Home > Economics - General, Economics in Two Lessons > Why is global finance so profitable (crosspost from CT)

Why is global finance so profitable (crosspost from CT)

May 12th, 2016

In a recent post, I asserted that

activities like tax avoidance/evasion and regulatory arbitrage aren’t peripheral flaws in a financial system primarily concerned with the efficient global allocation of capital. They are the core business, without which the profits of the global financial sector would be a tiny fraction of the $1 trillion or so now reaped annually

As I’m working on income distribution issues my long-running book project, this seems like a good time to see if this claim can be backed up by hard numbers.

First up, here’s my source for the $1 trillion number (actually $920 billion). As a plausibility check, I’ve tried to estimate the total size of the global financial sector. Various sources, including Wikipedia estimate that the banking and insurance sector accounts for 7-8 per cent of US gross product. Extrapolating to world gross product of about $80 trillion that would give around $6 trillion for the total size of the sector. The US is almost certainly more financialised than the world as a whole. Still, the profit number looks about right. A trickier question is whether the rents accruing to managers and top professional in the sector should be counted as part of profits. I’d guess that these rents account for at least another $1 trillion, but I have no real idea how to test this – suggestions welcome.

Is tax avoidance/evasion and regulatory arbitrage a big enough activity to account for a substantial share of a trillion dollars a year? Gabriel Zucman estimates that there’s $7.5 trillion stashed in tax havens, of which around $6 trillion is untaxed. He estimates the tax avoided at $200 billion . I’ll estimate that half of that ($100 billion) is creamed off in financial sector, mostly as profits or rents. That implies a profit margin of a bit under 2 per cent, which seems reasonable.

Tax evasion by wealthy individuals is only a small part of the story. Legal tax avoidance is almost certainly more important. Most of that involves companies, but it’s important to distinguish between “close” corporations, which hide the activities of an individual or family and large global corporations. I don’t have any idea how to measure the cost of avoidance through close corporations. As regards global corporations, Zucman estimates that “a third of U.S. corporate profits, or $650 billion, are purportedly earned outside the country, with a cost to the US of $130 billion a year . Extrapolating to the world as a whole, that would be at least $500 billion. Again, assuming the financial sector creams off half of the sum, we get $250 billion (the fact that the finance sector itself accounts for around 40 per cent of all corporate profits means there’s a problem of recursion that I haven’t worked through)

Then there’s manipulation of exchange rate and bond markets. I have no idea how to measure this, but given that the notional volume of trade in some of the markets concerned is measured in the hundreds of trillions, it seems plausible that the profits and rents from market-rigging must be at least in the tens of billions.

These are probably the biggest scams, but there’s also regulatory arbitrage, privatization (a huge source of rent over recent decades), domestic tax avoidance and more.

Adding them up, I’d suggest that $500 billion a year is a low-end estimate for the profits and rents associated with various forms of anti-social financial sector activity.

There’s lots of potential error around these numbers, but the order of magnitude seems reasonable to me. As against the claim that the explosion in financial sector activity and profits over the past 40 years has been driven by the benefits of a more efficient allocation of capital by rational markets, the claim that it’s all about tax-dodging and socially unproductive arbitrage seems pretty plausible.

Obviously, the social cost of a financial system devoted to undermining tax and regulatory systems far exceeds the profits earned from the activity. That’s true of any kind of socially destructive, but privately profitable, activity. But the problem is greater in the case of financial sector activity because of the disastrous effects of financial crises.

  1. dennis williams
    May 12th, 2016 at 15:09 | #1

    Not sure why, with demand flagging, the GST isn’t suspended/abolished and replaced with a cascading business VAT and turnover tax. A BVAT would need to be cascading, nondeductible & not able to be passed on.
    This together with a turnover tax would capture the tax evaders multinational or otherwise and offer potential relief for corporate tax.
    According to Treasury papers GST collection are $50+ billion and growing at 4+% per annum. This would lead to a stimulus of approximately that amount.
    The BVAT could be levied on all goods and services with no need for compensation. It would also have a positive impact on wage and purchasing power. Increased demand would partially compensate business for the cost.
    Finally business regularly call for an increase in GST to off-set drops in corporate tax or other business taxes. I say give them what they want and see if they continue to call for an increase in this type of tax – plucking the goose with the least amount of hissing. Thoughts

  2. May 12th, 2016 at 15:38 | #2

    Another way of looking at the cost is to look at the total cost of money, the cost of inflation and the cost of variations in exchange rates. The cost of money is the cost of the compounding of interest. The cost of inflation is the total value of assets times the inflation rate. The cost of exchange rates is the money earned (and lost) due to buying and selling currencies.

    It is argued that these are not real costs because one person’s gain is another person’s loss and they balance out. Tell that to the person who loses that it is not a cost. These are the costs we pay for having a market in money. The money market is meant to distribute Capital to the best advantage. That has proven to be false. That Theory of Efficient Markets does not hold for Money Markets.

    I suggest the total of these costs is a way of estimating the cost of the financial sector.

    My guess is that we will find it is closer to 50% than it is to 10%.

    Reduce the size of the money market and most of these costs disappear. That is, have other ways of allocating money resources. One way is via a market in future goods and services. Instead of using a money market as the main way to distribute capital, use a market in the future output of people and enterprises that produce goods and services of value, as the main way to distribute capital.

    The Reserve Bank has asked for suggestions from students on how it should act in a low interest rate world. I am not a student nor an economist but I sent them an “unsolicited” suggestion that you can see here. https://kevinrosscox.me/2016/05/12/economic-policy-options-with-low-interest-rates/

    This gets rid of the money market as the way to allocate money for national infrastructure. It fits well with ideas from Promise Theory. This Theory predicts that large tightly connected systems become too costly when there are too many autonomous agents being coordinated. Weaken the connections and the cost of operating the system reduces.

    I would suggest we have little to lose and much to gain from experimenting with this approach.

  3. Ikonoclast
    May 12th, 2016 at 16:15 | #3

    Why is global finance so profitable? Here are some tongue in cheek answers with maybe some truth in them.

    – Because it is unregulated.
    – Because numbers are easier to manipulate than real quantities.

    New numbers show the top 25 hedge fund managers had combined earnings of $12.94 billion in 2015.

    It is strange enough that governments tolerate this (along with massive tax evasion). Even stranger is that hedge fund investors tolerate it or are somehow powerless to stop it. What is it about this system?

    “The higher payday came “despite the fact that roughly half of all hedge funds lost money last year,” said Institutional Investor Editor Michael Peltz. He added that “about half of the 25 highest-earning hedge fund managers used computer-generated investment strategies to produce their investment gains.”” – Reuters.

    “Billionaire hedge fund managers have been leveraging huge amounts of investor capital to extract enormous cash payouts for themselves, the ultimate in “winner-take-all” economics. To squeeze out these payouts, they’ve been pressuring the enterprises they dominate to slash wages, eliminate pension and health benefits, and offshore middle-class jobs.

    “Hedge fund fee structures, in the meantime, divert most of the profits these tactics generate back to self-dealing hedge fund managers. The investors that supply hedge funds their capital — like public employee pension funds — end up getting diminishing or actual negative returns.” – Stephen Lerner.

    SUMMARY

    All of this is evidence that this economic system has entirely lost contact with reality. Rewards have lost contact with all productive reality. This is how the system behaves via its internal logic. Rather than being self-correcting it is an unstable runaway system.

    I agree with Prof. R.D. Wolff that it is no longer realistic to favour mere reform of the current system.

    ““I believe in (attempting) reform. Reform the laws. Try this reform, try that reform. Try the little steps, try the medium steps. But, if you discover that realistically, every time you do that, an escape mechanism is found. Every time you try a new law, the very people who helped you write the law are then hired away by the targets of the law, to help them escape the whole point and purpose of the law. Then at a certain point, it is no longer realistic to favour reform. Then you have to go to the higher bar, not because you would prefer it, not because you wouldn’t rather have the small steps work, but because you recognise, rather than be self-deluded, that the small steps have all been tried, have all been evaded, avoided, amended, circumvented. And at this point you throw in the towel, and by virtue of your realism, you become someone who is much more interested in fundamental systemic change, because anything short of that has basically shown it is not enough to solve the problem.” – R.D. Wolff.

  4. May 12th, 2016 at 17:32 | #4

    “Extrapolating to the world as a whole, that would be at least $500 billion. Again, assuming the financial sector creams off half of the sum, we get $250 billion (the fact that the finance sector itself accounts for around 40 per cent of all corporate profits means there’s a problem of recursion that I haven’t worked through)”

    So is there a code of honour in the finance sector that says one financial institution must use another financial institution to launder their money?

  5. hc
    May 12th, 2016 at 19:59 | #5

    I am interested in why the trading profits of groups such as Macquarie Bank are so high. Are the speculative markets they operate in efficient or do these dickheads set the rules? Generally like this post. The finance sector is not a servant of capitalism. as Marx suggested, it runs things.

  6. bjb
    May 12th, 2016 at 21:28 | #6

    @hc

    I too would like to know how the likes of Macquarie make so much. They have been a big player in PPP deals. Jim Stanford in his excellent “Economics for Everyone” says:

    “These so-called “partnerships” are in reality a gigantic taxpayer-funded giveaway to private investors, justified by a phony phobia of public debt…”

  7. Michael
    May 12th, 2016 at 21:54 | #7

    I’m still waiting for someone to answer the questions Paul Woolley (UTS The Paul Woolley Centre for the Study of Capital Market Dysfunctionality) raised 8 years ago about capital markets:

    Yet the figures bear out an amazing leap in prominence in a relatively short time. Forty years ago the industry accounted for 10% of corporate profits. It’s now close to 40% and growing. It is easily the largest single corporate sector. Received wisdom holds that capital markets are supposed to be lean and efficient. How then can bloated profits, price bubbles, and periodic blow-ups be properly explained?

  8. James Wimberley
    May 13th, 2016 at 08:08 | #8

    The comment thread at CT is exceptionally meaty, even with two comments from yours truly.

  9. Ikonoclast
    May 13th, 2016 at 08:31 | #9

    This is a fascinating paper, well worth a read. It seems to shed light on many of the questions people are asking above.

    http://www.people.hbs.edu/dscharfstein/Growth_of_Finance_JEP.pdf

    Here are a few nuggets lifted out of context from the first few pages. People really should read the paper.

    “Drawing on the Flow of Funds Accounts published by the Federal Reserve, the value
    of total financial assets was approximately five times US GDP in 1980; by 2007, this ratio had doubled. Over the same period, the ratio of financial assets to tangible
    assets (like plant and equipment, land, and residential structures) increased as well.”

    “Our main finding is that much of the growth of finance is associated with two activities: asset management and the provision of household credit.”

    In my over-simplifying way, I would say that the ratio of imaginary stuff to real stuff has increased. There will come a point where the real stuff can’t support the imaginary stuff. The castles in the air collapse. Then people see that the real stuff that is left is less than expected and left in a mess. The painful realities then set in.

  10. Ernestine Gross
    May 13th, 2016 at 10:57 | #10

    The USA may be more ‘financialised’ than other countries in some sense but other country’s banking sector is bigger, relative to GDP. For example, Switzerland and the UK. These two European countries have a long history in being leading in this area.

    http://www.statista.com/statistics/267352/size-of-the-banking-sector-in-selected-countries/

    The banking sector is not the only player. Big developers have their own financing arm, so do car producers, supermarkets, and of course the entire insurance industry is to be included, etc. But banks are linked to these financial service providers.

    Why are ‘financial services’ so profitable? Because the word ‘service’ is misleading. Extraction industry might be a better category name and the idea of a mining tax comes to mind.

    Last week I transferred Euro 150 from Australia to Germany to pay for a wreath. The cheapest Aussie bank I could find charged $22 and the German bank charged Euro10 (but the Aussie bank couldn’t tell me this in advance)[1]. I could have reduced the total transactions cost by $4 if I would have used the internet facility offered by the Aussie bank (with still unknown consequences as to what happens on the other side).

    The opportunity cost of $4 is the ‘labour service’ provided by me, the ‘capital cost’ of me having IT equipment and a mobile phone.

    If my opportunity cost is valued by the bank at $4, which is ostensibly the case, the question arises why do they charge me $18 for using their computer program for a very short period of time, given that the program can be used by a potentially unlimited number of semi-customers at the same time (ie economies of scale afforded by the inventiveness of the IT sector (the marginal cost would have to approach zero)? Who gets most of the benefits of economies of scale?

    At the time, my personal preferences were such that having one of the few remaining bank employees working, instead of me, was worth $4. Wrong. The employee took about 30 minutes longer than what I had expected to find the program, enter a few parameter values, check my identity and print out a contract. This implies again an opportunity cost for me (my time), an unanticipated opportunity cost.

    No matter how I look at it, the ‘production’ of a financial transaction is a joint product, involving the bank(s) and the customer.

    The transactions costs are fixed whether the amount is Euro 150 or Euro 150million.

    With a business model like this, it would seem to be difficult to make a loss as long as there are more ‘small’ customers than ‘big ones’.

    Fixed financial transactions cost would encourage, it would suggest to me, concentration of wealth being profitable.

    [1]: My transaction problem isn’t solved as yet. The Aussie bank could not tell me how much the bank on the other side would charge. The way ‘they’ handle this is to simply subtract the amount transferred, which means I still owed Euro10. I called a friend and asked to pay it and I’ll reimburse next time I meet them. Sending Euro 10 in the mail is outlawed. No, international flower services couldn’t help in the time available. No, having a tiny account balance in several countries as an insurance policy doesn’t work either because the tiny amounts would be eaten up by bank fees. No, not every non-financial business in every town accepts payment by credit cards. So much for ‘one world one market’.

  11. Ikonoclast
    May 13th, 2016 at 11:34 | #11

    I am sure the big corporations find money transfers easier and far less costly per unit transferred when transferring by SWIFT and say Transferwise. I just making assumptions of course.

    It’s interesting that Transferwise says:

    – Your bank will likely charge a fee to make a SWIFT transfer to TransferWise.
    – Make sure to inform your sending bank that although our account is in Europe, there’s no conversion necessary.
    – When the money is in transit, correspondent banks in between may deduct a handling fee.
    – We cannot deliver a specific amount to the recipient.

    The last point seems to indicate that they do not guarantee a delivered amount due to the unpredictability of charges midstream and downstream (so to speak).

    My son tells me that with Bitcoin (assuming you have a Bitcoin account and recipient has a Bitcoin account) matters would be much easier with no intermediaries. But with Bitcoin you suffer investment risks or arbitrage risks (correct term?) as the Bitcoin market can move.

    But in summary, I take the larger point. The conventional system(s) appear designed to milk excess rents, especially from smaller customers. So neither a one-world-market nor real competition seem exist. One is not surprised by this.

  12. Nevil Kingston-Brown
    May 13th, 2016 at 12:16 | #12

    I suppose for certain definitions of rational and efficient, ‘tax-dodging and socially unproductive arbitrage’ is ‘a more efficient allocation of capital by rational markets’.
    The Economist suggests that the figure stashed in tax havens is closer to $20 trillion than $7.5 trillion.

  13. Peter T
    May 13th, 2016 at 12:29 | #13

    I’ve had the same experience transferring money to the US – a bank in the middle saw some money going past and helped itself – without reference to the sender or the recipient.

    It helps, I think, to see money as a flow access to which various interests fight over. The financial institutions have the inside track, but a lot of business involves finding ways to generate a cash flow and keep as much as possible. Quite often it involves ways to compel people to monetise production so that some portion may be skimmed (the archetypical way to do this is to impose a charge, but privatisation is often a variant on this – it turns a purchase, which is a money sink, into a flow which can be tapped).

  14. Newtownian
    May 13th, 2016 at 14:04 | #14

    Regarding this frightening problem – two questions

    1. Could it be that the current (environmentally good) slow growth especially since 2008 reflects diversion of entrepreneur/innovation promoting capital to unproductive rent extraction and ironically is temporarily at least limiting economic growth and environmental impact to lower levels than might otherwise be the case and leading to such things as our current cheap oil and other commodities as well as production oversupply? For now?

    2. Given that super rich individuals/corporations dont spend so much of their loot as ordinary people, how long before they end up owning or having a controlling interest in everything that is saleable on the planet as the present situation seems a recipe for (their) wealth accumulation without limit even before it the non payall of tax is considered. As long as their take is relatively large and global growth which approximates to the rest of the global economy is slow this imbalance suggests their funds will keep accumulating relatively speaking in their pockets to the point where we are all rent payers? The complaint is often heard of increasing wealth disaparity but I have not heard of any end in sight other than this.

    On this matter of increasing turning all forms of property into rent extraction vehicles I heard recently an interesting illustration of this in respect to the ‘Circular Economy’, an effort by more progressive corporations like Unilever to nominally incorporate ecological sustainability/limits to growth into their desire to keep growing for out benefit as it were. The model proposed appears to be that less and less, we plebs will actually ‘own’ things but rather rent them from corporations who will then be free to extract rent at will. The excuse offered for this change in ownership relationships was that this would ensure proper life cycle management and recycling for things like computers cars etc.. The idea would be fine to me if ownership was maintained by the global population as a whole and companies were merely efficient facilitators of the process. But it sounded more to me like a plan to develop a rentier capitalists wet dream of privatizing the whole world. I would have gaped aghast at the speaker were it not for the fact that Microsoft are now pushing the idea that we wont buy their software but only rent it, everything will be in The Cloud, which they Google et. al. control, the problems with giving electronic books to friends because of sneaky licensing clauses, and the ranting on an academic involved in development of Kyoto trading ideas, that indeed the best way to solve the global environmental problems is to privatize everything including every natural environment.

    [JQ if this aspect of the circular economy interests you, you have but to query a couple of your local environmental management colleagues working in this area. I’m not sure they understand the problem of rentier capitalism but you might enlighten them. I am of course happy to be englightened that the corporates are really on our side ?!]

  15. Ikonoclast
    May 14th, 2016 at 08:43 | #15

    And let’s not forget the subsidies to the financial system. This from “What’s holding back the world economy?” in the Guardian by Joseph Stiglitz and Hamid Rashid.

    “In the US, quantitative easing did not boost consumption and investment partly because most of the additional liquidity returned to central banks’ coffers in the form of excess reserves. The Financial Services Regulatory Relief Act of 2006, which authorised the Federal Reserve to pay interest on required and excess reserves, thus undermined the key objective of QE.

    Indeed, with the US financial sector on the brink of collapse, the Emergency Economic Stabilization Act of 2008 moved up the effective date for offering interest on reserves by three years, to 1 October 2008. As a result, excess reserves held at the Fed soared, from an average of $200bn during 2000-2008 to $1.6tn during 2009-2015. Financial institutions chose to keep their money with the Fed instead of lending to the real economy, earning nearly $30bn – completely risk-free – during the last five years.

    This amounts to a generous – and largely hidden – subsidy from the Fed to the financial sector. And, as a consequence of the Fed’s interest-rate hike last month, the subsidy will increase by $13bn this year.”

  16. Ernestine Gross
    May 14th, 2016 at 13:38 | #16

    @Nevil Kingston-Brown

    Rationality relates to individuals only. In what sense could the word ‘market’ be rational?

  17. rog
    May 14th, 2016 at 18:23 | #17

    On a local level people are scratching their heads as to how Turnbull made his millions, was it through negative gearing, tax avoidance or both – plus a bit of whatever.

    It seems senior Libs think/thought/are mulling over that by living in a harbour side mansion worth perhaps gazillions Turnbulls political cards were marked. Are Libs obsessing about the pile at Point Piper, and I thought that they applauded lifters not leaners?

    If it’s to be a class war it’s him vs us.

  18. May 14th, 2016 at 21:16 | #18

    Further to my comment above I thought about the costs that will be saved if we replaced Money Markets with lower complexity methods to distribute Capital. The methods do not replace markets in real goods and services – just replaces some Money Markets. We cannot remove all the costs of distribution of Capital. But, based on improvements in other areas where we use a similar approach I suspect we will reduce the costs by at least an order of magnitude. An example of the approach is Google Search. Google Searches are several orders of magnitude cheaper than the previous method called Subject Cataloguing.

    The total current cost of Money Markets is probably 50% or more of the total cost of producing all the goods and services in a modern economy.

    Here is the outline of the way to replace some Money Markets and a list of the areas where costs can be removed.

    http://www.welcomer.me/welcomer/blog/2016/5/13/reducing-the-cost-of-the-financial-system

  19. May 15th, 2016 at 05:41 | #19

    Global Finance (or any finance that uses compound interest) cannot help but be profitable. Interest on interest costs the financier nothing to produce. The costs of providing the loan are already covered and interest on interest or rent on rent is mostly profit. The cost of inflation is also given to the lender if they have a mortgage on assets and seize the assets because rent on rent is not paid.

    This is the technique described in Perkin’s book ” Confessions of an Economic Hit Man”. It is the technique used by Colonial Powers. It is the technique used extensively in business by lenders who gain control of companies through diluting the value of shares. It is ridiculously easy to do and is very inexpensive. All it needs are some amoral lawyers, creative accountants, and an economics and legal professions that justifies it. It is very profitable.

    Those in society who spend their efforts generating goods and services of value typically are no match for the finance industry. The finance industry takes the profits that would be better left with the producers of goods and services.

    Luckily it can be fixed.

    Here is a suggestion for an experiment I sent to the Reserve Bank that is likely to work; but more likely to be ignored. The software to operate the suggestion will be Open Source which means the idea is freely available to the community. However, this experiment will not happen until a few more economists start acting like experimental scientists. More need to abandon disproven theories like the “Efficient Market Hypothesis”. More need to trial ideas like Promise Theory which may be the “Quantum Theory” of economics.

    https://kevinrosscox.me/2016/05/12/economic-policy-options-with-low-interest-rates/

  20. May 18th, 2016 at 18:00 | #20

    Here are some thoughts on Capital Markets and Renewable Energy.

    With CO2 now at 400 ppm it is imperative to reduce green house gas. To do this we need a lot of energy to replace fossil fuels and to remove green house gases from the atmosphere.

    The Cost of Renewable Energy from large scale solar installations is around $2,000 per kw. The cost of energy storage using pumped hydro is about $1,000 per kw.

    To provide continuous power we need about 1kw capacity of storage for each kw of solar generation. This gives a total cost of $3,000 per continuous kw. Today one kw of solar panels produces 1,500 kwh per year. Solar panels and pumped storage facilities will last at least 50 years. This means the average cost of producing a continuous kwh of electricity is about 4 cents per kwh. This means with existing technology we will save money by moving to 100% renewables. We can also afford the energy to remove greenhouse gases.

    However, to fund renewables we get the money to build through Capital Markets. Over 50 years the funding cost of $3,000 at 7% is $10,800. This adds 7.2 cents per kwh to the cost of energy. This almost triples the cost of renewables. This is the cost to run a Capital Market. It is not the cost to build.

    Capital Markets exist to distribute capital across different needs. If the need is imperative there is no need to have a Capital Market. Instead we can choose to fund renewables based on the cost to build and the useful life of the installation. If we remove the need for a Capital Market we save 7.2 cents per kwh.

    In summary Capital Markets exist to distribute capital for different needs. If we know the need a Capital Market is unnecessary. This reduces the cost of the Capital Market to zero.

  21. May 18th, 2016 at 20:32 | #21

    Further to the thoughts on Capital Markets and Renewable Energy

    For people to invest they need a return on their investment. With traditional Capital Markets the return goes to those who have the Capital.

    Another approach is for the purchasers of renewable energy to get the return on investment. We can do this with funding with discounts on the price of the output. The discounts give the return. Discounts do not involve extra money. We arrange the mechanics of discounts so there is no discount on discounts. Not needing extra money and not having a discount on discounts reduces the cost of funding. By increasing the amount discounted with inflation removes the cost of inflation.

    The discounts are set to encourage investment. The discounts investments are transferrable. This means the customers get the benefits of funding and they get the right to invest. This is how the allocation of funding rights is obtained – rather than using interest rates.

    The approach creates a negative feedback loop which leads to more efficiencies. This contrasts to Capital Markets that have positive feedback loops that reward inefficiency. Capital Markets reward the owners of Capital. The proposed Discounts system rewards customers.

    Note that this approach works well for projects like the NBN. That is, any project where there are efficiencies in having monopolies. Note that monopolies are no longer a “bad thing” because the customers do not seek higher prices. What customers want are the best value for money. The negative feedback is that higher prices leads to higher funding returns. The price is set to make it attractive for customers but no more than is necessary.

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