Secular stagnation and the financial sector (crosspost from Crooked Timber)

In my last post on private infrastructure finance and secular stagnation, I suggested a bigger argument that

The financialization of the global economy has produced a hugely costly financial sector, extracting returns that must, in the end, be taken out of the returns to investment of all kinds. The costs were hidden during the pre-crisis bubble era, but are now evident to everyone, including potential investors. So, even massively expansionary monetary policy doesn’t produce much in the way of new private investment.

This isn’t an original idea. The Bank of International Settlements put out a paper earlier this year arguing that financial sector growth crowds out real growth. But how does this work and what can be done about it?

The financial sector is an intermediary between savers and borrowers (for investment or consumption). So, the costs of running the financial sector and the profits generated in that sector must be included in the margin between the rates of return by savers and those paid by borrowers, or else they must be shifted on to society at large (for example, through bailouts or tax subsidies).

I’m still organizing my thoughts on this, so what I have are some ideas rather than a fully formed argument.

First, if the financial sector is unproductive, how can it be so large and profitable in a market economy?

There are a few possible explanations
(a) As in the official theory of efficient markets, the financial sector is actually earning its keep by allocating capital to the most productive investments, and by spreading and managing risk. I don’t see how anyone can argue this with a straight face in the light of the last 20 years of bubbles and busts.
(b) Tax evasion: the global financial sector allows corporations to greatly reduce their tax liabilities. Most of the savings in tax is captured in the financial sector itself, but the amount flowing to corporations is sufficient to offset the high costs of the modern financial sector, relative to (for example) old-style bank finance and simple corporate structures financed by debt and equity
(c) Volatility: the financialisation of the economy has produced greatly increased volatility (in exchange rates, asset prices and so on). The financial sector amplifies and profits from this volatility, partly through regulatory arbitrage, and partly through entrenched and systematic fraud as in the LIBOR and Forex scandals.
(d) Political capture: The financial sector controls political outcomes in both traditional ways (political donations, highly revolving door jobs for future and former politicians) and through the ideology of market liberalism, which is perfectly designed to support policies supporting the financial sector, while discrediting policies traditionally sought by other parts of the corporate sector, such as protection for manufacturing industry. The shift to private finance for infrastructure, discussed in the previous post is part of this. The construction part of the infrastructure sector (which was always private) has suffered from the reduced flow of projects, but the finance part (previously managed through government bonds) has benefited massively.

The result of all this is that the financial sector benefits from an evolutionary strategy similar to that of an Australian eucalypt forest. Eucalypts are both highly flammable (they generate lots of combustible oil) and highly fire resistant. So eucalypt forests are subject to frequent fires which kill competing species, and allow the eucalypts to extend their range.

21 thoughts on “Secular stagnation and the financial sector (crosspost from Crooked Timber)

  1. Prof John While endorsing every one of your items above, there is one that I think deserves a point of its own.

    I have just been reading The Wolf of Wall Street by Jordan Belfort, which is a potboiler rather than a serious analysis, but does give an insight into the finance sector’s ability to cream off profits through manipulation of share prices. Other books like those spilling the beans on Mike Milliken’s junk bonds and Enron offer comparable insights.

    The entrepreneurial finance sector has devised procedures that cost investors and/or firms seeking equity finance by siphoning off a margin that in effect is a tax upon productivity. High-frequency trading and short selling fall into this category. They surely serve no purpose in the classical model of assembling savings to finance productive investment. These activities are the modern equivalent of mediaeval shaving silver off the sides of coins which in effect debases the currency.

    This line of logic leads to a partial answer to your question: many operatives in the financial sector are disconnected from the classical role of intermediary between savers and borrowers. They are operating in a parallel universe where money is created out of promises and then leveraged to create more money in the same way. As the GFC hinted, a large proportion of the money assembled in the finance sector has no foundation in the real economy and simply evaporates when a reconciliation is forced.

  2. This is Theexemplary case of market failure, isn’t it? One might be forgiven for believing that the financial sector would be the place where market forces would reign: a cage fight where hard-nosed numerically-savvy combatants battle for naked dollars. In fact, it’s almost the perfect storm of information asymmetry, credential goods, near universal rent-seeking mentality, a culture of obscurity aided and abetted by greed induced psychological blindness, signalling failure and all sorts of cost-value disconnects, hidden influence and outright corruption, etc.

  3. The financialization of the global economy has produced a hugely costly financial sector, extracting returns that must, in the end, be taken out of the returns to investment of all kinds. The costs were hidden during the pre-crisis bubble era, but are now evident to everyone, including potential investors. So, even massively expansionary monetary policy doesn’t produce much in the way of new private investment.

    Seems to sum things up nicely. Regarding your four possible drivers here are some additional considerations:

    1. Lots more floating capital notionally in the hands of amateurs who dont/barely understand the scale of their investments…I am of course talking about superannuation and analogues currently in OZ at $2 trillion and heading towards $4 trillion in a few years – assets comparable to those held notionally by the 1000 top fortune 500 planetary billionaires, the evil 0.0001% – and unlike Murdoch’s loot this money is all notionally/nominally liquid and hence ripe for leverage.

    Now that is honey for flies. And it keeps on being ‘created’, ‘banked’ every week whatever the weather and the money (numbers on a balance sheet?) have to go somewhere. This creates a target for finance. I believe they use the term ‘dead meat’ and similar.

    An interesting corollary is that the fear and conservatism of the past few years means more money is going into the managed funds rather than substantive investment in the form ideal for financial predators who know how to game the system.

    1a. Asset inflation especially shares which are no longer linked to actual tangible assets in most cases.

    2. A market economy has notional efficiencies but it cant operate in fact without different knowledge and expertise levels so that there are winners (finance) and losers (the rest). Efficiency does not necessarily mean equity.

    This knowledge/information asymmetry is increasingly severe and finance goes hi tech while mom and pop investors still use numerology, horoscopes, and religion style trust/faith in the sharks.

    3. Complementing political capture is increasing recognition and exercise of their own power by the finance industry.

    4. Lets not forget the ugly sister of finance the original repository of wealth of historical rentier capitalism which gave it its name as extraction for nothing was and still is more blatant, real estate and its transaction by which I mean people sitting on land and not developing it and seeing its value increase over the CPI or buying a developed property rather than new construction …which has the same effect. Money for nothing by understanding the game rather than genuine efficiency increase.

    5. Using seduction of government not only for ‘political capture’ – but something deeper – to change the narrative to one which lauds the law of the jungle, neoDarwinian fitness etc. which normalizes equity equality property rights corporations as citizens without responsibilities and wage slavery – thinks here places where salaries are insufficient for workers to ever get ahead as in the US.

    6. Hijacking government short term planning arising from the new financial ideology e.g. in the water and energy planning.

    7. Avoiding risks like financing nuclear power station construction while pushing government and in effect the populace to take the risks. Privatize the profits and make the public pay for the losses. Selling us what we already own and claiming this is growth.

    7a. Hijacking secure income streams owned by government who took the risk often in developing them in the first place.

    7b. Privatizing personal social contributions like old age care and calling this ‘growth’. Pushing for more growth and defining growth and prosperity in such a way that waste is GDP positive.

    8. Finally understanding and exploiting the fact that people arent rational or at least the fact they are lousy on average at doing probability calculations. I’ve put this in several times before but its always good to remind people of their potential for error and self delusion in decision making/choice as evidenced by the three doors problem SLEMBECK, T. & TYRAN, J.-R. 2004. Do institutions promote rationality? An experimental study of the three doors problem? Journal of Economic Behavior & Organization, 54 337-350.

  4. I am still waiting for a wider discussion of secular stagnation, J.Q., not just a focus on financial sector effects. Do I wait in vain?

  5. As a humble PAYG taxpayer, without expert knowledge of corporate tax schemes, could someone please correct me if I am wrong. With reference to item (b) in JQ’s possible explanations for the finance industry, my understanding is the fees charged would be tax deductible from future profits. So in essence, even if a company pays more in fees than it would have in tax, as long as they have future profits and tax liabilities which this can be claimed from they are in front. If my reasoning is correct, the cost of the industry is born by the taxpayers who are required to make up the shortfall that should have been collected, but was diverted into the finance industry.

  6. It might be stating the bleeding obvious, but our financial industry has managed to convince very many and donate to political parties that foster the idea that they are adding greatly to our GDP. If there is any public discussion of our banks, especially in the Murdochcracy, it is amazing how many will push the line that our ‘strong’ banks saved us from the depredations of the GFC.

    Personally I see the whole finance industry as rent seeking with fees, charges and lending practices that are a dead weight on our economy.

  7. What is to stop a better more efficient financial sector coming in and replacing this one? I think explanation (d) is the one – although feels that it is less “political capture” than capture of the entire body of society, something like a parasite on the heart, or maybe a liver fluke.

  8. Probably a bit off the subject, but the present sale of NSW electricity assets to highly geared entities that ensures the flow of profits (in the form of interest payments and no doubt management fees) goes to Cayman Island based entities and therefore ensuring that little tax if any will be paid in Australia is surely the rort of the decade to-date.

  9. But how does this work and what can be done about it?


    introduce a different mode of production.


  10. Building on Geoff Edwards comment above, perhaps we need a bit of grit in the wheels of the financial services sector. Some regulatory and tax measures that makes it more difficult, more risky and more costly to operate globally in the way they do at present.

  11. I have no insights, except to be continually astounded at the profits made by banks. They are usually more than the biggest businesses that *actually do* something.

    As for (b), you may well recall how the back in the 80’s the banks very kindly offered pensioners accounts that paid no interest, so that they wouldn’t lose any of their pension. Even though most pensioners would actually come out worse off for using such accounts…

    And I’m not a fan of bitcoin, but our banks will refuse you a bank account if they think you are trading in bitcoin. I’m not sure that they are so proactive if they think you are supporting ISIS.

  12. Yes, John, given political will and/or a supportive press, this shouldn’t be too hard. Some measures that come to mind include a Tobin tax, a regulatory ban on short selling and high-frequency trading, a more disciplined system of registering accountants and lawyers and abandonment of public-private partnerships by our political leaders. ($500 million plus or minus a couple of hundred million was taken in fees upfront for the East-West Link project in Victoria within a few weeks of signing contracts).

    As an afterthought to my post, a quick answer to Prof John’s question, “How can the financial sector be so prominent in a market economy”, is that beyond a certain basic service core, the financial sector is built on theft. If theft is defined as taking someone’s property above and beyond any reasonable reward for service rendered, then high-frequency trading is outright theft (the victim doesn’t even know that a margin is being skimmed) and a range of other practices where the victim may be aware but has little choice are closer to theft than market exchange.

  13. Now 3 of our BIG 4 have cut interest rates on saving accounts to offset the costs of keeping the extra capital (did you know that Westpac’s home loan book according to its own numbers was leveraged some 77 times before they were forced to hold more capital!!!)
    My recent experience in organising a home loan through one of the BIG 4 was pretty amazing – a complete fiasco! What’s more, due to cost cutting (to maintain shareholder dividends of course) my local branch is down to 2 staff members – you can’t get through on the phone – ever!
    Enough is Enough – bring on the digital disruption to banking and finance!

  14. A potential point (e) is the time-dependent and contingent nature of money and monetary value in the financial sector. The financial sector works by turning expected future value (from the returns from actual productive investments) into current values, through borrowing against that future value, and trading in stocks/bonds/etc with prices set by the expectation of that future value. As “animal spirits” and the optimistic forecasts of an incipient bubble take hold, the financial sectors become larger and more leveraged and the implicit promise to pay becomes more and more difficult to actually fulfil. Eventually the bubble bursts when promises of return simply can’t be met – but until that date, the financial sector can look like they’re doing a great job and make large profits turning future expectations into current value. When the crisis hits, a great deal of money can actually disappear (not just change hands) through bankruptcy and bank collapses, and a lot of the rest is hoarded in safe assets or cash, due to fear. This is basically Marx’s (& then Minsky’s) idea of financial crises, but it doesn’t require subscribing to the rest of his framework to accept. You also then get Austrian misallocation of capital, destruction of human capital through unemployment and physical capital through obsolescence, etcetera.

  15. There might be a case for a point (e) to J.Q.’s original list. I am referring to ISDS (Investor State Dispute Settlement). In this arena, corporate finance seemingly operates according to its own rules and tribunals. State, supra-state (EU) and more “traditional” international law seem to be superseded and rendered obsolete by the corporate-finance system making its own laws.

    This and related corporatist developments seem to go beyond both regulatory capture and political capture in the usual senses. There is a form of power succession to corporate finance and corporations which, although still in its early phases, begins to supersede the powers of parliaments of nation states. If it continues and becomes fully established it will be as historically significant as the succession of power from monarchs to parliaments. It is patently the beginning of corporate fascism. We either nip it in the bud or we will soon be in a world of hurt. (Many places like the Middle East are already in a world of hurt for reasons which can be partly linked back to the issue of corporate profits in general if not ISDS in particular.)

  16. The objective of the financial sector is to sell mispriced risk. Higher risk does not necessarily yield higher returns but selling mispriced risk generally always does.
    Excessive leverage-enabled through weak regulation, massive expansionary money supply and securitisation-creates mispriced risk and disproportionately rewards the financial sector. Australian banks are a good example where about $2 of real capital leverages $100 of loans. The fees on the $100 accrue back to the $2. Those sorts of ratios must disproportionately reward the inter mediators and leverage their returns. In order to buy leverage you really need an asset to buy which yields a return. Assets which yield a reliable return are usually mature assets and don’t require new investment which take years to mature. We used to call that investment risk. Therefore the majority of loans now go to old assets and don’t generate new investment. One exception are infrastructure investments but these are usually sold with inherent government guarantees which deliberately misprice the risk by shifting the mispricing risk onto the eventual buyer of the service through either take or pay, the tax system or through regulated returns inflating the WACC. Add in tax arbitrage and vested interest patronage and there you have it.
    The Excel spreadsheet has a lot to answer for.

  17. @PHIL

    Of course, the Excel spreadsheet per se has nothing to do with it. It’s capitalism. The system continues to work in the way it has worked for at least 200 years. The technologies and financial instruments may change (be “innovated”) but the basic techniques are very similar.

    “But, says friend Samuel Gurney,

    “The great fluctuations in the rate of interest are advantageous to bankers and dealers in money — all fluctuations in trade are advantageous to the knowing man.”

    And even though the Gurneys skim off the cream by ruthlessly exploiting the precarious state of business, whereas the Bank of England cannot do so with the same liberty, nevertheless it also makes a very pretty profit — not to mention the personal profits falling into the laps of its directors, as a result of their exceptional opportunity for ascertaining the general state of business. According to data submitted to the Lords’ Committee of 1817 when cash payments were resumed, these profits accruing to the Bank of England for the entire period from 1797 to 1817 were as follows:
    Bonuses and increased dividends 7,451,136
    New stock divided among proprietors 7,276,500
    Increased value of capital 14,553,000
    Total 29,280,636

    This, on a capital of £11,642,400 over a period of 19 years. (D. Hardcastle, Banks and Bankers, 2nd ed., London, 1843, p. 120.)”

    from – Capital Vol. III Part V – Karl Marx.

    (Division of Profit into Interest and Profit of Enterprise. Interest-Bearing Capital
    Chapter 33. The Medium of Circulation in the Credit System)

  18. @Ikonoclast
    You may be onto something Ikonoclast. Although the mainstream never ceases to lecture the rest of us on the benefits of free trade across international borders, the theoretical foundation for assuming that markets in different countries or currencies can be mixed in together and still conform to microeconomic theory of supply/demand under competition is fragile.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s