The financial sector: paragon or parasite?
One of capitalism's articles of faith is that financial markets are the most efficient and effective means of ensuring that capital is put to its most productive use.
This piety, in the wake of the global financial crisis, is now in doubt.
Benjamin Friedman, Harvard University professor and author of The Moral Consequences of Economic Growth, is one of many modern heretics: ''The effectiveness of the economy's mechanism for allocating capital should be a matter for serious quantitative evaluation, not a matter of faith,'' he writes in the New York Review of Books.
At first blush, the post-war record of the markets seems ''reasonable'', Friedman allows. The carnage of the technology bust, for instance, still threw up Google. It is only when he totes up the total cost to the economy, literally trillions of dollars, that the price financial markets extract from the productive sector and society generally is called into question.
The litany of market booms and busts is not merely an example of financial losses but a titanic waste of real resources, Friedman contends.
To concentrate on the mispricing of securities, housing and technology stock is to ignore the larger question of the system's function and performance.
The price for the efficient allocation of capital is not measured solely by these episodic large-scale busts. Markets must also exact a profit from the transactions for which they are a conduit. From the 1950s to 1980 and the advent of Reaganism, Friedman notes, the financial sector's share of United States corporate profit was about 10 per cent. The market's profit share more than doubled by the 1990s and reached 34 per cent early in this decade.
It is a staggering statistic: more than one-third of all US corporate profit from just one sector, which by any definition is not productive and almost single-handedly brought the global economy to its knees.
Friedman also cites the cost of wages and salaries, a hot-wire issue in every Western democracy.
The finance sector's share of all American wages and salaries has grown from 3 per cent in the 1950s to 7 per cent, perhaps a modest increase given the extent of growth.
But that statistic doesn't capture the outsized bonuses and stock options awarded to financial-sector employees. The cost mounts.
Financial markets may once have been the most efficient means devised for the allocation of capital, but the privilege for its services is imposing more and more burdens on the companies and people it is supposed to serve, Friedman says.
In this scenario, the market is less a paragon of economic virtue and more a parasite that threatens to kill its host.
''An important question, which no-one seems interested in addressing, is what fraction of the economy's total returns to productively invested capital is absorbed up front by the financial industry as the costs of allocating that capital?'' he asks.
The available information shows an ever-appreciating curve, but a definitive answer to Friedman's question remains elusive. No-one can say what the cost is and whether it is a parasite or paragon.
Another unanswerable question is how much invested capital is allocated to productive purposes. The suspicion is, in New Zealand as elsewhere, the market is doing a poor job.
''There's some truth to that,'' David Tripe, Massey University's head of banking studies, says. ''There's a reluctance to recognise that anything is wrong. People still have this idea that you should be able to borrow money for any old, dodgy proposition and pump your money into housing and all the rest of it, and if you do that, the rest of New Zealand's economy will be right.''
Far too much capital is allocated to unproductive purposes. In New Zealand, $177 billion, or 41 per cent of sector credit, is swallowed up by housing, according to Reserve Bank figures. In comparison, agriculture accounts for $46.5b and business $78b a stark illustration of investment priorities.
What the figures don't show, however, is the use of housing to leverage investment in the productive sector, Tripe cautions. A percentage of mortgage lending how much is anyone's guess is used by small and medium-sized companies because mortgage rates are so much lower than business loan rates.
Also unspecified is the proportion used for residential investment. Not all borrowing is unproductive.
And New Zealand banks have lent heavily to the most important domestic productive sector, agriculture. Lending to farmers has increased 38 per cent in the two years to July 2009. This is not necessarily virtuous, given the headwinds facing dairy, in particular.
Reserve Bank Governor Alan Bollard recently touched on the worrying amount of indebtedness when he said, ''We will also be ensuring capital requirements for farm lending are prudent''.
It is easy to infer from this that Bollard believes banks have been reckless in extending farmers' credit.
Tripe agrees: ''Where it's been really criminal is the farming sector. It went completely bonkers. They've had some unrealistic views of the riskiness of some of the business they've engaged in.''
But bank executives face the sword of Damocles when assessing risk.
''Even if you're the chief executive and decide that things were risky and should stop, you would have got the sack because the bank would have done no business.''
This is not far-fetched. Former Westpac chief executive Ann Sherry was ''promoted'' to a role in the Pacific Islands, equivalent to being sent to Coventry, after admitting to not responding to the mortgage wars earlier this decade.
Now the banks are continuing to lend to keep the sector alive.
''Isn't it a wonderful outcome,'' Tripe says.
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"Far too much capital is allocated to unproductive purposes. In New Zealand, $177 billion, or 41 per cent of sector credit, is swallowed up by housing, according to Reserve Bank figures. In comparison, agriculture accounts for $46.5b and business $78b a stark illustration of investment priorities."
We all know this is the case SO why the hell does Mr Bollard not also make it quite clear what the answer is? Does he even know? Do he think lowering the OCR to such levels was a good idea? He loves making "obvious" statements! but he never puts forward solutions!, things like a Capital Gains Tax on Residential & Business Properties?, or for that matter lifing the OCR (where it should be) or forcing banks to encourage "business" growth rather than 'property bubbles" via making a law stating: banks must keep business mortgages & loans 2% lower than normal mortgage/loan lending? We all know what must be done so i say "start bloody doing it" before the s*** really hits the fan with another ridiculous property bubble based on debt & borrowing.
The govt now regulates More inside of business than an earlier post war period {human resources/wages/minority participation ect. Foerign competitors less so [china]- and the market is going to price the risk/cost-and employ more to evaluate proposals-and borrowing is on international markets -so we compete for funds. Major factors in the curve. Also govts are now regulator AND borrower,-should they need to in a capitalist economy-a sure sign of risk or failure.
Further- with David Tripes statement-"peoples allocation of capital into any old thing and they think the economy is o.k."-Then taxes,for the most part, should be classified by them as allocation of capital. With Friedmans argument alongside-"the costs of allocating that capital."[beurocracy wages to name one -oppotunity cost two]-Friedmans "quantitative evaluation over faith".[politisised decision making] . The nanny state is a constraint on productivity it regulates responsability which effects supply and demand.
The idea that markets allocate capital well does NOT imply they are humane and kind. They are ruthless in their operation.
It is a trader truism that markets will inflict the most pain on the most people.
Why do we expect them to be other than mechanistic (ie, not human but machine like) in operation? They are ruthless, emotionless machines. Just like a lawnmower or chainsaw, and just as remorseless in their action.
Careful Roger, you'll upset the libertarians!
"One of capitalism's articles of faith is that financial markets are the most efficient and effect means of ensuring that capital is put to its most productive use."
Well a spectacular FAIL on that one then and to top it off the US financial sector took 41% of corporate profit in 2007. This particular parasite has even managed to convince its host that it is so vital it must be saved, at further cost to the unfortunate host - us. While all this was going on real median wages actually fell in the decade 1998 to 2008, the first decade long decline since the thirties. Now we know that GDP was rising over this period. What happened? Why couldn't the average Joe enjoy this growth and worse is now having to pay for a doubling of personal debt and a doubling of government debt.
After decades of finance sector driven debt the US economy is now a massive ponzi scheme and the degree of government capture by the finance sector parasite is evident for all to see. After all that has happened they're resuming the looting where they left off.
They should have been left to crash and burn.
A rise in the financial sector's share of corporate profits from 10% to 34% is precisely what you should expect from a sector that enjoys more government-imposed barriers to entry than any other I can think of. But as usual, the answer to the problems caused by over-regulation is... more regulation.
In the long run, and almost always in the short run, residential property is a certain bet in New Zealand. Draconian zoning restrictions and recklessly lax immigration rules make certain of that. Banks have been very wise and prudent to move away from the so called productive sectors and concentrate residential mortgage lending.
Slightly OT but an interesting question. How come the rising level of money creation/debt is giving little or no increase in GDP? Or is it just offsetting declines elsewhere?
Doubling debt, as has occurred over the past ten years should have got the economy running red hot. Why not? Global wage arbitrage, peak oil and resource depletion, bigger government or a rapacious financial sector? All of the above? The answer may surprise. Professor Fekete.
"The key to understanding the problem is the marginal productivity of debt, the significant ratio to watch is additional debt to additional GDP, or the amount of GDP contributed by the creation of $1 in new debt. It is this ratio that determines the quality of debt. Indeed, the higher the ratio, the more successful entrepreneurs are in increasing productivity, which is the only valid justification for going into debt in the first place.
Conversely, a serious fall in that ratio is a danger sign that the quality of debt is deteriorating, and contracting additional debt has no economic justification. The volume of debt is rising faster than national income, and capital supporting production is eroding fast. If, as in the worst-case scenario, the ratio falls into negative territory, the message is that the economy is on a collision course and a crash is imminent. Not only does more debt add nothing to the GDP, in fact, it causes economic contraction, including greater unemployment.
The country is eating the seed corn with the result that accumulated capital may be gone before you know it. Immediate action is absolutely necessary to stop the hemorrhage, or the patient will bleed to death.
As long debt was constrained by the centripetal force of gold in the system, tenuous though this constraint may have been, deterioration in the quality of debt was relatively slow. Quality caved in, and quantity took a flight to the stratosphere, when the centripetal force was cut and gold, the only ultimate extinguisher of debtthere is, was exiled from the monetary system. Still, it took 35 years before the capital of society was eroded and consumed through a steadily deteriorating marginal productivity of debt.
The year 2006 was the watershed. Late in that year the marginal productivity of debt dropped to zero and went negative for the first time ever, switching on the red alert sign to warn of an imminent economic catastrophe. Indeed, in February, 2007, the risk of debt default as measured by the skyrocketing cost of CDS (credit default swaps) exploded and, as the saying goes, the rest is history."
http://www.financialsense.com/editorials/fekete/2009/0330.html
Thanks for a really interesting Blog.The reason the mkts dont work is government interferance. The best example is the NZ finance sector which is being driven by subsidy. These subsidies include Government Guarantees for deposits, $16bn NZ or 9bn US borrowed by the reserve bank and govenment in Febuary and distributed to banks , unrestricted use of tax shelters. rampant money creation through derivatives, and interest rates (OCR) held at about twice the level of our trading partners Government has removed the risk factor from investing . All this ensures an overvalued exchange rate . This is the only way the NZ economy can stay alive now the export sector has been almost demolished and is unable to meet demand for investment finance. Markets can work if allowed to but in this country they are not.
Rose C Evans
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I think you could be missing the point Nick, business is NOT about borrowing: it is about ownership and profits.