“Wall Street is back,” says the New York Times, and the economic cost is high. The excessive financialization of the U.S. economy reduces GDP growth by 2% every year, according to a new study by International Monetary Fund. That’s a massive drag on the economy--some $320 billion per year. Wall Street has thus become, not just a moral problem with rampant illegality and outlandish compensation of executives and traders: Wall Street is a macro-economic problem of the first order.
The Financial Tail Wags The Economic Dog
How has this happened? Properly scaled, the financial sector is a good thing. The financial sector plays a healthy role in translating products and services into exchangeable financial instruments to facilitate trade in the real economy. Through deposits, banks channel citizens’ savings to businesses that can use them productively. Through mortgages, workers can trade their promise of future wages for a home. Through insurance, homeowners are able to share financial risks and avoid financial catastrophe.
Problems occur when the financial sector gets too big. When the financial sector loses interest in the "boring" returns from financing the real economy and instead devotes its efforts to activities that are more lucrative in the short-term, like playing zero-sum games, or even negative-sum games, through complex transactions aimed at making money out of money, then excessive risk-taking occurs, with mis-allocation of human and financial resources and periodic financial crashes.
Throughout history, periods of excessive financialization have coincided with periods of national economic setbacks, such as Spain in the 14th century, The Netherlands in the late 18th century and Britain in the late 19th and early 20th centuries. The focus by elites on “making money out of money” rather than making real goods and services has led to wealth for the few, and overall national economic decline. “In a financialized economy, the financial tail is wagging the economic dog.”
How Big Is Too Big?
How big is too big? An IMF study in 2012 showed that “once the [financial] sector becomes too large—when private-sector credit reaches 80% to 100% of GDP— it actually inhibits growth and increases volatility. In the United States in 2012, private-sector credit was 184% of GDP.” So the U.S. financial sector is already way too big.
And what’s the cost? The new IMF study quantifies the direct cost to U.S. economic growth of an oversized financial sector: 2% of GDP per year. In other words, if the financial sector were the proper size, the U.S. economy would be enjoying a normal economic recovery of 3% to 4% per year instead of the dismal 1% to 2% of the last few years.
IMF study
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Undue Political Influence
The undue size of the U.S. financial sector also brings with it undue influence which prevents remedial change. “The jump in size and profits has also increased finance’s influence on government,” wrote Gautam Mukunda in Harvard Business Review in June 2014. “From 1998 through 2013 the finance, insurance, and real estate industries spent almost $6 billion on lobbying; the only sector to spend more was health care.”
The issue, as former Federal Deposit Insurance Corporation chairwoman Sheila Bair explains, is one of "cognitive capture." It’s “about listening too much to large financial institutions and the people who represent them and not enough to the people out on Main Street.’”
Can Better Regulations Fix Wall Street?
The IMF’s report sheds fresh light on the suggestion that financial sector problems can be fixed by improved regulation. For instance, Adam Davidson argues in the New York Times Magazine this week that simpler, clearer regulations could solve the problem of Wall Street.
He notes that the Dodd-Frank law of 2010 is a byzantine monster. The legislation represents the worst of all worlds: it is massively complex and adds cost to the financial sector, without providing real financial safety. Even the key provisions of Dodd-Frank that do provide protection are being rolled back as a result of energetic lobbying. “Banks, financial-services companies and their advocates call for subtle changes in the rule-making process, demand redefinition of financial instruments and in myriad other ways seek to change the letter of the law so as to alter its spirit.”
“Between 1980 and 2000, the large banks in America had significantly moved away from productivity enhancement and toward rent-seeking,” Davidson writes. “It was precisely because our banking regulations were so extensive and complex that banks were able to seek rents…banks have harnessed regulation and turned it into a powerful business tool.”
More and more complex financial practices lead to increasingly complex regulations, which in turn create the political momentum for deregulation, while leaving untouched the root cause of the problem: the financial sector is now simply too big.
Straightforward Rules That Laypeople Understand?
Davidson argues that the problem can be fixed by simpler, clearer banking regulations.
“To fight rent-seeking,” writes Davidson:
...we would need banking laws made up of straightforward rules that educated laypeople could understand. They would have to eliminate our maddeningly complex regulatory infrastructure… if done right, an overhaul of banking regulations could create a political context in which rent-seeking self-enrichment by banks is no longer the norm. We might even come to call it what it is: corruption.
Yet calling corruption by its correct name, “corruption,” is not a matter of drafting simpler, clearer regulations. It’s a matter of finding the political will to treat admitted criminality as criminal.
In Banking, Criminality Is Legalized
When individuals commit felonies costing the public billions of dollars, they end up in prison. But in the current political context, criminal behavior by banks is accepted as “business as usual.”
Just two weeks ago on May 20, five of the world's largest banks--
“Today’s historic resolutions are the latest in our ongoing efforts to investigate and prosecute financial crimes,” the new Attorney-General Loretta Lynch boasted on May 20. But giving criminals a free pass to go on with their activities as if it is business-as-usual is not something to boast about. It’s a historic shortfall in political will-power to treat felons as felons.
For the banks, life as a felon has only minor downsides, like paying fines to get the regulators off their backs—a mere cost of doing business, which can be passed on to customers and shareholders. Although in theory, the banks could be barred by American regulators from certain activities, the banks have been lobbying regulators to grant exemptions. The Securities and Exchange Commission has already provided waivers that allow the banks to conduct business as usual.
Only last December, one of the admitted currency-manipulating banks--Citigroup--was in Congress drafting legislation that rolled back a key part of the Dodd-Frank legislation. If mafia bosses were lobbying Congress and drafting legislation about moderating pursuit of organized crime, there would be an outcry. So why not with the banks that have admitted criminality?
Thus the challenge of dealing with the financial sector is not a matter of drafting clearer regulations. The challenge is to muster the political willpower to act on the consequences, when we already know that important laws have been flagrantly broken.
Widespread Felonies
Apologists for the financial sector like Nobel-Prize-winning economist, Robert Shiller, have likened banking misconduct to minor road traffic violations:
“It is hard to blame the crisis [of 2008] on a sudden outbreak of malevolence. The situation during the boom that created the crisis was rather more like that on a highway where most cars are going a just a little too much over the speed limit. In that situation, well-meaning drivers will just flow with the traffic. The U.S. Financial Crisis Inquiry Commission, in its final 2011 report, described the boom as ‘madness,’ but, whatever it was, it was not for the most part criminal.”
This overlooks the depth, breadth and severity of the criminal conduct that went on before 2008 and has continued thereafter. These crimes are not like minor traffic violations. They are serious felonies with disastrous consequences for the public interest.
The Origins Of Criminal Misconduct
How could such widespread criminal conduct happen in our biggest institutions? It starts with the single-minded search for profits, and maximizing shareholder value. When profits from normal banking are modest, the financial sector starts pursuing “bad profits.”
Initially, these practices are not illegal, even if they are not in the best interests of customers or society. Banks get involved in price gouging, seeking unusual ways to levy hidden charges on customers, particularly customers who were vulnerable. Banks and others start gaming the system, by betting against securities that they themselves create. Banks and others have practices that resemble toll collecting, such as high speed trading, using their position to extract charges and profits, simply because of their position in the system. Banks and others began to spend a large part of their energies in zero-sum proprietary trading in derivatives, with dubious social benefit and great risk to society.
From here, it's only a short step for these “bad profits” to turn into practices that are literally illegal. They include price fixing of LIBOR, abuses in foreclosure, money laundering of drug dealers and terrorists, assisting tax evasion and misleading clients with worthless securities.
These criminal activities are encouraged by recruitment and compensation practices that make such activities part of the corporate culture.
Treating Admitted Criminals As Criminals
The financial sector has always claimed that limiting its activities is unthinkable because the economy needs an ever-growing financial sector to grow the whole economy. Banks argue that if we reduced the size and scope of the financial sector, just because of “a few rotten apples in the barrel,” the economy as a whole would suffer. Even a fine critbic like Davidson succums to this fallacious argument and concedes that with a constrained financial sector: “The financial system might not perform as efficiently and the economy might not grow as quickly during boom times.”
What the new IMF study shows is that the argument is wrong. With a smaller financial sector, the financial sector would perform more efficiently and the economy would grow more quickly.
The Political Will To Act
The issue isn’t essentially one of getting simpler, clearer banking regulations. The issue is finding the political will to act on the criminal behavior that is admitted by the banks to be criminal and that is now staring us in the face.
To suggest, as Davidson does, that better regulations could create a political context to treat criminal conduct as criminal is to get things back-to-front. We need the political will to act on criminal conduct that has already been admitted to be criminal.
Being an institutional felon should not be treated like an regrettable but excusable unpleasantness involving a few insignificant underlings. It should be treated as criminal conduct for which the top management of each institution is responsible.
Banks that have admitted criminality should be barred from fiduciary activities such as managing pension funds or banned from lobbying legislators and regulators until they have shown that they have mended their ways. After all, treating admitted criminals as criminals shouldn't be hard argument to master.
A shift in political context would in turn prevent the ongoing rollback of the regulations that already exist and enable the passage of banking laws and regulations that would right-size the financial sector.
In this different political context, fresh regulations would be needed to limit the financial sector’s role in trading in zero-sum or negative-sum gambling and regulatory arbitrage. It would re-focus banks primarily on the traditional "boring" task of financing real goods and services for real human beings. It would limit "hedging" to genuine hedging and insurance and ban gambling in derivatives for its own sake. The regulations to accomplish this would flow from a change in the political context, not vice versa.
The problem we are dealing with here is not a technical matter of writing clearer financial regulations that lay people can understand. The issue is one of political will to deal with the consequences of blatant, systemic criminality.
How could this political change happen? There are two possibilities.
We could wait for the political will to be generated by another massive financial cataclysm.
Or the change could come from courageous political leadership to call corruption corruption, to recognize felons as felons and to treat organizations responsible for criminal conduct accordingly.
The choice is ours.
And read also:
Five Steps The Banks Must Take
How Jamie Dimon Endangers Public Safety
Why financializataion has run amok
The five surprises of radical management
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Follow Steve Denning on Twitter @stevedenning
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