: the move from roughly balanced trade to a permanent, structural trade deficit of 5% of GDP has left us with what would otherwise have been workers and firms producing an extra 5% of GDP in manufacturing missing. This is more than a Pentagon: call it an Octagon.
The obverse of that fall is the rise of a peculiar piece of the service sector: the growth of finance, insurance, and real estate transactions (i.e., the paper shuffling and the exchanging, not the construction). It was supposed to be the high-productivity sector of the future. It has turned out to be the equivalent of a peacock's tail--damnably awkward and reducing your mobility and survival characteristics, but fascinating to the peahen, for a while at least. Moving our economy into FIRE did not create lots of new high-paying middle-class jobs for the modern equivalent of past generations' engineers, technicians, and skilled blue-collar craft and assembly workers. Instead, we appear to have more-or-less doubled the profit margins and the pay of our financiers. The legions of bank clerks and back office workers did not see rapid pay increases nor achieve high incomes. It all went to the top. Over 2004-6 fully 30% of corporate profits were in finance--a share that was double what it had been back in the 1960s. And the many of the most
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lucrative parts of finance were not structured as corporations: the growing fortunes of the partners in our investment firms come on top of that 30%. When you think of it, for finance to collect 30% of corporate profits is terrifying. Finance collects savings from households and lends to younger Americans so that they can buy their houses. But mortgage finance is supposed to be a low-margin low-risk business, with the government providing a backstop. The interest payments on mortgages are supposed to flow through with very small subtractions to the interest earned on the savings accounts of other American households: they are not supposed to be profits. Finance again collects savings from all over the world, underwrites the securities that corporations issue, makes them liquid, and so gives nonfinancial operating corporations their capital base. But it is the operating companies that make the profits. Finance is supposed to simply aggregate and slice the profits in various ways. It is supposed to take a small commission as it serves as intermediary between the companies that make the money and the households that saved the capital by packaging the money flows to households in safe, convenient, and liquid forms--and keeping an eye on the managers of operating companies as well. But how did this provision of safety, convenience, and liquidity--which turned out, of course, to be none of the three in the fall of 2008--ever come to be valued at 30% of the total? And it is not all finance. Our newly redrawn map of the U.S. economy shows another leading sector besides finance. The administration of our ill-designed health care system now costs us about 4% of GDP over and above the costs of administering health care in other comparable countries. Do not get us wrong: we do not hate service industries. But most service industries produce something of value in return for their profits. Health care administration simply produces denials of coverage. Finance as currently construed simply produces portfolios for individuals that involve
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them bearing extraordinarily large and idiosyncratic risks that they had no idea they were bearing. There are two ways to make money in health care: (i) by providing people with valuable treatments that they are willing to pay for, and (ii) by collecting insurance premiums and finding some excuse not to pay them out when people get sick. There are two ways to make money in finance: (i) to find people who are willing to bear risks that they understand, selling them risks that offer attractive risk-return tradeoffs, and collecting a commission; and (ii) by selling people risks that they don't understand. It looks to us very much as though our modern health-care administration and financial sectors are good at the second but not the first. December 23, 2010: 1212 words
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