China Rising, Rent-Seeking Version

The usual concern about the US-China balance of economic and political power is couched in terms of our relative international payments positions.  We’ve run a large current account deficit in recent years (imports above exports); they still have – by some measures – the largest current account surplus (exports above imports) even seen in a major country.  They accumulate foreign assets, i.e., claims on other countries, such as the US.  We issue a great deal of debt that is bought by foreigners, including China.

There are some legitimate concerns in this framing of the problem – no country can increase its net foreign debt (relative to GDP) indefinitely without facing consequences.  And the Obama administration, ever since the Geithner-Clinton flipflop on China’s exchange rate policy early in 2009, seems quite captivated by this way of thinking: Will they buy our debt? Can we control our budget deficit? What happens if China dumps its dollars?.

The reason real to worry about China, however, has very little to do with external balances, China’s dollar holdings, or even capital flows.  It’s about productivity and rent-seeking.

China mostly invests in activities that raise productivity, raising the amount of goods and services that they can produce.  This could be manufacturing or infrastructure or various kinds of services. Agriculture lags but continues to get some new investment. And of course they pour money into education.

I’m not a fan of the Chinese way of organizing their economy or their society.  They no doubt have weaknesses that will catch up with them eventually (including waves of overinvestment in some sectors), and there’s good reason to think they will be the center of a big new “Asia Century” Bubble that is just now starting to emerge.

But contrast their pattern of investment in recent years with ours.  What sector in our economy has expanded more than any other?  Where should you work if you want both the highest wages on average, potentially very big bonuses, and quasi-retirement by age 40?  Finance.

Of course, we need finance and an important part of modern economic development involves intermediating savings and investment.  The US did this well, with some bumps in the road, and built a system that worked through the 1960s or 1970s.

But finance as a share of our activities (i.e., percent of GDP) has roughly doubled in the past 40 years.  What has this really added in terms of productivity?  The ATM and the credit card were great breakthroughs, but they are old.

What has “financial innovation” brought us since the 1980s?  One answer, of course, is “hedging strategies” that lower the cost of doing business for companies large and small.  This is plausible, although not likely to be large relative to the economy – send me your favorite study on the cost of capital since 1990 (you choose the definition), and we can talk about whether this effect is significant, sustainable, or even sensible.

Because financial innovation has mostly facilitated a big increase in finance.  If a sector grows, pays more wages, and rises as a share of GDP, surely this is a good thing?  Not necessarily – if this is a rent-seeking sector.

Rent-seeking means effectively a tax extracted by one sector from the rest of the economy.  We’re used to thinking of this as something that occurs through trade restrictions and the big breakthroughs in this area came from analysis of tariffs and quotas (Anne Krueger, Jagdish Bhagwati).  If a tariff, for example, will make your life cushy, you will devote great resources to getting one established or increased – irrespective of the effects on the rest of the economy (call this strategy “let’s hammer the unprotected consumer”).

Finance is rent-seeking.  The sector has devoted great resources to tilting all playing fields in its direction.  Consumers are taken advantage of; consumer protection is vehemently opposed.  And great risks are taken, with the downside handed off to the government (and the consumers again, as taxpayers).  This downside protection allows an overexpansion of debt-financed finance – reaching the preposterous levels seen in mid-2008 and now re-emerging.

Finance in its modern American form is not productive.  It is not conducive to further sustained economic growth.  The GDP accruing from these activities is illusory – most of finance is simply a tax on what is done by more productive members of society and a diversion of talent away from genuinely productivity-enhancing activities.

The rise of China does not necessarily imply slowdown or demise for the United States. But if they specialize in making things and we specialize in finance, they will eat our lunch.

On an urgent basis, we need real consumer protection against predatory financial practices and an end to all forms of Too Big To Fail behavior – which is actually just the biggest, nastiest form of predation. 

This is our most pressing national and international strategic priority.

By Simon Johnson

146 responses to “China Rising, Rent-Seeking Version

  1. Predation is the correct terminology and may also contain the seeds of the solution to the problem which you outline so clearly.
    The playing field can only be tilted so far to favor the rent seekers from innovative finance and we may be close to the tipping point. An estimate today suggests that 30% of American homeowners have negative equity and the disappearance of middle class income in the US will result in a continual diminution in new punters playing the Wall Street casino.

  2. As usual, an excellent comparison.

    I see one problem, though.

    You conclude in the next-to-last sentence that the solution is a government program to protect consumers. Why wouldn’t that program get co-opted? The Agriculture Department has been, the FDA has been…come to think of it, which significant state programs do not essentially become case studies in Public Choice problems?

    In general, there seems to be an assumption among elites that “problems” require “solutions” imposed or proposed via the state. Perhaps one can be concerned about “problems”, but similarly even more concerned about the long-term effects of programs designed to “solve” them.

  3. Great post, Simon. However, I agree with Eric that a program protecting consumers is likely to get co-opted. The key problem is the immense political power and leverage the finance industry has over the legislative and executive branches. It would appear that there have been a mountain of illegal irregularities through naked short selling, front running, etc in the finance industry on a massive scale that could be prosecuted under current law, but is not due to industry’s influence.

  4. Grey Economics

    I agree thoroughly with Eric, and it strikes me (because you have said this kind of thing before) that you are in a bind, because (1) you want to champion the common man, and (2) you see the world as dominated by two powerful forces: the State, and the Market.

    You don’t trust the Markets to take care of the common man, so you are left with the State. Incompetent, and co-opted as they can get, they still can get un-elected or overthrown; not so with the Markets, which seem unassailable by anyone but the State.

    Am I getting this right?

  5. But Grey Economics, what is the State? In a democracy, in theory, the government represents the will of the people.

  6. Eric: “Perhaps one can be concerned about “problems”, but similarly even more concerned about the long-term effects of programs designed to “solve” them.”

    I have found it interesting to look at politics from a systemic point of view. Politicians are great for offering simplistic proposals that ignore systemic effects. Curiously, the same politicians (many of them, anyway) are good at seeing systemic problems with the simplistic proposals of their political opponents. I do not know if there is a kind of collective blindness or simply a cynical belief that the voters will not buy anything but simplistic proposals.

    That being said, the fact that regulation might be coopted, while often true, is not sufficient argument against regulation per se. Bond Girl’s proposal for private entities which profit from doing the work of regulating other private entities is basically a good idea. It alters the system to add an antagonistic element. Regulators cannot really be antagonistic to those it regulates unless they commit crimes.

    Currently, the Fed has charge of financial consumer protection. But the Fed is a bank. Even without regulatory capture that gives the Fed a certain viewpoint. A financial consumer protection agency would have an antagonistic viewpoint to that of the Fed. Furthermore, if it did not preserve such a viewpoint, it would run the risk of being absorbed by the Fed, so it would be in its own interest to emphasize the difference, just to defend its turf.

  7. Of course, the Fed is a banking system, not a bank per se. ;)

  8. Excellent essay!!!!

  9. winstongator

    I like to call this ‘make my share of the pie bigger’ versus ‘make the pie bigger, my share bigger, and everyone else’s share gets bigger too.’ The second is the issue with the butcher and baker of the Wealth of Nations, while the first can apply to many sectors – law and finance come to mind.

  10. Andrew Macphrson

    Great point well made, but the solution is not likely to come from a government that lives by the dollars gifted by it’s kind supporters.

    Finance is one of the largest donors to Rem & Dem Incs, and since becoming a US citizen I’ve honestly come to see them as a Punch and Judy show to keep everyone distracted from looking at the oligarchs who really are pushing for a new world order, a one world bank, with them in control.

    Foreclosures and 90 days in arrears have grown steadily every month since Oct of last year, as have personal bankruptcies. Can there ever be any hope for the consumers while the banksters rule Washington?

  11. Huey Long called the R’s and the D’s ‘Lopoppahiram and Hipoppaloram’, the same patent medicine made from the bark of the same type of tree, but one with bark stripped from the top of the tree down and the other from the bottom up. Punch and Judy works, too.

    Now the Republicans are in complete disarray, reduced to only their most hardcore supporters. Not so long ago the Democrats were in the same postion. Those voters who are in play switch back and forth, never getting any satisfaction. In a capitalist society everything, including ‘democracy’, is a commodity, and you get just as much as you can afford.

    The oligarchs, being wealthy, can of course afford a lot. Hence, despite the soaring oratory and promises to the contrary, Obama delivers a bailout scheme pretty much the same as his predecessor, continues in Iraq pretty much the same as his predecessor and even continues with signing statements pretty much the same as his predescessor.

    It only takes two hands to do a Punch and Judy show, and these hands are parts of the same body.

    P.S. Lest anyone get the wrong impression, his apt analogy aside, Huey Long is otherwise reprehensible.

  12. “The rise of China does not necessarily imply slowdown or demise for the United States. But if they specialize in making things and we specialize in finance, they will eat our lunch.”

    You don’t even need to make a rent seeking argument or any other to reason that it is bad for a society to do nothing but shuffle paper. Many people have been saying something akin to the above for many years in one form or another. Generally, they are people living in communities that have seen middle class jobs eliminated and/or outsourced.

    It’s a race to the bottom with a small subset of winners.

  13. Dear Prof. SJ,

    You are arguing for common sense, against ideology. This is rather perilous.

    Your enemies – high powered economic theorists that are backed by high finance – will pose the infamous question:

    “What do you believe, the Efficient Markets Hypothesis, or your own lying eyes?”

    And many will answer the EMH.

    Until some bright young econometrician comes out with _the_ seminal paper showing that the development of the finance sector is beneficial up to a point, but then harmful beyond that point (presumably due to rent seeking), the academic debate will not shift. And this will be hard to demonstrate empirically, because sophisticated financial markets tend to develop in _parallel_ to other things that are _good_ for society (e.g. computing power, telecom infrastructure, higher education). A quack model could easily “show” that highly sophisticated financial markets lead to positive outcomes.

    A good model would need to be non-linear, with an “ideal point” for financial market % of GDP so that the result is not polluted by a bunch of corrupt dictatorships with no financial sector that drag the line down on the low end and yield an upward slope. You would need an appropriate lag (since in the short term, financial bubbles can accelerate perceived growth), and a good measure of REAL growth (perhaps median PPP income, stabilized for exchange rate volatility).

    And a really good model would find some creative instrumental variable for size-of-finance-sector, that is semi-exogenous to all the other things (which is very hard, since many things that you would think are exogenous – like technological development, are not; computing power dramatically accelerated speed of capital flows for example).

    Tough problem. Don’t suppose you have an enterprising graduate student who has already started assembling the dataset?

  14. Hello Mr. StatsGuy,
    I think that common sense is much more important than ideology which represents but the ‘political ideals or aims of a group’ typically imposed on others. The funny thing is that in the wake of the ’08 Financial Crisis leading advocates of the EMH publicly admitted that ‘their ideology failed’! Maybe there is a young bright econometrician working on the ideas that you present… But how or why in the world would he or she need to “find some creative instrumental variable for size-of-finance-sector, that is semi-exogenous to all the other things”. If there is a new (non-ideological) theory that aims to be scientific, why would it not try to sustain the link to the worth of labour? If we remove our notions of the value of money and finance sectors from what labour produces (whether at home or abroad) then wouldn’t that be the exact situation desired by a dictatorial anti-democratic hegemonic group or country (big finance or China)? What you suggest sounds (unintentionally I think) like an edifice permitting ‘super-rent’ or something. What is for certain, is that there won’t be any advance toward revitalized theory without common sense taking hold beforehand! :)

  15. In the 1980’s I had work to do in the executive offices of a number of America’s largest corporations and when I talked to the production or marketing people who were responsible for designing, making and selling the companies’ products I heard a consistent complaint: the office next to the CEO was now occupied by the Chief Financial Officer. Why? because the CFO could earn the company up to 10-15% just by putting the company’s money into financial instruments of one sort or another while no products they made could generate those kinds of returns. This started in the 1980’s (look at any chart of the stock market–and, incidentally, real estate values– over the last century and you’ll see what I mean) Our corporations were completely hollowed out and became disguised finance companies (see GE) No one has yet explained to me exactly what happened then to cause this.

  16. Marion, a very good point. Is it another form of capture? It reminds me of how many municipalities were seduced into investing in various derivatives.

    Part of the explanation of what caused this is the seductiveness of bubbles, even when you know it’s a bubble. Right now, today, I struggle with investment decisions. I _know_ that we are in a mini-bubble. I know it. Am I invested? Yes. Man, that “easy money” (I know, I know, it’s not very easy) sure is tempting. I even know that I am a target for the predators out there. Not too many other choices.

    The whole setup of the Federal government and the Federal Reserve forces everyone to take on riskier behavior to try to stay even. Who gets the fees (rents, guaranteed profits) from that riskier behavior–the state through taxes and the banks through interest, commissions, fees, HFT kickbacks, front running, manipulation, etc.

    As for who is eating whose lunch, that one’s easy, it’s my lunch, my mother’s lunch, and my friends’ lunch that is being eaten.

  17. Marion: Corporations stopped using a proper double-entry book-keeping framework of rules. In other words corporations everywhere found a quick and dirty solution by gaming the system. Book-keeping alone, if studied scientifically, would explain to you exactly what happened.

  18. Marion I fully agree, and the following was a letter to European friends and that I extract from my “Voice and Noise” 2006.

    Europe, you need electrical, not financial engineers (like me)

    A couple of years ago when the hundred-year-old private electric utility company that served my hometown (Caracas) was taken over by an international player, it became within a short time leveraged up to its hilt in debt, and I suspect also poison pills and golden parachutes, and I knew we were heading into the wrong direction.

    Now when I read about all those high valuations paid by financial wizards purchasing utilities in Europe and that will, sooner or later, need to be repaid by all those European electricity consumers who are currently living in blissful ignorance, I cannot help but singing “another one bites the dust!”.

  19. “The rise of China does not necessarily imply slowdown or demise for the United States. But if they specialize in making things and we specialize in finance, they will eat our lunch.”

    To my mind these two sentences contradict each other, assuming that my understanding of ‘eat our lunch’ is a painful one.

    Perhaps another way of looking at the future for the US is this

    China – 4
    UK – 113
    USA – 309

    The key to the future, in my humble opinion, is innovation and invention and the US is somewhat ahead in these areas, practically out of sight of the rest of the pack!

  20. That piece of statistics is set to change over the next years. And underlying education in China and India even more so.

  21. E. Barandiaran

    I agree with you about some structural problems with the financial system (US and everywhere), although I believe most of these problems are caused by government intervention. In this post your analysis fails to take into account (1) the implications of changes in comparative advantage for investment, and (2) the implications of corrupted political systems (everywhere but specially the increasing corruption of your country’s system) for allocating resources and redistributing incomes.
    BTW, as a former student of A. Krueger in Minnesota and a former colleague of Gordon Tullock in Virginia, your definition of rent seeking fails to take account of the critical role of the political system in intermediating rents between individuals and companies.

  22. Three cheers. But as a number of commenters have suggested, nothing will change while economists are still giving a dollar spent on fraudulent, rent-seeking financial services the same GDP weight as a dollar spent on R&D or some other highly productive activity. The macro folks don’t even seem to recognize that they are assuming an extremely strong version of the efficient markets hypothesis in their most basic measurements of progress.

    I am highly skeptical that a consumer protection agency will accomplish much in the absence of fundamental reform. It is certainly reprehensible to allow Wall Street to recapitalize on the backs of the poor, but late fees aren’t what caused last year’s crash, and they won’t be what causes the next leg down either.

  23. “The rise of China does not necessarily imply slowdown or demise for the United States. But if they specialize in making things and we specialize in finance, they will eat our lunch.”

    I wish you had expanded upon that paragraph.

  24. Add my vote to Mischa’s.

  25. The economy is about producing food, clothing, shelter, transportation, energy & health care. Not printing paper money. You can’t eat, wear or fill your car with paper money. It takes stuff.

  26. Depends what you mean by “things”.

    The US actually produces a lot of value – especially intellectual property – but has a hard time capturing the gains. IP protection in India (lousy) and China (getting better, but not great) is a major issue. The number of pirated copies of western media – either entertainment or productivity software – is simply beyond belief. India, for its part, has engaged in low-cost generic production of drugs with IP protection in the US. The US, essentially, funds research for pharma by keeping the price of drugs in the US high, but allows those drugs to be made/sold cheaply outside the US.

    The deeper threat of the rent-seeking activity created by finance (other than casino-like concentration of wealth) is the brain drain from productive enterprises into rent seeking enterprises. Talent (often) follows money.

    In terms of manufacturing, the chief threat is really long term endogeneity of productivity. That is, once an industry leaves the area, it’s very hard to regain that industry because the hard and soft infrastructure goes with it and co-evolves with the industry. Local college graduates learn the industry. Local suppliers serve the industry. Local innovation-through-production (“learning by doing”) generates free human and intellectual capital that is not easily replicated once the industry is gone.

    This is what many non-traditional (and much despised) industrial economists have argued, and the justification for buffering manufacturing from short-term economic dislocation.

    This is the case, btw, for rescuing auto-production in the US – and look how viciously the Friedmanomicons fought that spending even while demanding the US rescue Big Finance…

    It is a very short step from intervening against Big Finance to intervening against Free Trade – many of the arguments are similar. (And, since SJ is a former IMF guy, I have a strong hunch where SJ stands on the free trade vs. fair trade debate.)

    But really, it’s the “slippery slope” argument that so many idealogues have resurrected… Once we intervene a little, then it’s a slippery slope to total Stalinist h3ll!

    By denying the existence of a pragmatic middle ground, the Friedmanomic fringe will paint the debate as EITHER pure free market or Stalinism. That is a hard debate to win.

    If I could found a political party, it wouldn’t be the Populist Party, it would be the Common Sense Party.

    Or maybe just the Anti-Stupidity Party.

  27. And I would be an early Member!

  28. It does make attractive green wallpaper though. And a pallet of bills will keep a house warm for a week.

  29. Paper money is just a medium of exchange used to move stuff around in the economy. The problem is that finance is moving stuff to the wrong places & too much into their own pockets. Basic enough? Or too basic?

  30. And as we all know, paper money is created by the banks, thru loans from the Fed. Not by the Congress as stated in the Constitution.

    “It may have also have been and still is illegal according to Article 1, Section 8 of the Constitution which happens to be the inviolable law of the land. The article states that Congress shall have the power to coin (create) money and regulate the value thereof.”

    All you ever wanted to know about the cause of the “financial crisis” – the Fed.

  31. Man-oh-man, Simon has really hit the nail on the proverbial head this time. I’m glad to see him get his dander up. We very much need him to have his dander up. For the good of our economy.

  32. Another great post by Simon. In a recent interview on his new book Plunder and Blunder Dean Baker said:

    “It is important to remember that finance is an intermediate good like trucking, rather than a final good that directly provides benefits, like health care or housing. An efficient financial sector is a small financial sector. Furthermore, a large financial sector will be a politically powerful financial sector. It will be more likely to be able to use its political power to prevent effective regulation, as was quite obviously the case over the last 15 years. ”

    I thought he made a great point, finance is perfectly analogous to the trucking sector and as Johnson said is a rent seeking sector of the economy. America needs something like the Ministry of Economy, Trade and Industry of Japan to promote alternative energy investment without paying rents to the gods of finance.

  33. This has to do with the larger financialization of the American economy that started some 3 decades ago.

    As Joseph Stiglitz puts it, “the U.S. has turned to exporting T-bills instead of automobiles or other commodities. Global demand for dollars has supplanted demand for manufactured goods and services.”

    It seems the dollar’s use as the world’s reserve currency has contributed to this process. America has essentially provided two public goods to the world:

    1) the U.S. dollar as the global reserve currency

    2) outsourcing financial intermediation functions to what have been viewed as deep and predictable U.S. financial markets.

    Replacing the dollar with SDRs or a more international currency would force America to end its reliance on finance. A return to traditional ways would curtail multilateral trade deficits and stem domestic job loss.

  34. I’m all in favor of moving to SDRs (assuming the regime for controlling SDR-as-money-supply were agreed upon a priori), but only if the agency issuing the SDRs also agrees to absorb all current US federal debt.

    Otherwise, we will be abdicating the power to control the value of our currency, which is directly related to controlling the value of our debt.

    If we owed our debt in non-dollar denominated currency, there would be minimal difference between the US now and Argentina in the 1980s. Converting to SDRs _now_ would be a profound economic disaster for this country.

  35. StatsGuy,

    I’ve just read your comments on “dollarization”. I have 2 questions:

    1) You say many foreign countries buy dollars to use as a stable currency. From whom exactly do they buy those dollars? Is it from the US government? From private banks? Can we trace who ultimately benefited from this trade?

    2) Can we assume there are now more dollars outside the US than inside? What happens if all the people outside start selling them? Would that cause hyperinflation in the US?

  36. 2) Foreign countries “bought” dollars from the US by trading us goods and services in exchange for those dollars.

    The problem with building an “industry” that “supplies” dollars (as an export good) is that the industry is only sustainable so long as we continue to export more dollars (and foreign countries continue to want them). However, people don’t really “consume” dollars like food. That dollar supply sticks around.

    2) I guess it depends what you define as hyperinflation. 15% per year? Or 50% per month? I have said many times that I doubt the latter will occur unless the US starts borrowing debt that is denominated in foreign currencies (though our oil addiction represents a significant risk).

    I can’t find an estimate of the numbers of physical dollars outside the US, though I recall reading that a couple years back Russia alone had something like $200 billion in physical dollars floating around the country. Any links you can dig up?

  37. bungalowbill

    StatsGuy: “Foreign countries “bought” dollars from the US by trading us goods and services in exchange for those dollars.”

    If it happened in that manner, then someone must have noticed the disappearance of dollars from the US and decided to create more dollars.

    Who has the authority to do that? The president? Congress? The Fed? Banks?

    Many thanks for enlightening us!

  38. Excellent post.

    The US specializes in creating money, while China specializes in collecting it. It’s hard to gauge who wins and who loses, at least in the long run.

  39. You fail to ask why China is playing this game. The only sensible reason is to catch up with the West in technology, where communism has left it woefully behind. When it does catch up, China no longer will have a reason to finance America’s debt. It won’t have to dump Treasuries, merely stop loading up, to force American interest rates sky high and blow up whatever bubble the boys at Goldman may be engineering at the time.

    Thenceforth, America will become an exporter of grain and beef, like Argentina and Poland, and it will probably have the same kind of currency, so you will need a lot of it to buy a gallon of gas. Of course the Chinese will have plenty of oil to sell us. Do you think they will take Tom Cruise movies in exchange? Do you think we can sell them enough weapons to cover the bill? Perhaps P&G can sell enough Tide and Crest to the Chinese to cover our oil bill, but I would not bet on it.

    The financialization of our economy someday will put Alan Greenspan and Bob Rubin and Larry Somers and the incumbent financial gymnists on the same pedistal with Benedict Arnold. The past twenty years have been a scam on the American middle class. Our manufacturing base fled to capitalize on cheap foreign labor and the workers were given credit cards permitting them to continue consuming by paying for everything two or three times despite shrinking real wages which were disguised by phony inflation calculations that discounted all the goods people need to buy and instead focused on the price of ‘computing power’, as if anybody could eat it.

    When a country no longer produces manufactured goods its days as an economic superpower are numbered. The terms of trade will become progressively worse and worse and it is hard to see what can be done about this even if anyone in authority cares enough to try. Of course, energy independence would help, particularly if it can be accomplished while the rest of the world remains willing to accept dollars.

  40. China no longer will have a reason to finance America’s debt.

    once only once have I heard that they still depend on American grain and as Orwell’s teacher drilled into his class: “what is the most important thing in the world?” Answer “food” that knowledge makes me breathe easier – there is one belief that the Soviet Union didn’t make it because Staling believed in an agriculture nutcase and so never managed to make it without American grain.

  41. Funny you should mention food…,_emerging_powers_and_petro-states_are_snapping_up_huge_chunks_of_farmland_in_the_developing_world/

    Curious trend. That and the privatization of water worldwide. Almost… important enough to point out now and again.

  42. you are right but if you let the whole implications of a tripling of India’s population in just 60 years dawn on you it doesn’t feel good. It is not the masses per se I find so frightening it is the rapid change/increase – rapid changes of basic parameters to date never turned out to be beneficial to the “normal” person

  43. bungalowbill

    I feel Simon is preaching to the converted here. I’m not sure how it advances our cause.

    Should we start thinking about action? I’m not sure there’s enough of us yet.

    I’ve recommended Baselinescenario to a few friends. They like it, especially its didactic slant. But those were basically already converted. They just found a website that articulated their intuitions in a substantive manner.

    I have other friends to whom I haven’t bothered talking about this website. They basically don’t care about politics or economics. They still have their jobs. Nothing seems to have changed for them. I don’t think we can reach those people now. They need to be personally hit to care.

  44. Capital Munch

    You make very good points, Simon.

    What I don’t get is how you can make these arguments on the one hand, and then call for appointing Tim Geithner head of the Fed–and giving him even more extraordinary regulatory powers to the exclusion of other arms of the govt. You did that last week.

    Can you please explain to your loyal readers how you came to such a conclusion? I don’t see how TG gets you to “ending all forms of too big to fail behavior.”

  45. Does someone have any good studies/links to studies on the cost of capital? I would like to see a graph comparing cost of capital to the size of finance as a share of the U.S. economy as a whole.


  46. If you really wanted to eliminate the rent-seeking, you should have pushed for solutions to the crisis akin to a second Resolution Trust Company. Is that what you advised then, or did you favor the bailouts?

  47. Labor Flight

    This is an interesting article. I agree to some extent that movements of factors of production away from sectors outside of finance, particularly manufacturing, may have a long term negative impact on total factor productivity. However I have a few questions to Prof. Johnson.

    If the financial sector in the US is rent-seeking and “not conducive to further sustained economic growth”, then why do international investors still invest here? Wouldn’t this glut in rent-seeking means it’s safer and perhaps more profitable to invest anywhere else where the financial sector is limited and less powerful in rent-seeking ventures?
    Moreover, shouldn’t a large financial sector with a large number of firms mean higher competition that deflate the “tax” on production you mention to describe financial transactions?

    I wouldn’t be surprised if capital cost/price has not been affected by financial innovation. My understanding is that these instruments as you mention are geared towards risk-sharing and hedging and ofcourse to liquidity provision. The cost of capital should only be a matter of scarcity and may not provide a full account of the financial sector’s affect on production.

    I fully share your view regarding government intervention in the sector and the distortion in incentives and a sector that is probably already too bloated. However on the general topic of the merits of a healthy financial sector I think the argument can be more broad. I would be interested to hear your thoughts on the proper regulations needed and the limits that the government should impose to safeguard consumers. Thanks for a stimulating article!

  48. What you have here is a very interesting thesis that bears a great resemblane the the Anglo Disease argument that has been put forward by Jerome a Paris at the European Tribune.

    The idea that finance is rentseeking is simple, but the implications are gigantic.

    First and foremest, it suggests that the growth of of the financial sector has only come at a cost to the broader economy.

    Second, ever since Okun published Equality and Efficiency as a mimeo from Brookings, the argument that there is a tradeoff between equality (e.g. a small income spread) and efficiency (e.g. the total GDP produced by the economy). If we take the rent seeking hypothesis seriously, then we have to conclude that insomuch as financialization is basically covers up a changing distribution of income from those who live by work, and those who live by wealth, that it is inequality that is inefficient. This is to say that the million dollar bonuses for Wall Street bankers can only come at the cost of shrinking the size of the pie that society cuts up.

    So it’s not welfare queens or $73-hour autoworkers (both of these are established bits of neo-lib mythology) that have resulted in the destruction of the real economy. It’s the bankers and their minions.

    And, the light at the end of the tunnel is that equality is efficent. Which means that the only way we can grow the pie is to make sure that everyone gets a fairer share of what they actually put into its making.

  49. Try the gedanken of reading Prof. Johnson’s post as though you were a middling-to-senior official in a Beijing ministry (take your pick). From that perspective, it makes a pleasant read.

    One of my problems with almost all the commentary that blogsphere has engendered about the financial crisis is its tendency to over-emphasize what’s happening to us, and focus on the impact of various events in the American economy.

    If you are a policy maker in a BRIC economy, having your American counterparts all knotted up in their underwear with the lights out has its advantages.

  50. Just denke an die Wedgies.

  51. thank you for this addition to my vocabulary
    having lived on a Greek island close to the Turkish border this has special resonance for me – didn’t know a habit the Greeks claimed, the Turks had, survived in such softened down form

  52. Simon, time out! (please)

    Simon, you mention “cost of capital” studies to assess the “real” productivity created by “finance”. It is not just the “cost of capital” that matters–although it certainly matters, but the massive amount of capital the financial system is able to raise and trade. Our financial companies are global and are capital raisers and liquidity providers—not merely “punters” financed by ripping off stupid (so called) consumers. You seem to think this function is simply nothing at all–almost as if any set of IMF :)–grin–“bureaucrats” could do it.

    Our financial system provides extraordinary liquidity in the secondary market. Think of what a “stock” is. It is nothing. It promises the holder nothing under many conditions. Imagine a privately held 2% interest in Intel purchased in 1977. Further imagine there is no secondary market and no dividend (before you say how unrealistic this is, imagine being a 2% minority owner of the NY Yankees). Intel did not pay dividends for almost 30 years. The investor received no cash. But the secondary market allowed for massive cash gains. Were there no secondary market, there would have been no 2% investment to begin with. Which is why minority stakes in baseball teams are considered play toys–by and large.

    Obviously, I am aware you agree. But what is its value? You seem to assume the marginal value at this stage in history is close to zero–in fact it is negative. You also assume, through assertion, that you are correct unless others produce studies suggesting otherwise. But one can just as easily turn that around on you. You are the one making the “extraordinary claim” (that measured GDP is fake). I would think you should be providing the “extraordinary evidence”, not those who may disagree–or simply are looking for better evidence than “prove me wrong”.

    Once again we have a floating number causing “agita”. The new floating number is $38 billion for “over drafts”. What is an “over draft”? You seem to think it is a mere technicality. In fact, it is a option on liquidity owned by the over draftee. It is a right to borrow money at will–during a recession. Do we know what the underlying overdrafts amount to? Do you really know that consumers are just blind idiots being manipulated by big evil rent seekers? I don’t know if $38 billion is the fair clearing price or not. Perhaps, as you imply, if this were more transparent, the true clearing price would drop. But if these over draft fees are truly rent seeking, given that we have thousands of competing banks, it is difficult to accept this is merely a corrupt sleight of hand by finacial evil doers. If more transparency is what you want, you have my vote. But you are implying much more than that.

    Finally, even if “finance” is rent seeking, why does that imply GDP is overstated? What it implies is it is a tax on the system which has caused growth to be lower than it would otherwise be—but if, as you imply, it is a wealth transfer, it is hard to see why that makes overall GDP over stated.

    Your comments and those of others are of course appreciated.

  53. With all you seem to know about finance & the markets, I’m surprised you weren’t able to prevent the crash or at least see it coming & alert us. You obviously know more than Simon. You must have written your congressman or congresswoman or something.

  54. I agree it may seem like I am asserting with certainty my views. What I am doing, however, is expressing my concern with Simon’s argument—in other words, it is the equivalent of asking questions by presenting my best argument against what he said. I am doing this because what I read does not seem correct, or at the least, properly explained. I have not seen his answer–don’t know if he reads all of these or responds. I assume that is why we have these types of forums.

    But what does my response have to do with “preventing” the crash. Where do I assert anything remotely related to that? For what it is worth, I was explicitly opposed to TARP and the AIG bailout. You can go to my website if interested. I also was a broken record that we mistook a localized and very large real estate bubble in (California/NV/AR and Fla predominantly) and mistook it for a global liquidity crisis–thus making it so. I also have been on record that the mark to market Mtge prices implied an absurdly high default and foreclosure rate that was not plausible (although possible, like anything).

    I cannot say I was correct about all or any of these things. I do know that AIG has not experienced a default; I do know that upon AIG’s takeover, there was massive CDS shorting, which drove the payments to AIG by the Government(and companies like Goldman) and whose price drops were largely locked in by Government sanctioned unwinds by those same firms. So clearly, I have no love lost for many financial firms who used Government to game the system.

    None of this has anything to do with what Simon said, although it responds to your sarcastic comments somewhat. You seem happy to just obey and believe I gather. By the way, my educational and work background is reasonably sufficient to disagree with certain assertions made by MIT professors.

  55. “By the way, my educational and work background is reasonably sufficient to disagree with certain assertions made by MIT professors.”


  56. Can anyone on this site actually respond to the substance of any of my comments?

  57. Well not sure what the WOW!!! implied but a background of is more than sufficient experience to speak with wisdom.

  58. I think you are confusing profit-seeking with rent-seeking.

  59. To Bond Girl

    Let me think about it. I think the statement To Bond Girl

    Let me think about it. Simon has said directly that “finance is rent seeking” and that is a very extreme statement. The rent seeking we have seen has been created by the government by subsidizing moral hazard. Just as auto unions are rent seekers in Chrysler or Gore and Co in climate change legislation. This does not mean these activities without subsidies are rent seeking. But Simon is saying Finance is. Having capital invested in the “right” places on average is clearly critical. I think Simon underestimates the role US financial firms play globally. I also resist (am always open to evidence) the concept that finance is a mechanistic utility primarily. Again, what Simon is saying is extreme ( does not make it wrong of course). I think this topic is open to conflation (per your comment to me) and requires more specificty—even at the general level of a blog—than Simon has put forth. I still maintain it is just an assertion— and one whose implications are also extreme—regarding global government coordination. I admit to a bias against entities such as the IMF.

  60. Simon has said directly that “finance is rent seeking” and that is a very extreme statement.

    Yes, so very extreme. I can’t even imagine the extremism of someone who would think that the financial sector would want to make profits wholly disportionate to the value they confer on society.

  61. I do not think he is saying that finance in general amounts to rent-seeking, but that the behavior of large financial institutions that has made them so “profitable” of late is actually rent-seeking. I also think this is uncontroversial.

    The major financial institutions undertake many legitimate profit-seeking enterprises, but they have come into a position of dominance by making business decisions that are not even remotely connected to creating value for their shareholders because it enriches a small group of the professionals at that firm. A bank does not bet its existence as a going concern on subprime lending because that is a strategy that will pay off for its shareholders in the long run. It makes this decision because it can in effect purchase a friendly regulatory environment for less than it can invest in genuine innovation (where genuine innovation translates into increased productivity and wealth for the overall population – hence the discussion of GDP). This process results in the firms perpetuating behaviors that in a true free market environment would annihilate them, but continues because the firms are not picking up the tab.

    I do not think this is a political issue, in the sense that one political party has ownership of it; but I do think that proponents of the free market system who mistake policies that are favorable to specific corporations for policies that are favorable to free markets are completely out-of-touch. If this debate continues to be built on mistaken assumptions, and concerned citizens continue to talk past each other, nothing constructive will be done to avert future crises. It may take time, but the cumulative effect of living from one crisis to the next is the end of an empire.

  62. I think what Simon is trying to accomplish is to create productive jobs that produce something for hard working people.

    What are you trying to accomplish?

    “Can anyone on this site actually respond to the substance of any of my comments?”

    I fail to see anything in your comments that is about creating actual jobs that produce something & improves the lot of the middle class. The substance of your comments sounds like rent seeking-profit seeking, esoterica.

  63. I write this to throw in my 2 cents worth in response to the substance of your query on Prof SJ’s essay; “Finally, even if “finance” is rent seeking, why does that imply GDP is overstated? What it implies is it is a tax on the system which has caused growth to be lower than it would otherwise be—but if, as you imply, it is a wealth transfer, it is hard to see why that makes overall GDP over stated.”
    I agree that the implication is that GDP is overstated because of the current dis-connect between economic theory, based on the static identity that the value of all goods consumed equals the value of all goods produced – and a reality that sees leaders of a financial sector earn dozens of times more in a year than what a Nobel Prize winner works a lifetime to earn, and, thousands of times more than what a minimum wage earn makes while he or she contributes to GDP… Therein lies the philosophically messy little question of what exactly the financier produced to “contribute” to GDP….This minor theoretical problem of how to value labour in a knowledge-based economy is not going to go away. Until there is a more satisfactory approach to this matter (through intellectual advance in theory), the tautological exercise of trying to determine if the rentier’s source of ‘income’ is a ‘tax’ or ‘wealth transfer’ will remain just that.

  64. I think it is neither. More specifically, the case has not been made that finance is rent seeking. We tend to underestimate any activity which does not produce physical objects directly. Yet 70 percent of our Economy does not. I have followed the views of James and Simon for a while. I don’t necessarily disagree with their view that Finance is too big due to government subsidies and bailouts. One way to find this out is stop bailouts. But this is a long way from the idea that “finance is rent seeking”.

    Also, pay may be far too high (or not). Again, let’s not subsidize moral hazard and find out. I also think mark to market accounting is an extraordinarily complex topic. This is another area where James and Simon seem to have more faith in than I do. I raise these seemingly random points because these have all contributed to the financial crisis. But the leap from these to “finance is rent seeking” is a huge leap with, I think, dangerous political implications. If Simon’s prescription is no more bailouts and improved capital and risk regulation, then we end up in the same place. If however they believe we need more agressive controls, then they lose me. If finance is indeed rent seeking let the market demonstrate it. I don’t want government theories predetermining the outcome

  65. I agree. They were providing a valuable service in repackaging liar loans based on the assumption that housing prices would grow exponentially indefinitely.
    They earned all their trillions fair and square.

  66. Hi Mike,
    Sorry for the delay in noticing your interesting response.

    Discussion of value of labour in relation to the generation of wealth in the financial sector does not infer a exclusive relation to the production of physical objects. The problem with wealth creation in the financial sector is its potential to be entirely unrelated to GDP which includes all sorts of intangible production of knowledge etc. It is the potential for the financial sector to trade more assets and liabilities than what can be ultimately connected to some sort of reality that leads to precarious imbalance… Otherwise why would bubbles, at least in finance, ever happen at all? Of course, if we allow a sort of separate reality where people can be “worth more” than everyone else simply based on their connection to finance – this is full engagement of moral hazard and is bound to undermine democracy.

    Evidently, economists are still struggling with what Keynes attempted to address in his General Theory. Given the huge changes since the early 1900’s evolution of thought is needed again to both deepen understanding of the multi-dynamic links between people and money and expand the structure of economic theory. This is how ‘subsidization of moral hazard’ can be avoided.

  67. “The problem with wealth creation in the financial sector is its potential to be entirely unrelated to GDP which includes all sorts of intangible production of knowledge etc.”

    If GDP includes tangible and intangible values, what is the third value type that “wealth creation in the financial sector” is made of? It sure sounds like intangibles to me.

    “…to trade more assets and liabilities than what can be ultimately connected to some sort of reality…”

    How can anything I pay for not be connected to some sort of reality? Even if I buy a CDS and I don’t have any bonds that need insuring, the person on the other side has a liability to me. If that’s bad or not connected to reality, you have to lump nearly the entire economy of Las Vegas into your definition of “bad economics not tied to reality”, and if you ban CDS contracts not tied to some reality, you have to ban all gambling in all forms, since the event of a three and four on two dice is no more connected to the real world than the event of default behind the liability of a CDS.

    “Otherwise why would bubbles, at least in finance, ever happen at all?”

    Because value is always and everywhere subjective (see Human Action, by Ludwig von Mises).

    “…people can be “worth more” than everyone else simply based on their connection to finance”

    Absolutely! Otherwise you’re trying to declare the value of someone’s time must conform to some objective standard that some gang of planners decides is right for everyone who does business with that person. Again you try to tie value (this time of someone’s time, intellectual skill, and relationships) to an objective standard to ensure it doesn’t exceed something you decide is a limiting factor. All I can do is point back again to the fallacy of objective value.

    If I want to do something brash and absurd and pay the gardener $10,000 to cut 100 square feet of grass because I hope to get in on the good side of his Dad who has connections with others I value, what business is that of you or anyone else?

    Economics can easily deal with the “subsidization of moral hazard” by simply not insuring predefined outcomes by the State. Moral hazard has it’s root in the minority of decision makers who insist on specific predefined outcomes for specific events, who then coerce the population to pay for it through the use of tax dollars.

  68. I have to agree with Bhernon. He has stated a point I had been trying to make. We can almost define any final product or service as rent seeking. In my area, there has been a chain of massage stores called Massage Envy, a low cost service. If I were to say that this is a waste of labor that is better used to help–say– educate children in the inner cities, then I can say as Simon does about Finance; massage is “too big” and “in effect” is a form of rent seeking. Again, as some other (not you) commenters have said, that the mere fact of high pay in an industry that achieved disaster in recent years is prima facie evidence it is “rent seeking”. People have grown wealthy in industries that have eventually lost billions throughout history. But they don’t get subsidized to stay alive. To repeat my previous main point, if we established a no bail out policy to begin with these industries will never have the opportunity to get larger than they should. SJ seems to conflate his normative value system with some objective concept of rent seeking. I would love to see the study that tells us all the industries that are “just the correct size”. Is the ethanol industry too big? Yes, because it is subsidized. Let’s get rid of industrial policies. Not increase them

  69. Mike Rulle: “To repeat my previous main point, if we established a no bail out policy to begin with these industries will never have the opportunity to get larger than they should.”

    Doesn’t that claim fly in the face of economic history? For instance, didn’t Jay Gould (among others) get larger than he should, without the benefit of a bail out policy? Didn’t his failure spark a panic and usher in the Long Depression?

    Also, “larger than they should” is not exactly well defined. ;) Suppose that we take it to mean, highly interconnected with the economy as a whole, and containing highly interconnected units so that the failure of a few of those units will have dire consequences for the economy as a whole. Then doesn’t network theory suggest that such highly connected units (e. g., corporations) and groups of units (e. g., industries) will tend to form simply by the formation of connections?

    Guaranteeing bailouts for banks that are Too Big To Fail may be pernicious. But the claim that a policy of no bailouts will be sufficient to prevent banks from becoming too big to fail or banking from becoming too big is questionable on its face.

  70. I would like to test this notion of “too big to fail” to see if there is any merit to it.

  71. I will try to answer specific points:

    1) First, it’s probably worth reading these:

    They were written by James Kwak, who has slightly different views from SJ, but I believe on this issue they are pretty well aligned.

    2) The essence of the argument that finance is bloated has several points:

    a) It’s 6% of our GDP, up from 3% not too long ago; we seemed to be growing pretty well and experiencing solid quality-of-life gains when it was at 3%, but since Finance shifted into high gear (1980s) life has gotten worse. (I would note that a lot happened in the 1980s, and again in the 2000s, that fundamentally changed the infrastructure of the American economy for the worse, so it’s hard to pin all the blame on big finance.)

    b) The relative wages for finance have increased, compared to other “less productive” sectors of the economy; if the market is functioning and the financial sector were NOT rent-seeking, then we would presume that financiers must be contributing AMAZING value to the US economy

    Here’s a somewhat frightening graph:

    c) Sadly, just as finance is getting larger and better paid, we don’t seem to be benefiting from higher growth or greater productivity or (heaven forbid) a higher real standard of living for the median worker.

    d) Financial “innovation” – the creation of “new products and services” by those very smart people who are being paid so well – has contributed nothing of truly significant value for over 30 years. Basic securitization and its diversification/liquidity benefits are NOT new. (Your example – Intel – was founded 30 years ago… before CDS and CDOs, before LBOs became commonplace and before the reserve ratio became meaningless due to “innovations” like “sweeping” which use information technology to effectively evade traditional reserve ratio requirements…) What do CDS do that a combination of bonds + options can’t? (And, indeed, these markets largely run in parallel, suggesting significant duplicity.)

    e) GDP does not represent improvement in quality of life – it represents economic activity. If my name was “Guido the Shark”, and I were to create a ‘company’ that sold a special type of ‘insurance’ – the kind you could not refuse – which had high premiums but delivered no real value, the premiums paid would count as a contribution to the GDP. In fact, however, it simply represents a transfer of wealth because I’m delivering nothing of value in return.

    From a conventional economic perspective (here’s an area where economics seriously lacks common sense), it’s not the transfer of wealth that is the problem – transfers are just transfers. It’s the _wasted effort_ that goes into securing those transfers. (All those wasted finance MBAs who could have been biotech researchers…) In practice, transfers are also a problem in that they deter productive activity. So not only are we wasting valuable social effort by training our best and brightest (like you) as MBAs, but we’re destroying the incentive for non-MBAs to generate the real value that MBAs can vampirize (to support their dilettante lifestyle when they retire at 40).

    GDP, remember, does not measure _value_ in the sense of consumer surplus. That is unmeasurable. GDP merely measures trade-value, or price times quantity. Rent-seeking activities like predatory finance can make price go up without increasing quantity or quality, in which case this simply represents a tax on the entire economy. It’s wasteful in two ways: most taxes destroy incentives, and it takes a lot of effort by smart people to gather taxes.

    f) Finally, you seem to think that most of the problem is just the government’s interventionism. This, I think, is the risk of focusing so much on the Too-Big-To-Fail narrative at the expense of all the other narratives that explain how we got to our current sorry state. The TBTF narrative strongly implies that the solution is to get government out of the way, but this becomes virtually impossible when we even try to contemplate what _might_ have happened if we had let AIG fail. Let alone Fannie Mae, Freddie Mac, and Citibank. (Bank of America can make a legitimate argument that it shouldn’t be punished for swallowing Merrill Lynch at the behest of the FDIC/Fed.)

    The anti-govt. rejoinder is that if the govt. had not implicitly backed Big Finance from the start, they would never have made such stupid investments. But this flies in the face of history…

    For example, the Panic of 1907, which started when Big Finance tried to support a failed attempt to corner the copper market…

    There are a contingent of commentators on Baseline who believe that getting govt. out of finance is not really an option, and we’re better off trying to restore common sense regulations that were wiped out over the last couple decades.

    SJ’s challenge to us is two-fold: First, how do we prevent the financial oligarchs from ripping down whatever regulations we manage to construct in in 10-20 years? Second, how can regulation anticipate the impacts of “financial innovation” that is primarily designed to get around regulation rather than contribute real value to anything?

    We (and many others) have struggled to answer these challenges, though I think we’ve offered a few decent ideas.

    It’s worth nothing, also, that the Baseline Scenario’s version of the Too-Big-To-Fail argument has increasingly focused on the “oligarch” version (from the Atlantic article) rather than the simple moral hazard argument.

    Hopefully that will catch you up – welcome to the debate!

  72. You’re still focusing on the metrics of the US industry as if it operates in isolation. Take your view, count the numbers relative to the entire world, and US financial industry growth as % of global GDP is not out of proportion.

    Furthermore, if you count the value of global economic expansion as a benefit of U.S. expertise in capital allocation, you find the salaries are probably well earned.

    We tend to only see the bad side of China/US balance of payments. But the fact is without that imbalance there would be no middle class in China. How much is thier existence worth?

    Add Brazil, India, Russia, and whomever else benefits and you have a calculation problem you won’t easily brush off.

  73. wasn’t London pretty close to becoming financial capital of the earth? or even there for a short moment? I remember dimly having read a howl of triumph
    – in that context how does the appeasement of the investors from the oil-rich countries progress?

  74. Simon J. has a deeper think piece than the mass of the electorate can comprehend. And it is from this vantage point that the fulcrum for change can occur to redress the economic balance in a highly flawed political system.
    Excellent article

  75. I assume Brian is above the mass of the electorate in his ability to comprehend deeper think pieces. But since we voluntarily are posting opinions and/or statements of facts in formats that are not “deeper” think pieces, it does not seem unreasoable to ask for clarifications–particularly when remarkable assertions are being put forth.

  76. I wonder if it’s really oligarchs which are evolving
    to me it seems more and more like a feudal system
    by which I mean the basic relation of the actors is more one of blackmail than dominance

    the nobel warlords had the sovereign always in a bind because the king couldn’t go to war without them partaking with their troops – they had sworn allegiance but … there were a lot of buts and quite often

    the financers have the government always in a bind because they can always threaten to let a crash happen and thus bring inability to act if not defeat to the government which after all cannot afford bail-out after bail-out after bail-out

    the king got eventual out of his bind by getting enough of an army of his own
    I do not know enough of finance to imagine what could be an equivalent for government

  77. Silke, that’s exactly right. During the period of “globalization”, the west saw the Chinese (and the rest of Asia) as their vassals. Now everyone is thinking about how to put them back in their place and worried they might not stay there.

  78. Yakkis
    and as I have felt again and again when talking to Chinese patent lawyers they certainly did not consider me a member of a superior culture quite the contrary
    – of course while talking business I was in every way treated as it is the due of a representative of a major client but when I got them to chat, this changed even reversed and not because of any communist beliefs but because of their superior understanding of the nature of a dragon etc.
    also their service from a strictly bureaucratic point of view was superb in its client-oriented way and that, even though the Chinese patent people were originally mentored by Germans ;-)

  79. Richard Hoogesteger

    I am reminded of Aristotle who in his “Politics” observes that the problem with markets is fraud and that if you wish to have markets they must be tightly regulated to function properly. Fraud is of course a type of rent seeking and much of the problem we face in financial markets.

    Granted that today we talk about asymmetric information but it still boils down to the same problem. Being a lawyer I tend to see this problem from a slightly different perspective than my friends who went on to get Phds in economics.
    Markets are ultimately created by regulators. The great Roman market of the ancient world was created by the Roman court system. Granted that the Romans did other things to encourage markets including road-building, coining currency and so forth but without an honest umpire there would have been no market. And in fact during the dark ages the collapse of the Roman judicial system was one reason large markets ceased to exist. The creation of law schools and the development of commercial law made large scale trading systems possible again. In England specifically the development of modern commercial law by Lord Chief Justice Mansfield in the eighteenth century made the huge market of the British empire posible. In the late nineteenth century however the common law courts in both the UK and the U.S. were increasingly unable to adequately regulate complex industrial societies to prevent fraud and other types of market failure. So in the U.S. we had the rise of regulatory agencies like the ICC to help control markets. This system was created mostly by the Roosevelts and was largely based on the ideas of Thostein Veblen who openly spoke of people in certain parts of the financial markets as “predators”. For a generation after the new deal the system worked reasonably well and created one of the few large middle class societies in the history of the world.

    Starting in the 1980’s the system began to collapse. Some of this was due to globalization: Nick Leeson and the Barings scandal showed the limitations of merely national regulators. Some of it was due to the rising cost of politics, some of it was due to ideas coming from the University of Chicago, but much of it was due to generational change. William O. Douglas the man who regulated Wall Street was only dead for a few years when the system he had done so much to create began to come unraveled. Sometimes I think that fear of Douglas while he was on the Supreme Court was part of what made companies investment banks behave in the nineteen fifties and sixties.

    One danger today is that average citizens will simply lose faith in financial markets and give up on saving and investing.

  80. That’s a bit spooky because I’m presently sat at my laptop researching on the fall of the Roman Empire for a blog post next week.

    If, and that is a massive ‘if’, there are any parallels, the one of the common folk having a tax revolt is an interesting muse.

    “The central Roman state collapsed because the migrants forcibly stripped it of the tax base which it had used to fund its armies …”

    from here

  81. Another theory is the decline of the Roman Empire was caused by lead poisoning. Roman wines were sweetened and preserved by a grape syrup called sapa or defratum, produced by simmering unfermented grape juice in lead lined pots.

    See here and here

  82. I know the story as their lead poisoning due to material they used in their otherwise definitely beneficial aqueducts
    – but didn’t women use make-up containing big amounts of lead at the time?
    – I do not believe in the lead explanation – the Roman elite was forever travelling all over the empire and built aqueducts wherever they went – if lead damaged their fertility they made up for it by adoption
    and they had stopped being dependent on only their own population for staffing the military even before they reached their peak

    my personal impression is that once a society looses a certain coherence a capability of uniting to face a challenge it is in danger – and maybe coherence is most threatened by complexity by the constant improval of rules and regulations which unintentionally increases opaqueness year after year after year

    and to add some gloom: now they have the computer to throw veils without end
    at work we used to console ourselves with the quote: “to err is human to really foul things up you need a computer”
    you could find the sign prominently in almost every office of one of the lower orders – the higher ones of course knew better …

  83. like almost any info-bits that are thrown at us about the Romans it is mute about the Roman Empire remaining for quite some time alive and kicking in Constantinople holding vast territories and yes until 1453 it was never called anything else and regarded itself as nothing else than the Roman Empire and intermittently even large parts of Italy belonged to it.

    – as Constantinople was founded by Constantine this is amazing since he should be dear to any Christian’s heart (recognizing it as a state religion) and for the fact that the Muslim advance was greatly hindered by it, but that’s another story.

    – obviously the only way it prominently figures at least in the English language is by the adjective “byzantine” – maybe that’s justified but they also had a vastly higher literacy rate than let’s say the participants of the crusades and lots and lots of ancient texts came down to us through them
    – all that does not figure prominently, but why? just because Italian Rome, the Pope, still dominates the news/the history writing and does not want the merits of schismatics mentioned or because Edward Gibbon didn’t like them?

    Here is a podcast which first got me intrigued – I never was before, their art doesn’t turn me on –
    it has made me discover, read and enjoy John Julius Norwich who has 3 volumes on Byzantium, 2 on the Normans in Sicily (fascinating: start as a rogue. end as a king), 2 on Venice and an overview of the history of the Middle Sea in one volume – after any of this you’ll never focus on Italian Rome alone when you think about our early forebears

  84. Except as a practical matter there is no modern equivalent of the polis. In Aristotle’s time (although he was on the cusp of change in terms of the political structure), citizens as such participated directly in government; they did not delegate political decision-making to people who then delegated the execution of their policies.

  85. Richard Hoogesteger

    That’s true. I only referenced Aristotle to point out that the problems with markets have been discussed for a long time. Even the ancients saw a need to regulate markets. Aristotle was particularily concerned with monopolies and fraud though in his discussion of the need for inheritance taxes he is writing about the problem we refer to as economic rent. I was trying to suggest that any student of history should be able to see the need to regulate markets, particularily ones that are not naturally transparent like financial markets.

  86. Richard Hoogesteger. You’re back! I noticed your comments on benefits of a civil service.

    It seems to me strengthening the existing legal and social institutions might be the way forward out of the current “mess” in the financial system which some consider corrupted by rent-seeking activities.

    If you share this view … What legal and social institutions should be strengthened and how might this be achieved?

  87. Oh, you know, like de-capturing regulatory agencies.

  88. Richard Hoogesteger

    Well, to start, besides rebuilding the civil service I would like to see real campaign finance reform, something like the Canadian system except that we need a complete ban on economic actors like corporations making campaign contributions. Having judges solicit campaign contributions from lawyers is particularily troubling to me. If we must have elected judges then I think public financing of judicial campaigns is the only sane path.

  89. Yes, the Canadian system is different. For those reading this post who might want to know:

    (1) our judges are appointed not elected
    (2) there is no ear-marking when legislation is passed
    (3) our election campaigns are six weeks long
    (4) at the federal level, a political party receives $1.75 for every vote cast in its favour
    – the intention here is to reduce dependence on political donations from special interest groups
    – it also encourages voter turnout
    – eg, you know the Green Party won’t win but if you cast your vote in their favour you make a small contribution to the its “war chest”
    (3) there are limits on individual and corporate donations; I am not familiar with what the limits are, but I believe somewhere well under $10,000 per donor)

    In its wisdom a Liberal government in Canada — watching what was unfolding in the United States and after an extremely long-winded Canadian political scandal known as the Airbus Affair — tried to put in some forms of controls to prevent lobbyists from gaining too much influence.

  90. Edit required: after — what became — an extremely long-winded Canadian political scandal. After 20 or 30 years the “Airbus Affair” has never really reached a definitive conclusion.

  91. One danger today is that average citizens will simply lose faith in financial markets and give up on saving and investing.

    In that case, we must come up with other rackets to part them from their money.

  92. bungalowbill

    That has already been solved. Remember $4 a gallon?

  93. Simon said: “On an urgent basis, we need real consumer protection against predatory financial practices and an end to all forms of Too Big To Fail behavior – which is actually just the biggest, nastiest form of predation”

    No, Simon, we don’t need “real consumer protection.” We first need to understand how a proper book-keeping framework of rules works. The too big to fail are stealing form the system.

    Double-entry book-keeping is 660 years old. In all but the last 40 years it is the first place culture looked when things go wrong. Finance today is gaming the system in ways that only going back to insisting on a proper double-entry book-keeping framework of rules will reveal. What has passed for double-entry book-keeping since the 80s bubbles, and every government supported Ponzi scheme since, is little more than a bad book-keeping joke.

    Accountants and CFOs cannot, today, even define something as simple as debits versus credit, beyond saying “left side, right side.” Book-keeping literature and Internet attempts at book-keeping definitions are beyond a joke. Bad book-keeping is a crisis that deserves fare more attention that anyone in positions of power today is giving to it.

  94. I would go even further, whenever you hear or read something with resounding long words, get out paper and pencil and do the even more ancient one plus two equals

    refuse to sign (if you have a choice) any contract where the other party is not willing to provide you with sample calculations (in writing to take home for further reference) of best and worst case scenarios and some in between which you can understand without the help of any device other than your own head – and if you do not get it on your own and need their help watch out if you ingesting those examples takes too long for their taste and they get impatient or make you feel you are stupid – if any of this happens get up and walk

  95. It is worse than that. The financial distortion skewed all of our economic statistics as well as the distribution of wealth and capital. Here’s how.

    The Real & Virtual Economies

    A specter hovers over debates about the financial crisis. It is the prospect of realizing that our numbers about national economic performance are badly skewed by the practice of treating activity in the financial sector as an actual addition to GDP. If indeed we have been ascribing value to evanescent transactions of a virtual nature, then the implications are profound. The American economy may be far smaller than nominal figures state; rates of growth, productivity and calculations of wealth distribution may need to be revised drastically; and the United States’ place in the OECD league table may have to be adjusted downwards by several slots.
    Oddly, the import of discussions about the financial/money economy and the ‘real’ economy has slipped through our mental fingers. The logical connections have not clicked in. Understandably. A Copernican revolution in our belief system is hard to digest – especially what it threatens to shake the foundations of public policy, not to speak of collective esteem. At the heart of the matter is the simple observation that if the largest part of the value created by the trading of exotic financial instruments is fictitious then so too is counting them as additions to the economy. Let us remind ourselves that GDP figures are little more than the sum of all expenditures registered in standard statistical categories. Every time a piece of financial paper (actually, electronic dots) with little or no intrinsic value was transferred from one party to another the national cash register recorded it as a number in the tally, and did so at the face value of the transaction. This is an absurd methodology based on an absurd measure of value. We all may have been living in a world of statistical make believe.

    Questions of course jump to skeptical minds as to how this possibly could be correct. For instance, were there a large discrepancy between the aggregate amount of money people have at their disposal and the real goods and real services available, why haven’t we experienced a dramatic rise in inflation. This is puzzling. There is, though, an answer. It is estimated that at least 80% of the nominal wealth created by the phantom financial economy went to the top 2% income bracket. Their expenditure pattern barely overlaps with the other 98%. How much food can one buy? How much fuel can one consume? How many big houses can one construct? The essentials incorporated in the price index are largely untouched by the accumulation of vast wealth. When one looks at the prices of the extreme luxury goods that the super rich spent their money for, there is a noticeable price hike. Think of resort property in favored locations, speculative investment in prime real estate generally, large yachts, designer clothing, vintage wines, upscale single malt Scotch, etc.

    Finally, the truth could be that there is no way to spend the huge sums accumulated. It was invested in financial instruments, including the virtual ones that generated the fortunes in the first place. The sharp drop in their value has little practical meaning for the super rich since that ‘electronic’ wealth was never accessed. Ashes to ashes, dust to dust.

    That collapse has had a far more dramatic effect on all but the super rich. The real economy is in sharp decline; relatively small financial investments (including private holdings in pension and mutual funds) have taken a hard hit; and government revenues have swan dived, thereby limiting the money available for all government programs at federal, state and municipal levels. In one sense, we all were parties to the fictional world of the virtual financial economy. Most were only passive parties and innocent victims of the illusion’s puncturing. And most gained almost nothing from the go-go years that could soften the fall.

    MichaelBrenner April 28, 2009
    University of Pittsburgh

  96. Most of the American economy is in fact in its military bases abroad, and the tribute that is extracted from other countries through implicit threat of force.

  97. my recent reading of Byzantine history has made me aware how much tribute they paid to those at their borders to keep them away from invading and how much the procedure resemble the development aid (Entwicklungshilfe) of today.
    The way of the Romans was just more direct less loaded with implications. If you were a Bulgar with a nice military force willing to be paid by loot the Byzantine emperor would either keep you away by paying you or pay the Hungarians in your back to keep you busy with something else, same with the Seljuks and later the Ottomans

    – I am very wary of maligning the American military we had it just too good as long as they were there in substantial numbers. I seem to remember we paid for the occupation but I very much doubt that on balance we paid more than we got. And the education in friendliness was totally for free.

  98. Michael Brenner, as a non-economist, I tend to agree with your analysis. The economic bubble has been sustained by evanescent credit card debt, mortgage debt and AAA-rated financial products packaged with incredible sophistication now labeled as “toxic assets”.

    My question is: What can be done to grow a real economy in the United States? What might this real economy be?

  99. thank you for this
    and most of all for making it accessible/comprehensible to an “average reader” and of course confirming my gut feelings …

  100. Mike Rulle said-

    “We tend to underestimate any activity which does not produce physical objects directly. Yet 70 percent of our Economy does not.”

    Did you just shoot down Mike Rulle? Sounds like we’ve been over estimating “any activity which does not produce physical objects directly”


  101. What a great and correct article, Simon, you’ve done it again!! I noticed that the market fell today, not precipitously, but about 1%. Not large, but maybe a bit ominous, since it was in response to bank profits, or lack thereof.

    The banking community is going to hit another wall, and hit it hard. Mark my words, it will happen. As you put it, their rent seeking activities are not to their or our benefit. When they hit the next wall, sometime in the next year, it won’t be pretty, because all good will toward Wallstreet and the banks is now completely gone. There won’t be any more TARP to gobble up, and the guarantees will only go so far. In fact, once the health care and environmental legislation time is gone, regulation is next, late this fall, and the arguments against it just won’t work.

    Then, Congress will look at our unfunded liabilities in the way of guarantees especially, and will find that they will have to find a way to fee the banks to develop funds to control a future run on the Treasury.

  102. To Stats Guy and Bond Girl

    I can’t believe I am doing this at 2:00am in the morning but here goes. If I may, let me go back to square one and try to explain my issues/discomfort with Simon’s assertions.

    Simon began his comments with a discussion of trade deficits, specifically our bilateral deficits with China. I believe our total exports as a percent of GDP have grown at a reasonable rate (from a trough of about 7% in 1985 to a peak of about 13% in 2007/08. It is about 11% now. Imports over that same time frame were 9%, 18%, and 13% now (source, NYT, May 9th, 2009). The good news is trade is larger overall, I assume. Interestingly, as I am sure you know, our net income from these mutual flows has remained slightly positive regardless of trade deficits. Either way, the good news of more trade dominates any bad news of deficits (assuming one believes they can even be called “bad” at these levels–)

    Simon seems to agree the deficits per se do not matter in any event. He then goes on to say that “China mostly invests in activities that raise productivity”. I have no reason to disbelieve this. However, the government spending for the Olympics (including the infamous under utilized “birds nest” stadium in Beijing) has made me wonder just how much of this “growth” is over shooting. He then says they may likely be the center of a big new “Asia Century” bubble. Well, which is it? I suppose it can be both.
    but I am not sure what the “take away” should be. Are you? It is a bubble economy, but the non-bubble part, I suppose, raises productivity. While true, that has to bring a grin to your face to some degree (as that statement is true every where and always–i.e, they are always productive, except when they are not).

    But I buy into they are productive, net. Then this part bubble, part productivity machine is compared favorably to our “pattern of investment in recent years”. He then says finance is the the sector in our economy which has grown the most. I do not believe that is literally true. But finance certainly has grown substantially. Looking back long term, according to Thomas Phillipon of NYU/Stern, finance grew from about 1.8% of GDP in 1860 to about 6% of GDP in 1935. It then collapsed (war effort perhaps?) back to 2.2% in 1942. It has been straight up ever since. By 1980 it was 4%, by 1990, 6% and now it is 8%. So far these are just numbers–and frankly tell me nothing over this long history as to when finance may have been or not been productive.

    Simon says we need finance (“of course”). For some reason he believes it worked great, or least fine until about 1980. I don’t know why he believes that one way or the other. One bit of anecdotal evidence he provides that it does not add to productivity is that on average finance people apparently make a lot. (I think many people in many industries make a lot–but I won’t quibble now–but does anyone remember the tech bubble?). I certainly don’t believe we can assert prima facie, that high wages mean “rent seeking”. The bias, if anything, should lead to the opposite conclusion. But that is the point of the discussion–to determine the evidence–so lets continue.

    So far, up to 1980, all is supposedly ok in finance land. Then, apparently, something bad begins to happen because of (or maybe just within) finance. I think if something “bad” in finance began to happen, that is a peculiar year to pick. The Dow was at 700-800 or so. We had massive inflation, Walter Wriston and Co. was lending to 3rd world dictators who never default, a 15 year negative return in equity markets was concluding, and we had 12 plus percent unemployment. But whatever the cause of that, it was not the fault of finance! Who were the rent seekers then? Even if we assume the last 10 years have been a waste, I have a hard time seeing 1980 as the break point. Don’t you?

    He then dismissively states finance has merely brought us “hedging strategies”. Well, it has done that. But is that all it has done? Hasn’t the financial industry raised capital–lots of it—for lots of global industries? Is that a rent seeking activity? Please define why it is, if so. (Lets keep in mind that the entire validity of finance does not rest on the fact that we had a housing bubble in that began to burst in 2006/07–that can’t be the reason–can it?).

    Now Simon gets to his meat and potatoes. He asserts his “finance is rent seeking” idea. I will concede (should I?) that he does not mean that literally in the identity sense. He means it has gone too far. It has started to engage in activities–I think this is fair to say regarding his intent–which is predominantly one of trickery. After a few 100 years these guys finally figured out how to rip off customers (?). Some how, uniquely, these guys engaged in activities which other capitalists were unable to pull off–getting money for nothing. (I thought that was Vegas’s specialty–or is that a subset of finance?).

    I realize I now risk sounding like an apologist. However, if you were to read what I have written over the past year, you would know this is not true. But my reasoning apparently is different than Simon’s. I feel like I have walked into a different ideological world where the first principle is “finance is rent seeking”–like I missed the first month of class. But I digress.

    Oddly, Simon now ventures into territory where I am in agreement with him. The downside was “handed off to government”. I whole heartedly agree! What industry wouldn’t take free money when the dopes we elected were willing to give it to them? This should never have happened. But Simon seems to believe we were caught in a trap set by these Machiavellian financial geniuses. (Is it that we had no choice but to bail them out?) If that is not what he is saying, then I agree we should not have, and did not have to.

    The reason I think that, and I am quite sure you will not agree, is that this crisis was never as bad as it seemed. I believe the statistical coincidence of a severe regional real estate crisis, a presidential election with all the great depression talk, a Treasury Secretary with conflicts of interest (conscious and or unconscious), a Fed Chairman who did not realize the recession started in January ’08 (hence tight money), a misreading of AIG’s position–i.e over stating its systemic risk, predatory (yes!) short selling of CDS by financial institutions, an undisciplined Bush administration–both in message and action, and an incoming big government spending team on the horizon– all helped make things “not good”.
    Yes, I think that. If you are really interested why you can go to my website for last fall and winter. Its boring, but it is written.

    But this is really besides the point–at least as it relates to my commentary. Somewhere, according to Simon, our most pressing strategic priority (!) is “real consumer protection against predatory financial practices and an end to Too Big To Fail behavior”. Well, to disagree sounds like I am for predatory practices. I am for the end of absurd subsidized entities like Fannie and Freddy. I am for the end of bail outs. I am for consistent regulatory capital regimes that cannot be arbitragred. (While I am at it, I am first and foremost against massive deficit spending–which Simon places behind his first priority).

    So what am I disagreeing with? Perhaps a mild Bayesian prior infects me. So far, I see an odd assertion that “finance is rent seeking” per se. That 1980 was some turning point (?!). And if only we can protect us all from these really uniquely bad guys all would be fine. How does that happen? Perhaps I fear Simon is engaging in magical thinking that Governments and IMFs can save the day on this. Am I wrong in my reading of what Simon is saying?

    I am still waiting for the evidence that Finance is uniquely rent seeking. Of course, Simon does not really say that–he just says there is too much of it. If not in the 1970s, why now? High pay and 8% of GDP says nothing about this at all. And, my opinion is, if we let well (or bad) enough beginning with Bear Stearns, it would have probably already been smaller. Am I disagreeing with Simon, in fact?

    I really do not get his point. Perhaps I am hung up on this rent seeking tag line. Or perhaps, his point really is confused like his comment re: Chinese productivity. Which is it? He seems to be saying finance is rent seeking, except when its not. And vice versa.

  103. One parting comment:

    You mention the tech bubble of the 90s…

    One thing to note is that when the tech bubble ended, we at least had the internet and a massive telecom infrastructure.

    Just like when the railroad bubble of the 1870s ended, we at least had the railroad infrastructure.

    What have we gotten out of the finance bubble of 2006/2007?

  104. Lots of houses got built. Acres of useless empty wetlands were converted to golf courses. A few billion barrels of fossil fuels were consumed. Tons of deliberately inefficient cars and cheap chinese-made goods were gobbled up.

  105. deliberately inefficient cars

    – there was a little 3 l Volkswagen a bit more expensive than his “normal” brother
    – I think it had quietly stopped to be offered before the gasoline price bubble hit last year
    – and now we have our own very successful 2.500 € per car subsidy if we trade in the old one for a more efficient new one, but the only real miracle of gasoline saving efficiency is not available anymore (also it seems that people have already found out how to save the cars from being really dumped/crashed and sell them to countries about which nobody cares.

  106. Yakkis: “Lots of houses got built.”

    Yes, in places where they should never have been built.

  107. “What have we gotten out of the finance bubble of 2006/2007?”

    heaps and heaps of sold handbags …

    other than that maybe not even the equivalent of a tulip bulb

  108. Now that we’ve made peace (hopefully) some specific factual comments:

    “this crisis was never as bad as it seemed.”

    I have to disagree on this… In September, we were facing total monetary implosion. Inability of perfectly solvent companies to make payroll simply due to loss of access to short term debt markets (which froze). Without the 185 billion in payments from AIG, the absorption of losses for Freddie and Fannie, the investments in Citi, the support for GM, the expansion of the Fed balance sheet (including buying a trillion in short term high grade corporate paper), the subsidized acquisition of Merrill… the list goes on. I DO think this crisis was every bit as bad as it seemed. And George Soros and most other veterans agree with me.

    “I believe the statistical coincidence of a severe regional real estate crisis, a presidential election with all the great depression talk, a Treasury Secretary with conflicts of interest (conscious and or unconscious), a Fed Chairman who did not realize the recession started in January ‘08 (hence tight money), a misreading of AIG’s position–i.e over stating its systemic risk, predatory (yes!) short selling of CDS by financial institutions, an undisciplined Bush administration–both in message and action, and an incoming big government spending team on the horizon– all helped make things “not good”.”

    I’m going to take issue with just a few points… First, AIG’s centrality. Without AIG’s payments (and others) I highly doubt that Goldman, Barclays, UBS, and many other banks would still be in business. And I do not believe for a second Goldman’s claim that it was covered if AIG went under (I would need to know exactly what the counterparty risk was, especially during a total financial meltdown.)

    Second – predatory short-selling. It’s odd you focus on this, amid the dozens of other problems, but yes… Goldman had private information in August/September. It knew that ITS books were bad (due to being stuck with bad mortgage securities), thus it knew that it’s competitor’s books were bad. And, being a highly-leveraged under-regulated investment bank, it massively shorted it’s competitors (using naked shorts to boot). Which, of course, helped trigger the run…

    It also shorted the CDS (basically, insurance contracts on the mortgage backed securities) – the same CDS contracts it had recommended to its own clients (including institutional investors and hedge funds) only a year earlier.

    What a nasty, brutish, uncivilized, viciously cannibalistic thing to do. Who could believe that Goldman would do something like that? But heh, that’s the free market…

    Third, failure of the Fed to recognize that the recession started in Jan 08, and continuation of a tight money policy to stem the dollar run (which was concomitant with the commodities bubble of summer 08)… Yep, I 100% agree with you on this! Very few people get this, however, and many well-respected economists continue to state that Fed policy in 2008 was “loose”. For the best recap of this issue, Scott Sumner covers it well at his Money Illusion blog.

    Fourth, fear of a “free-spending” Obama Administration… I’m sorry, please look at the federal debt-to-gdp ratio under Reagan and Bush II… The conventional neo-con attack line that Democrats are tax-spenders just doesn’t line up with reality.

    What we do know, however, is that recent Republicans (since Reagan) have been borrow-and-spenders… Prior to getting stuck with the energy crisis, Obama’s team was all about restoring the fiscal discipline that we had under… ahem, Clinton.

    You write:

    “Somewhere, according to Simon, our most pressing strategic priority (!) is “real consumer protection against predatory financial practices and an end to Too Big To Fail behavior”. Well, to disagree sounds like I am for predatory practices. I am for the end of absurd subsidized entities like Fannie and Freddy. I am for the end of bail outs. I am for consistent regulatory capital regimes that cannot be arbitragred. (While I am at it, I am first and foremost against massive deficit spending–which Simon places behind his first priority).”

    I do not, as I’ve stated, agree with SJ on the order of priorities… But my guess is that you and SJ probably agree on more things than you think.

  109. Great post—again, no time now–but my take is a bit different–I am not wedded to my view–but many of my “disputes” with this view to me still go largely unanswered–in fact may be unanswerable.

    Again, more later.

  110. Prof. Johnson’s reason for blogging is very different from yours, Mr. Rulle.

  111. I don’t know what you mean. I blog to express my opinion on things when I think I have something to say. With fraction of his audience, my objective is to influence opinion. I am not a lobbyist; I have no vested interest one way or the other. SJ is a prof and former IMF economist. Quite a few Eco. Profs blog–I know because I think I probably read about 20 of them. I assume he is trying to 1)influence public opinion; and 2) provide a forum for learning and discussion

    Isn’t this about right?

  112. please educate me

    is there anything wrong with either 1) or 2) ?

    to me Mr. Johnson is dear because I like the way he writes English and explains stuff and also I would guess that he is smart enough to test via his several blogs how to phrase his arguments so that they will be understood as he means them to be understood

  113. No, I think both are very good reasons.

  114. Your posts strike me as earnest reflections of what you believe — a very good thing.

  115. I think you are building a straw man of Baseline’s position to take down. Recognize that I don’t agree with everything Baseline says, but before going on the offensive, you should step back and take a breath.

    It seems clear that SJ is not implying that all of finance is rent-seeking, but that recent financial innovations – largely designed to evade regulation and take excessive risk (with the taxpayer owning the downside) – have been rent-seeking. Among this list he would probably include certain CDOs, a large swath of CDS (especially non-collateralized stuff with heavy counterparty risk), various predatory credit card lending practices, possibly certain option ARMs (where interest on houses gets added into the principle for a few years, before a payment cliff), etc.

    He is clearly not arguing against securitization across the board (we’ve had securitization for, literally, hundreds of years, and JK has lauded its benefits). But he is arguing that a large proportion of the value the US economy claimed to have in 2006/2007 was illusionary – profits were massively inflated because the underlying “assets” were assumed to be much higher quality than was in fact true. Those assets proported to deliver “future value” from the “investments” that could not possibly be delivered, because the underlying “real” stuff that supported these assets (e.g. McMansions, or refinance loans to support consumption spending) were not productive but consumptive. These complicated and “risky” assets were fabricated by individuals who were highly incentivized by short-term gains (aka, yearly bonuses that were literally big enough to retire on), and the individuals owned none of the downside. Indeed, their firms owned a limited downside because of the taxpayer. This incentive structure caused our financiers to create products that would SEEM quite profitable for 3-5 years (until they could safely extract their rents), then blow up. SJ has effectively likened this to a Ponzi Scheme in previous posts.

    So far, the argument has been about rent-seeking, fairness, and equity… transfer payments (e.g. “welfare”) to anti-government finance folks. Also, about the current recessionary/depressionary shock, which was triggered by the financial crisis, and its impact (e.g. unemployment, reduction in local government services, loss of retirement savings).

    Like you, many have argued that transfer payments from middle-america to the wealthy financiers don’t impact real GDP (although conservatives, and by your blog I take you to be one, argue that transfer payments DO harm GDP when they’re from rich to poor).
    SJ’s point in this post is that there’s a REAL component to the bloated financial infrastructure, which is an underinvestment in REAL economic activities that can generate REAL value. And this doesn’t mean only physical “things”. It also means R&D, knowledge, engineering skills, etc.

    In this view, the huge profits from creating assets with illusionary value attracted vast amounts of capital (human and physical), and vast amounts of talent, and in the process CROWDED OUT investments that had lower _apparent_ value but higher _real_ value. For example, science, engineering, infrastructure, energy…

    Just imagine where the country would be if we had taken the _banking losses alone_ (not to mention the TARP money, the Fed loans, the stimulus money, etc.) and plowed it into a non-imported-oil-based energy infrastructure over the last 8 years?

    Now a lot of people would say this was really a bad political policy decision (aka, it was Dubya’s id1ocy) – the free market was not serving the national interest, and our political leaders failed to do what was in the national interest. (Why? Depends who you ask.)

    Simon (like most IMF folks) is not so willing to give up on the free market, however. The free market did not fail to make optimal investments simply because free markets are inefficient (he would argue), but because it was distorted and perverted by hugely bad incentives. These incentives ultimately have their roots in political decisions resulting from excessive political influence of the financial oligarchy. (This is the argument in the Atlantic piece.)

    If you reflect a little, you’ll note that SJ is really not an idealogue – nor have you wandered to the “wrong side of town” where all the crazy Marxists live. The argument in this post is about excessive and malproductive investments in finance, and the long-term losses due to crowding out of investments that desperately needed to be made over the last 20 years.

  116. I don’t have time to respond in full—but my quick reading of your comments are that I largely agree–but need to read more carefully. Will respond later. There is a normative and “statement of fact” conflation stirring about in many of these comments, mine included. These need to be distinguished and separated first, so more clarity is brought to the discussion (speaking for myself at least). More later


  117. Welcome. Here’s your union card & your cap.

    I think perhaps that China is concentrating too much on building a mid-20th century manufacturing economy. Yet we know that the technologies of production and the sources of energy we use will change in this century. But the financiers are not interested in new technology or sustainability, either. It used to be that the US rich were proud of creating real value. Now, as our host says, they are simply pushing the counters around and have been for a generation. So, then…?

  118. Thanks–that is funny.

    There seems to be a very strong bias–perhaps undertone is more precise–on this site that there is something uniquely “bad” about financiers; either now or for all time. This leans disturbingly close to “demonization”. The latter word itself is loaded. I think on average most people are the same. They seek work they like, and given their own trade-off scheme, tend to try to be successful. They can make mistakes. They can be good people. They can be nasty dirt bags.This is industry neutral. Industries can be high growth, they can be over invested in, or starved for capital.

    SJ and JK believe finance is “too big”. I actually do not have an opinion on that. I think also that is a very difficult proposition to support–as it is for any industry.

    What I do think is that Government has helped subsidize and incentivize bad economic activity by “finance”. This, in my opinion, is foolish. But Government does that for many industries–all foolish. But if finance is indeed “too big” one way to “fix” the problem is to do a few basic things. I think firms should be largely self-regulated. But the key to that working is to stop the incentives–negative and positive; stop future bail outs, stop the regulatory capital monopoly the rating agencies enjoy, etc.

    There seems to be resistence to this. SJ used the term “rent seekers”. That has a very real and specific meaning. A few have interpreted his comment as not literal but “in effect” rent seekers by the fact of being too big. But if that is the case, then other words should be used. As it relates to bail outs–they have been rent seekers. As it relates to their size–to the extent size has been a function of the implied moral hazard “put”—they have been rent seekers.

    But I don’t sense that is what he means. He calls them rent seekers because their percent of GDP is higher than he wants and they get paid more than he wants. He may be correct–if the causes are of the type I mention above. But, again, SJ is saying more than that–or at least I sense so. He thinks the activity itself has some uniquely peculiar ability to rent seek (he uses the term loosely, as mentioned) from “real” industries beyond any impact public policy may have. I do not know how one can plausibly demonstrate that.

    To bring up another topic to make a point—Personally, I think health care in the US creates massive incentives on the part of individuals to “rent seek”. I think health care is “too big”. But what is being proposed does not fix the “rent seeking” problem. It only will make it worse. That is 17% of our economy. Some of the rent seekers are just acting rationally given their incentives (tax free health care makes us want more of it–3rd party pay and annual fixed premiums make us want to use more health care than we pay for). But we do not and should not demonize them. They are reasonably acting in accordance with what makes economic sense.

    As I said in my previous post–I feel like I don’t have the “secret code”. It is as if “of course finance is rent seeking”. I do not accept this–at least as proposed.

  119. I agree. Financiers are just these well-meaning guys struggling to put food on the table like you and me. They caught some bad breaks through no fault of their own, and so the government did the right thing in taking pity on them, bless their hard-working souls, and kicked in a few trillion to help them from having a bad year.

  120. Personally, I prefer criminalization to demonization.

  121. US rich were proud of creating real value

    that was before they invented those huge hand bags …
    the ones in the good ol’ times did not have that temptation and therefore couldn’t succumb to it

    somewhere I have read that Chinese men have a real hard time providing all their concubines with that stuff
    – another indication that the world is about to go down the drain because in the good ol’ times courtisans would go for diamonds (remember Lorelei-Lee?) now women are contenting themselves with a piece of cloth with Louis Vuitton print

  122. Handbags: a very interesting metric!

  123. “Finance in its modern American form is not productive.”

    This man is a communist, heretic, and blasphemer!

  124. “But Simon seems to believe we were caught in a trap set by these Machiavellian financial geniuses. (Is it that we had no choice but to bail them out?) If that is not what he is saying, then I agree we should not have, and did not have to.”

    There was no trap set by evil financial geniuses, but the bailout money for Wall Street was certainly not free. It was paid for with campaign donations (free speech dollars) provided to our elected representatives by Wall Street lobbyists.

    The purpose of the campaign donations was to buy legislation favorable to Wall Street and they definitely got what they paid for.

  125. they definitely got what they paid for.

    Well, since the conversion ratio is $1 campaign contribution : $1000 benefit, and they contributed hundreds of billions, I think they were short-changed. Expect the government to make up the difference in the coming years.

  126. You are certainly correct, there will be more money going into the financial sector from the taxpayers pocket.

    It should be remembered that the bailout could, in theory, cost the taxpayer 24 trillion dollars. I think your 1:1000 ratio is still very much in the cards.

  127. “I am for the end of absurd subsidized entities like Fannie and Freddy. I am for the end of bail outs. I am for consistent regulatory capital regimes that cannot be arbitragred.”

    If you really believe the above, then lobby for an end to the “free speech dollars” that pay for the legislation that leads to the bailouts you find so offensive.

  128. I have a hunch you don’t know what you are talking about.

  129. What have your millions in wealth, accumulated from supposedly productive “finance”, done for the 6 million plus unemployed Americans? Share with us the “substance” of that.

    There are a lot of people around who don’t know what they’re talking about, even some unproductive multimillionaires from finance. They recently proved it to all of us.

  130. “I do not think this is a political issue, in the sense that one political party has ownership of it; but I do think that proponents of the free market system who mistake policies that are favorable to specific corporations for policies that are favorable to free markets are completely out-of-touch. If this debate continues to be built on mistaken assumptions, and concerned citizens continue to talk past each other, nothing constructive will be done to avert future crises. It may take time, but the cumulative effect of living from one crisis to the next is the end of an empire.”

    Quote BondGirl

    This is a great statement and,to me at least, personifies our current times where everyone is an expert and doesn’t have to listen to opposing arguements.

    Let’s face it, we are always being sold a bill of goods whether it be from tv commentators, reporters or bloggers (no offense Simon and James as I very often agree with you). And the importance of the finance industry was sold to the public as “we are changing from a manufacturing to service industry predominating country.” We were told that this was a good thing. Heck, I would rather have a fully stocked pantry than a bunch of paper bills stuffed under my mattress.

    The general public needs to be educated about all things financial rather than to listen and accept what they are told by people often backed by industry money. Things change and it is a constant learning process. Those who fight changes to our health care policy because they are happy with it will get more of the same, continual increases in premium payments.At least look at it and then you can disagree.

    Change can be good but not if you are the last to know about it.

    Sorry,I went slightly off topic.

  131. Sir,
    Though your analyse is good, it is bit behind the times. China is fast catching America in the rent seeking stakes. Check out the latest writings by chinese economist Andy Xie. Also, ever notice how China’s leaders never adopt polices that would upset their businessmen children?

  132. priscianus jr

    Great analysis. You really put your finger on it this time.

  133. Simon Johnson has nailed it. Rent-seeking is the correct way to describe it.

    The Fed is the primary conduit for the government sanctioned rent-seeking behavior by the financial industry. Regulations and licenses contribute too of course.

    And what many like Mike Ruelle seem to miss is how terribly finance can distort the real economy, far beyond the wasted MIT physics majors that reap destruction on Wall Street. As an entrepreneur I’m intimately familiar with how cheap finance and commodity speculation destroy industries. That’s what your outsized financial industry has wrought.

  134. Today in Venezuela,where I write a weekly comment, once again I cried out against the minimum capital requirements for banks concocted by the Basel Committee and that are exclusively based on default risk… as if that’s all there is to banking.

    Again I begged the regulators, or the schemers as the Joker would have called them, that if they insist on arbitrarily fooling around with the risk-allocation mechanism of the markets, then they should at least use a “risk-purpose matrix” for those capital requirements… because it cannot be that society prioritizes the financing of what has the least perceived risk.

    If anyone reads Spanish and is interested here is the short link.

  135. Gosh, this sounds really good. But it’s built upon a premise that I’ve never seen anyone prove — it’s taken as fact. I don’t believe it’s necessarily true, though, that service fees are necessarily less useful to the long-term health of the economy.

    The “problem” is phrased in many ways, mostly seen as “America doesn’t actual build anything anymore”, or “America is too dependent on consumerism”, or in your case, this idea about taxes, rents, tariffs from one segment of society on another. Well, when you use the word tax and tariff, it certainly makes this sound like a problem. But that’s psychology, not fact.

    At the practical, real-world, effective level of human action, why is it bad for me to pay a little for a long time instead of a lot all at once up front to acquire something I desire? And if I desire someone to do something for me (a service) that I can’t do on my own, why is that not as good for society (the economy) as if I want to buy a thing and own it? Where is the evidence to support the unsustainable theory? Once might also show it isn’t consumerism and rents that is the problem with America, but in fact lack of justice and equity in law, forced behavioral choices by government in the name of morality in financial affairs, subsidized consequences of bad choices with tax dollars (whether you bail out the bankers or bail out the high school dropouts, or simply insure an entire class of people so they don’t have to learn for themselves how to protect themselves in life), or any other number of market-manipulating government interventions in our rights to speak, associate, and exchange.

    Underlying this whole idea is something that sounds very Marxist — that humans exist for the sake of work; that the most valuable economy is one in which everyone all the time is always working to build “stuff”.

    Certainly humans need to conduct activities to “earn” the right to take in trade what others have (i.e. to trade the value of their activities in day N for food, then clothing, then shelter, then luxuries in day N+m that others have worked for or acquired at some point in their lives).

    But the goal of mankind’s existence is not to work. Work is a tool used to achieve the real goal — a quality of life where leisure and comfort is maximized, or if you prefer (but is exactly the same thing, where pain, misery, suffering, and hardship is minimized). Don’t brush that off without thinking it through. Think about the 9 year or coal miners of the 19th century who had no other choice in life but to follow in Daddy’s footsteps into the dangerous underground mines. Think of the Sherpas in Nepal who risk their lives in the most dangerous conditions on the planet, not because they love mountain climbing so much they wouldn’t want it any other way. It’s because they were born in a location that offers them no other choice — except for the rare few who get to “escape” and find work somewhere else.

    Don’t impart your abhorrence for greedy rich people’s excessive luxury and opulence onto the idea that the goal of common man is toward comfort, or that if everyone isn’t equally successful at achieving the goal then society is not well governed. Kurt Vonnegut wrote Harrison Bergeron, which someone points out is an excellent example supporting even Nietzsche’s critique of the idea of human equality. (

    We should not build a society that demands equality of outcome, because doing so requires someone or a few necessarily make personal subjective value choices for every single man, woman, and child in that society. And doing it through democracy is even more evil, because now me and my friends can gang up on you and yours and force you to abandon your gay lover, pay through the nose if you want that dream car, give up the convenience of having the grocer put your food in a free carrying bag, lend money to people that are unlikely to pay it back, or whatever popular notion of righteousness makes it into the popular agenda.

    This topic, Simon, sounds very good on the surface, but it appears to be build on either a weak foundation, or at least an unsubstantiated one.

  136. Underlying this whole idea is something that sounds very Marxist — that humans exist for the sake of work; that the most valuable economy is one in which everyone all the time is always working to build “stuff”.

    To me the idea that people should work all the time to make “stuff” is not Marxist at all; it is the very essence of capitalism.

    One thing thing Marx was concerned about was the negative effects that modern production techniques had on human nature (Gattungswesen). To paraphrase wildly, Marx thought people who were being forced to use modern production techniques were treated like machines instead of being treated as human beings with intrinsic dignity. When labor is bought and sold in the marketplace, laborers (much like slaves) become commodities to be bought and sold. Marx believed this to be a huge problem because he believed the thing that made people uniquely human was their ability to transform the world they live in through work.

    Nowhere that I have read did Marx say people should work all the time. He felt that when people work all the time using modern production techniques they lose an essential part of their humanity.

    To me, What Marx wrote about work more than 150 years ago still rings true today. I think you are attributing to Marx everything he criticized when he lived and wrote.

  137. I confess to having not read Marx but found an interesting info-bit/thought somewhere (London Times/TLS?) which was even new to my GDR-educated tutor in all things socialist/communist/marxist

    the info-bit is that at the writing of Kapital England was in a long lasting slump – the article mentioned a Dickens novel being written at that time and describing life in England at the time (I’m not a Dickens reader but seem to remember Bleak House) – of course the most vulnerable were hardest hit but the article wanted to suggest that Marx maybe saw this downturn this slump going on for all time – if they were right how interesting that 150 years ago somebody smart could not yet be “philosophical” about a bust and cheerfully rely on the certainty that the next bubble will surely come.

  138. I think you are reading too much into my comment. I’ll defer to someone more knowledgeable about Marxism and economic theory …

    “Remember, in Marx’s theory labor is the source of economic value.”

    My comment is only trying to connect at that *one* point. This blog is focused on rents and values. I’m simply proposing that discrediting “rent”, or suggesting it has some threshold above which it is harmful is close to the Marxist theory of value (since production is labor intensive and rents are not) and that production of goods is necessarily more valuable than production of services.

    It’s also ingrained in our psyche that hard work is what you do to “earn” something, and therefore to earn something without labor is somehow inferior or immoral. I suggest that’s an arbitrary distinction, if not simply archaic.

    I think the reason most people buy the argument that production is superior to services is not based on economics, but on the ease at which you can value something you see and feel, and how hard it is to “experience” or quantify the value of being able to find some stranger in who-knows-where who has more money than they need that is willing to lend to a stranger in who-knows-where for productive or personal use.

    It’s easy to quantify and value the sum total of cars produced by GM. But how do you quantify and value the sum total of economic activity brought about by facilitating the productive use of savers’ capital in the hands of young consumers and entrepreneurs?

    If that doesn’t make sense, check out this MIT material on how the secondary market in bonds facilitates the allocation of capital. The relevant part is the prequel, which frames the problem and demonstrates the efficiency and economic benefit of such a system.

    I’ve heard it said that America excels at the efficient allocation of capital. If that’s true, and if in fact that is a valuable service to the entire global economy, then this system of “rents” can hardly be considered inferior to a system primarily based on production.

    I’m not trying to argue for throwing caution to the wind and being cavalier about financial services. I’m simply suggesting it not be disparaged as some inferior economic value to the production and sale of manufactured goods. As a matter of fact, since the 90’s, the global economy has expanded phenomenally from the advent of the adoption of capitalism by the former command economies of the world. If then, America was the most efficient allocator of capital, it’s stands to reason that the financial services industry in America would have experienced the most phenomenal growth.

    Totally by coincidence, as I was looking up the link to, there was this title promoted on the home page. I’ve never heard of Fetter or this book, but it might be of interest to someone who wants to dig deeper into this concept of rent, interest, and financial markets. I’ve ordered it for myself.
    “Capital, Interest, and Rent” (source:

  139. Silke,

    I read this, “if they were right how interesting that 150 years ago somebody smart could not yet be “philosophical” about a bust and cheerfully rely on the certainty that the next bubble will surely come.”, and was not sure what you meant by it.

    Were you being sarcastic? Could you elaborate?

  140. UnRulley
    first please keep in mind that writing about the following in part I am translating from the German and probably do not have the adequate English vocabulary available – that said

    no I was not being sarcastic probably I was being nostalgic for a world view that for good or for evil could convince itself that it felt it had a clearly defined starting point from which to go somewhere

    – that struck me as a different world view
    – the way my “tutor” explained it to me Marx saw the condition of the world he lived in as something given something from which either further “progress” towards exploiting the masses or something better would come (about that part we haven’t much talked yet for him it is opening up a lot of old wounds, he was a believer and he is a decent man but we’re getting there, my admiration for Orwell helps) i.e. a starting point from which things would progress like a road does.
    Today we seem to see the world more in a constant waving up and down round and round bubble to bust to bubble (maybe that already existed at Marx’ time but maybe he didn’t acknowledge it as much as inevitable as we do or maybe he just rebelled against it while we have become meek and docile?
    – I’ve noticed that “plus ca change …” is currently very popular. I am very much in favor of the image of Yin and Yang when it is cleared of all esoterics and think it is a very apt image for how we think today (i.e. the seed of the opposite always ready in the dominant). But even if I believe that this way of thinking is right for our times I can still feel nostalgic for somebody who could think something through he felt he could be sure of.

    hope I didn’t mess it up again

  141. Kung.Fu.Panda

    I think that part of our problem is that the finance sector enabled/facilitated the shift of manufacturing investment from the US to China, in the name of quarterly profit targets. The finance sector globally sees itself as being independent of any state, and therefore has no problem with organizing economic activities that are detrimental to the national interest of any particular country. Even the country that hosts the primary center of the finance sector.

  142. To blame the financial sector for this particular problem is plain silly.