The Nature of Modern Finance

Is modern finance more like electricity or junk food?  This is, of course, the big question of the day.

If most of finance as currently organized is a form of electricity, then we obviously cannot run our globalized economy without it.  We may worry about adverse consequences and potential network disruptions from operating this technology, but this is the cost of living in the modern world.

On the other hand, there is growing evidence that the vast majority of what happens in and around modern financial markets is much more like junk food – little nutritional value, bad for your health, and a hard habit to kick.

The issue is not finance per se, i.e., the process of intermediation between savings and investment.  This we obviously need to some degree.  But do we need a financial sector that now accounts 7 or 8 percent of GDP?  (For numbers over time, see slide 19 in my June presentation.)

As far as we know, finance was about 1 or at most 2 percent of GDP during the heyday of American economic innovation and expansion – say from 1850.  The financial system of the nineteenth century worked well, in terms of mobilizing capital for new enterprises. 

Those banks had much higher capital-asset ratios than we have today.  Even the dominant players were smaller in absolute terms and relative to the economy – JP Morgan, at his peak, employed less than 100 people.

No one is suggesting we go back to the nineteenth century (although abolishing our central bank would certainly have undesirable consequences in that direction).  But is it really healthy – or even sustainable – to have a finance sector as large as what we face today?  (It is surely not a good idea for finance to account for 40 percent of total corporate profits, see slide 16 – such performance, in an intermediate input sector, suggests someone else in the economy is being severely squeezed.)

There is a great deal of research that finds finance is positively correlated with growth, but this work has a couple of serious limitations – if you want to derive any robust implications for policy.

First, it is about the amount of financial aggregates (e.g., money or credit, relative to GDP) rather than the share of financial sector GDP in total GDP.  I know of no evidence that says you are better off with a financial sector at 8% rather than, say, 4% of GDP.

Second, the research shows correlations not causation.  So all we really know is that richer countries have more financial flows relative to GDP, not that more finance raises GDP in any linear fashion.  Attempts to dig into causation tend to show that financial development is not the bonanza that it is cracked up to be.

Third, we know finance can become “too big” relative to an economy.  Ask Iceland.

The work in this area is still at any early stage.  Given what we’ve seen over the past 12 months, which way should we lean: towards believing in the positive power of finance, until the opposite is proven; or towards being skeptical of finance in its modern form, until we see evidence that this actually makes sense?

Surely out skepticism should extend to financial innovation.  Show me the evidence that this kind of innovation really adds value, socially speaking – rather than providing a very modern way to extract amazing “rents”

By Simon Johnson

Address of this post: http://baselinescenario.com/2009/09/01/the-nature-of-modern-finance/ (an experiment to help Kindle readers access the comments section more easily)

141 responses to “The Nature of Modern Finance

  1. Michael Wasserman

    That the financial sector is outsized in relation to its contribution to the economy seems intuitively correct. How is it that it captures such a proportion of the fruits of production without adding a proportionate value? Is it through an oligopolistic control of an essential resource? Or is it really junk food? Maybe the better analogy is gambling–an activity that produces no tangible or lasting good to its willing participants, yet yields to its operators an ever increasing share of economic output.

  2. While it’s true that correlation in itself doesn’t prove causation, and therefore the fact that the era of financialization and globalization has coincided alomst exactly with the era of real wage stagnation, wholesale job destruction, accelerating wealth inequality, exploding consumer debt, and an economy based on the boom-bust of bubble-and-crash (called the “Great Moderation” in classic Orwellian fashion), does not prove that financialization caused or helped cause these things, it does prove one thing:

    It did not prevent them.

    Therefore, if the purpose of an economy is to distribute wealth in a way fair to its creators, and to generate good jobs for all who want them, and to lay the groundwork for socioeconomic stability (and all non-Hobbesians or social Darwinists agree that this is the purpose), then financialization and its Orwellianly-named “innovation” has failed miserably even if it was not in fact intended as a direct Hobbesian assault on these things (though I believe it was).

    (For anyone who’s interested, just this morning I put up a new blog post related to this subject, titled Innovation? It includes a reference to Simon and James’ recent article on the subject.)

  3. Old Lady in Red

    I think this contains your answer:

    Occam’s razor or Ockham’s razor[1], attributed to 14th-century English logician and Franciscan friar, William of Ockham is the principle that “entities should not be multiplied unnecessarily” or, popularly applied, “when you have two competing theories that make exactly the same predictions, the simpler one is the better.”[2] The principle states that the explanation of any phenomenon should make as few assumptions as possible, eliminating those that make no difference in the observable predictions of the explanatory hypothesis or theory. The principle is often expressed in Latin as the lex parsimoniae (“law of parsimony”, “law of economy”, or “law of succinctness”): entia non sunt multiplicanda praeter necessitatem, roughly translated as “entities must not be multiplied beyond necessity.” An alternative version Pluralitas non est ponenda sine necessitate translates “plurality should not be posited without necessity.”[3]

    When competing hypotheses are equal in other respects, the principle recommends selection of the hypothesis that introduces the fewest assumptions and postulates the fewest entities while still sufficiently answering the question. It is in this sense that Occam’s razor is usually understood. To quote Isaac Newton: “We are to admit no more causes of natural things than such as are both true and sufficient to explain their appearances. Therefore, to the same natural effects we must, so far as possible, assign the same causes.”[4]

    To summarize the common understanding of the principle, “Of several acceptable explanations for a phenomenon, the explanation containing just the facts will do.”

    What is happening today in finance is errant nonsense, fantastical craziness, bizarre lunacy and, fifty years from now, we will not be able to fathom how we could have been so stupid for so long.

  4. Excellent post. Related to your third point. It is indeed possible to find non-linearities in the relationship between finance and growth. I am trying to write a serous paper on this, but I have a short note which suggests that the relationship between the size of the financial sector (using the traditional measure of credit to the private sector over GDP) and growth becomes negative when credit to the private sector over GDP reaches 70-80 percent of GDP.

  5. Love the post’s content, and I think that an approach that popularized an understanding of rent-seeking behavior — perhaps we could call “rents” “private taxes?” — would have salutary effects.

    NOTE IMNSHO, too many WikiPedia quotes. One reason I come here is to get educated on sourcing, and not to check links I already know about.

  6. “Errant nonsense” is redundant.

    Arrant nonsense is correct.

  7. Old Lady in Red

    C’est bien. Too quick!

  8. Old Lady in Red

    Our quarter-century penance is just starting

    By Ambrose Evans-Pritchard
    Published: 10:00PM BST 29 Aug 2009

    Comments 79 | Comment on this article

    Corporate credit has seen the steepest rally in almost a hundred years, according to Morgan Stanley. Hedge funds are reviving the final bubble play of early 2007, writing put options on long-dated “volatility” contracts to wring out extra profit.
    It is as if the Great Contraction – as the Bank of England now calls it – was just a random shock, as if we should naturally expect “V-shaped” resurgence to take us back to where we were. Yet that is what precisely we are being told will not and cannot happen.

    “The current financial crisis is unlike any others,” says the Bank for International Settlements. Lasting damage has been done. The “cumulative output loss” is likely to reach 20pc of GDP in the major economies. ….

    ….. We know what caused this crisis. The West kept short-term interest rates too low for a quarter century, luring society into debt: and the East held down long-term rates by flooding bond markets as a side-effect of their mercantilist strategy (ie suppressing currencies to gain export share).

    The outcome was over-investment, excess capacity, and too much debt among those supposed to buy the goods. Has any of this changed? No. Have we cleared the excess plant? No.

    Jeff Wenniger from Harris Private Bank says an army of baby-boomers have seen their old age plans shattered by the housing bust. Their nightmare is here. They will have to spend less, and save more. “Generational destruction of a society’s balance sheet down not rectify itself in a matter of months”.

    How about a quarter century?

    I commend the article and the excellent appended comments for reading:

    http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/6110621/Our-quarter-century-penance-is-just-starting.html

    I find it impossible to consider the possibility that paying banks more profit might, possibly, “fix” all of this.

  9. Excellent post, keep up the good work Simon.

  10. “the research shows correlations not causation. So all we really know is that richer countries have more financial flows relative to GDP, not that more finance raises GDP in any linear fashion”

    Yep – that’s pretty much the main problem with these arguments. (The other is spurious correlation.) I get so tired of pundits blowing up causation to make self-serving arguments.

    The latest one I keep hearing is: “A weak dollar is bad for the economy… when the dollar was stronger our economy was healthier.”

    Er… could the causation possibly be that “When our economy was healthier, the dollar was stronger?”

  11. I basically agree with a lot of this, BUT I have a theoretical problem here –

    We OFTEN complain that this is Greenspan’s fault – that he kept rates too low for too long.

    Then we go on to note that the problem was an overly strong dollar and excess lending from the east to the west due to mercantilist policies (I agree with this).

    BUT, these things are not consistent. If Greenspan had raised rates, this would have strengthened the dollar, and it would have accelerated lending from east to west (this lending manifested in terms of the dollar/yen carry trade, which was one of the dominant features of INTERNATIONAL financial flows over the last 2 decades). The lending would have supported an even more dangerous trade deficit.

    As to the army of baby boomers, I’m having a hard time being sympathetic… this is the army of boomers that borrowed 10 trillion dollars to vote themselves a 30 year tax cut and handed that debt to their kids. That bought oversized houses on leverage, figuring they would make money on property values rather than saving. That voted down a national energy policy and bought giant vehicles. The list goes on… (Certainly there are individual exceptions, but the generality is supported by the data.)

    Was the boomer generation a product of policies (they got suckered into borrowing money due to low interest rates) or ideology (Friedmanomics, which told us that if people were borrowing money then they must be benefiting) or international trade… Or was there any role for personal or generational responsibility?

  12. Simon,

    Is the possibility that finance might be of “little nutritional value, bad for your health, and a hard habit to kick” based on its propensity to generate costly crisis, from time to time, or are you thinking that finance might be junk food even when it isn’t generating crisis? If that latter, exactly who is consuming it and with what motives? I understand why people wish to eat junk food, but why would people wish to pay bankers to do things that do them no good? Or do you have in mind services that are individually advantageous / rational, but unproductive in aggregate (paying to play a zero sum game). But which bits of finance fit such a model?

    I’m not sure electricity versus junk food is the right way to frame things – what about the possibility of finance being electricity that we are being over-charged for, by an oligopoly?

    I know this is a short blog post, and you are probably well aware of the following, but reducing “finance” to “intermediation between savers and investors” loses too much. Among other things, the list should include allowing producers to lay-off risk (bad weather, exchange rates, interest rates) which should enable to producers to raise output. There’s also capital allocation (an aspect of intermediation, I suppose). One could debate the merits of market pricing, but a lot of the finance sector consists of speculation, the useful output of which is prices. Prices that determine costs of capital across listed firms, and who merges with who on what terms, and prices that motivate the actions of early-stage investors who wish later to exit via equity markets. The long-run gains to better factor allocation decisions are, as I’m sure you’re aware, potentially very large. Would you agree that speculation (which needn’t be irresponsible – a diligent and prudent fund manager is still a speculator) has a productive role?

    And, are you really sure of this assertion: “The financial system of the nineteenth century worked well, in terms of mobilizing capital for new enterprises”? How easy was it for the man in the street to obtain a start-up or business development loan, or for small firms to find VC investors, in those days?

    None of the above disproves the idea that the finance sector is too big – I can quite believe aspects of it that are unproductive* (although I’d be happier with concrete examples) and I also think there are large excess profits made from the productive aspects. I just think this post gives too narrow a picture of what the finance sector does.

    [*something like securitization may be productive if conducted responsibly but destructive if carried out as was the case recently]

  13. If one of the things that the finance sector provides is “taking investment decisions on the behalf of clients”, then how much larger would we expect such an industry to be now versus the 19th Century? What proportion of the population demand such services now, versus then?

    Note that fund management is a zero-sum game from the perspective that, on average the fund manager you pay fees to isn’t going to beat the market – but that if fund managers perform an asset allocation service, then they grow the pie by raising real output.

  14. We seem to be in an era when many economists (and very many politicians) do not believe there are any ‘laws’ of economics. They think realities are pliable and bendable; they think you can just buy your way out of what you bought your way in to.
    If true, they have no profession. If untrue, well, they have profession but have disgraced it.

  15. Thanks to Simon for another excellent post and to Lambert Strether for highlighting the need for a phrase that might popularize the perils of “rent-seeking” behavior.

    How about “tax farming”? One can argue that for fairly modest up front payments (political contributions, etc) the providers of various necessary financial services (intermediation, insurance, et al) obtain the right to collect private taxes on what have become necessary public services.

    I recall the difficulty of explaining “rent seeking” to my slightly younger brother, a very sophisticated retired attorney who got it quickly but for whom the connection was not obvious.

    If i remember correctly, the regulation of “tax farming” vexed several early civilizations.

    Keep up the good work.

  16. Petter J. Karal

    You brought up the fast food analogy, and then cautioned that correlation (between economic growth and financial innovation) is not causation. I was surprised that you did not follow up on the analogy: The life expectancy has risen strongly in correlation with junk food consumption. Doesn’t mean junk food is healthy.

  17. I think there are still financial innovations that can be very useful. Something like the opposite of a convertible bond – equity that the issuer can convert to debt at some negotiated point. Our capital markets are structured pretty much the same way they were when our main businesses were more based on utilizing capital equipment, and less based on ideas and human capital.

    There are also innovations that could help today – composite debt-equity instruments to work out mortgages.

    In examining innovation, you should look at what problem is being solved, and what the motivations are for positing a given solution. When applied to most of the recent innovation you get obscuring risk, and trading short term profits for long-term losses.

  18. «But do we need a financial sector that now accounts 7 or 8 percent of GDP?»

    Or something like 15-16% doing health care? Both of which are largely overheads?

    Well, from what I understand of many policy pronouncement over the past 20-0 years, governments in the first world have been rather worried how to generate jobs for voters; and they almost all, but more so in the USA, come to conclusion that there wouldn’t be enough jobs for everybody.

    So as a matter of industrial policy many western governments, and in particular the USA one, decided that finance and health care could be made to provide a lot of make-believe middle class jobs, and decided to steer those two sectors into growing beyond need, just to park voters; as some kind of stealth upward redistribution device.

    Suppose that in an ideal world finance were to account for 3-4% and health care for 7-8% of GDP. Yo have just made 12% of USA voters unemployed. Something like 10-20 million insurance salesmen, real estate marketers, claim administrators, … looking for a job.

    What you call rent-seeking looks like good paychecks to a lot of middle class boomers and the politicians they elect.

    Once upon a time there was massive underemployment which generated make-believe jobs in farming and servants; now underemployement manifests itself as hordes of mortgage processing clerks and healthcare claim deniers.

    What I am saying is that the rent-seeking nature of so much of financial and healthcare service is a *policy goal*, as politicians prefer to redistribute income via private rent seeking that just raising taxes and creating new public sector jobs or college students or retirees or those on disability (something that they have also increased massively to hide the dramatic collapse in the number of productive workers needed to sustain our economy).

    Sure, it is a crazily unfair and wasteful system — but the wastefulness is intentional, and the unfairness benefits high earners most, so it is all good and fine :-).

  19. Post-industrial society where everyone makes a living washing each others shirts. It isn’t just financial and health services providing jobs, but the whole service based economy.

  20. > Is modern finance more like electricity or junk food? This is, of course, the big question of the day.

    No, I think the big question is whether Simon’s posts are more like electricity or junk food. He’s clearly a smart guy, but is he committed to thinking and writing clearly about things he understands?

    For example:

    > we know finance can become “too big” relative to an economy. Ask Iceland.

    iceland served as a part of the financial sector for the entire world, not for iceland, so the percentage is not important here. mr simon knows this, obviously; why does he make statements like this?

  21. Simon, thank you for posting the big question. The first time I heard that finance in the years before the crush captured 40% of all profits, I had to ask: For what? The only thing that rang true: For filling the pockets of the politicians who allow finance to do as it pleases and who backstop it with the money from the other industries after it has fallen flat on its face. The best solution seems to me: Corporations should not be allowed to give ANY financial contributions to politicians, PACs, etc. They should succeed in the marketplace, not in congress.

  22. … until the opposite is proven; or towards being skeptical of finance in its modern form, until we see evidence that this actually makes sense?

    You should probably clarify what would constitute proof or evidence. As we know, any bad news can be spun.

  23. This is really far too mild. Of course globalization caused real wage stagnation, wholesale job destruction, accelerating wealth inequality, and exploding consumer debt–that was the whole point!

    The whole idea was to make people in countries without real laws, a very low standard of living, and terrible working conditions compete on a dollar for dollar basis with people in the U.S. over wages.

  24. Finance arises because money, like water, will always seek a way out. A government may try to find a way of limiting the flow of money between nations, currencies, and parties, but in my experience, alternate channels will always arise.

    Black markets dominate in some of the biggest economies in the world because people will find away to move their money and make it work.

  25. I find boomer-bashing deeply satisfying too.

  26. This is a good post that really starts going to the central issue… since all depends to what that electricity is connected

    If finance intermediates resources to a sector that is perceived as “risky” but that if it grows produces great benefits for the society that is a much better finance tha an intermediation to “risk free” sectors and where financing is more of a basic utility service.

    And so we could even speculate that if banks lend to BBB+ clients or riskier rated, then perhaps they should benefit from a lower tax rate on their profits than if they lend to AAAs… but, no our current financial regulators act as if it was just the opposite, because they have only one thing on their minds…avoiding bank defaults… as if that’s all there is to it.

  27. That would be very nice except for the fact that there is actually a ton of work to do but that is not being done.

  28. That is perhaps the most absurd thing I’ve read yet about Iceland.

  29. The electricity analogy obviously is the right one for the finance industry, but why is no one suggesting that the U. S. adopt the solution we found when the electric utility hogs went wild? There was a time, remember, when a few giants controlled the flow of electricity without oversight, deciding who got the juice and how much they paid for it. When the pain became great enough, the country rose up, adopted the “public utility” model, wired the country coast to coast and farm to farm, and turned America into an industrial giant. Once upon a time the utility moguls (Samuel Insull) had the kind of hammerlock on the economy that Goldman Sachs has today. So, where is the Frankfurter-FDR team of the 21st century? Why not a “public” banking system?

  30. And assuming that you’ve met a sufficient number of wall street types, I think we can both agree they should be the last people on earth to decide for our society what these “great benefits” should be.

  31. The bankers should of course not take the decision but I do not mind listening to what they have to say about it either. In fact I would at this moment settle for the regulators just wiping away all that distortion of capital requirements based on risk perceptions. Actually when risk are perceived as larger people tend to behave more carefully and there is nothing as dangerous that telling someone about the existence of an AAA.

  32. We do not have in finance electricity to take care of all possible demand so there is a need to be selective.

    I do not know your public bankers but, in my country at least, I would a thousandfold prefer a private one. They would at least not force you to dress up in red and shout silly slogans.

  33. Tax farming captures what the American health insurance business is doing.

    I find it astonishing that many Americans object to higher taxes to fund health care. Yet these same Americans will pay health insurers for the “right”: to pay for health insurance, to pay high annual deductibles, be subject to recission and capitation. When there is a major illness or injury the “right” includes: lose all your savings and home, go bankrupt, go into life long debt.

    I live in Canada and in our universal health care system there are — no such things — as recission or capitation. I read somewhere Canadians pay .1% (one-tenth of one per cent) more than Americans in taxes as a percentage of GDP.

    So the health insurance business is “tax farming” those who think they are better off with tax cuts.

  34. In the province of British Columbia where I live the health care premium is $108 a month for a family of three or more. And recission and capitation are virtually unheard of in Canadian health care.

  35. I find it deeply unsatisfying… I simply have a hard time feeling sorry for them when I’d rather spend my time feeling sorry for their kids.

  36. You can often find valuable information in the wikipedia footnotes.

  37. Personally, I see finance as something more like gut flora/fauna rather than food. You need a certain amount it to thrive. Too little and you can’t digest food properly and too much (or the wrong kind) and you can get critically ill. I think TBTF finance today is the equivalent of giardia or e coli.

  38. People from Herbert Hoover to Hyman Minsky to Norman Gall have scorned financial innovation. Minsky referred to much of it as ‘retrograde’. And Doug Noland who languishes in obscurity because he is a practitioner and a (gasp) ‘permabear’ at that was juxtiposing news of record money center bank profits/balance sheets with airline/car manufacturer’s slide into bankruptcy back in 06.

    There is plenty of evidence for what you write Dr. Johnson- no need to be coy about it.

  39. “compete on a dollar for dollar basis with people in the U.S. over wages.”

    ts, ts, ts, you are forgetting all those much cheaper WalMart-stuff people could buy which in effect increased their, the buyers’, wealth day by day even hour by hour
    - at least that’s what I get told again and again when somebody gets asked about stagnating or declining income levels
    - so everything is fine if now a McJob (that’s what we call those low wage service jobs) enables you to still afford butter on your bread.

    BTW did you know that WalMart tried in Germany and failed, I think they even closed their first and only market after some years – I still haven’t read under which brand/umbrella they operate now or whether they have really given up on us.

  40. Simon van Norden

    A nice example of what happens with a “too big” financial sector: Luxembourg (among others.) When the US has a banking crisis, the US government has the tax base to afford a bail out. When Luxemburg has a banking crisis, they don’t have the real resources to bail them out.

  41. There is a great deal of research that finds finance is positively correlated with growth

    For some reason this reminds me of the adage about financial genius: it is a long position in a rising market.

    Obviously growth is going to spin off increased finance. But whether the arrow of causation even can (let alone typically does) run the other way seems rather dubious. How is finance going to bring more people into the workforce or make them more productive? Finance qua finance can’t even provide the actual means of production; you need investment for that.

    Most of the growth in finance has been financed consumption, which doesn’t seem to do the economy any good, particularly in the long term; it’s mainly a form of upward wealth transfer (in the form of interest). Meanwhile the consumer doesn’t even actually get to consume more in the short term because of the upward pull on prices which is not matched by an equal upward movement of wages. The consumer takes on more and more debt just to have his standard-of-living growth come somewhere near his productivity growth (and not even quite match it).

  42. The walmart stuff was initally cheap, but only so the small businesses that used to exist could be driven out.
    Then the prices went back to normal or higher. In addition, you were actually paying more for lower quality.

    Walmart died in Germany because Germany already had places like Aldi, which was already more competitive and better adapted to that market.

  43. Another fun fact about walmart is that they would encourage their employees to go on welfare since their wages were not high enough…effectively asking everyone to subsidize their operations.

  44. what about the boomers on state pension Roger Lowenstein tells about http://www.uctv.tv/search-details.aspx?showID=14382
    shouldn’t they be in your list also?

    and it is always very helpful when the little ones get at eachothers throats whether for the benefit of the next generation or their own doesn’t matter – only thing that matters they are busy with controlling eachother
    - if I were on top every time I read that they are at it once again I would rejoice that divide and conquer still works

  45. this guy got a bit of an acquaintance with Canadian Health Care but not in British Columbia where hopefully such things do not happen. Beware!!! and keep in mind that I think he is very good at exaggerating but he also seems to be quite beloved by the British (strange taste these islanders have)
    http://www.timesonline.co.uk/tol/comment/columnists/jeremy_clarkson/article6814702.ece

  46. That’d make a good Weekend Comment Competition…

    We need something that conjures the appropriate parasitic imagery, while communicating that the activity crowds out productive behavior with non-productive but highly compensated activity. In 2 words. Tough problem.

  47. but surely, for work that must be done we do not have the money

  48. “there is nothing as dangerous that telling someone about the existence of an AAA.”

    … and making vast numbers of people of all educational backgrounds believe that AAA is so AAA they do not even need to know how it is made

  49. “They would at least not force you to dress up in red and shout silly slogans.”

    that totally depends on how powerful/feudal a private banker might become – once jobs with them become desirable enough they can force any uniform and any kind of silly behaviour on them – I remember dimly that WalMart tried to force its GErman employees undergo a morning ritual with together shouting sales-power-enhancing slogans – and WalMart surely is private …
    at the time there were probably still enough jobs available so that self-respecting people could afford to quit

  50. and as always the combination of junk and food must be destroyed!
    as my mother used to say “Essen ist nicht Pfui” (food is not phooey)

  51. Aldi markets are small with very limited choice like all our other so called discounters (Lidl, Netto, Penny, Plus just to name the others in my small town of just about 10000) are – Walmart tried the same thing on the scale of the big supermarkets and got a lot of ridicule for its labour motivating gimmicks

  52. the gimmick to have welfare supplement insufficient income is used in a lot of ingenious ways by employers here – not only in supplementing wages but in supplementing old age pensions so it is cheaper for corporations to send people into early retirement

  53. donthelibertariandemocrat

    I know that some people find this an easy issue to deal with, but I don’t. I can see positive uses for CDSs and CDOs. But, in this last crisis, I’m still not sure that I feel comfortable knowing what happened.

    For example, I do not accept that the CDOs were impossible to price. I think that there was a huge gap between bid and ask. The question for me is why didn’t the people ‘asking’ lower their prices? My view is that it has to do with how the bailouts are working.

    The fact that CDOs became illiquid in a Flight to Safety isn’t a mystery. I’m just not of the opinion that the Flight to Safety was inevitable or mainly caused by CDOs.

  54. Fascinating to think that the generation that was going to change the world did it by borrowing so heavily against their children’s inheritance.

  55. fascinating short introduction what happened to the British pound from 1762 to the present day – how stable it stayed all through the industrial revolution – amazing … – and what happens to accumulated savings if the retired get hit by inflation

    I wonder how the same story would read for the US and if “normal” boomers would still deserve to be regarded as being such bad people after that

    http://www.city-journal.org/2009/19_3_otbie-inflation.html
    THEODORE DALRYMPLE
    Inflation’s Moral Hazard
    An age of loose money not only destroys savings; it corrodes character.

    “I still remember the letter that the bank sent me when I was a student, pointing out with considerable asperity that I was almost three pounds overdrawn and asking when I would correct this serious irregularity. Nearly 40 years later, I briefly overdrew my account again—this time by much more—and wrote to the bank, explaining that I would clear the balance in a few days. Unusually, the bank called me: a banker wanted to see me, and would like to come to my house. I made an appointment and expected him with some trepidation.

    When he arrived, I repeated that I would pay off the overdraft, and more, in less than a week’s time. “Oh, we don’t want you to do that,” he said. “I’ve come here to ask whether you want to borrow more money.”

  56. If one looks at the attention, government support and money the financial sector has received in recent years, one might think that the finance was the entire economy….

  57. Wow! A link to a British newspaper owned by Rupert Murdoch, the guy who owns Fox-TV, while there is a disinformation campaign underway in the American health reform debate.

  58. In order to have free markets you need to have an intellectual police state in the media.

  59. Yes, U.S. banks are the envy of the world for their ability to tax taxpayers for their losses.

  60. Ten thousand thanks Simon Johnson for another important and well articulated post. At the risk of beating a dead horse, the financial innovations of the last decade, since the repeal of the Glass Steagall act in 1999 opened the Pandora’s box of predatorclass abuses, criminality, cloaked unregulated, darkpool PONZI schemes, and wanton profiteering that have grieviously harmed the larger society, and provide absolutely NO benefit whatsoever to the peoples lives, – while simultaneously massively increasing the wealth and resources, and hence power of the predatorclass, the richest 1% of the population.

    Financial innovation is “junk food”. Exceedingly expensive, highly toxic, and globally unhealthy junk food and exactly why the derivative operators are working like rabid monkey’s lobbying congress and the Obama government to walk away of from regulatons that would require transparancy and accountability, not to mention accounting the $592 Trillion dollar OTC markets – markets the benefit the predatorclass alone, singularly, and exclusively. A cloaked overtly oneside market where all the gain and benefits are funnelled into the offshore accounts of the predatorclass, and predatorclass oligarchs, and – when problems arize, like grotesque failure to account for risk, or the collapse of the irredeemable debt PONZI schemes – then these same thieves and swindlers and pathological liars, and greedmongers come running and crying to congress like little school girlz for trillions of dollars in taxpayer funded bailouts – or else!!!

    The brutal heart of the matter is “…there is growing evidence that the vast majority of what happens in and around modern financial markets is much more like junk food – little nutritional value, bad for your health, and a hard habit to kick.”, Just ask anyone in the American poor or middleclass. We glean nothing, and recieve absolutely NO benefit from modern finance which is totally focused on advancing the interests of the predatorclass, and – yet we are expected to pay the piper when the PONZI schemes, and FAILED managements, of FAILED institutions, bruting and pimping FAILED financial models FAIL!!!

    I’m long on gold, pitchforks, canned and stored food products, and guns and ammo.

  61. What good things can happen with finance that can’t happen without it? That difference is, to me at least, the measure of the economic benefit of finance.

  62. FLIMFLAMATION – The result of “Financial Innovation” on a broad scale.

  63. D. Christopher Leonard

    financial innovation may well be correlated with (gdp)growth. but then again, it probably co-relates with increased rates of autism and the publication of bodice-ripper novels. It also (in the U.S. at least) over the last 30 years has correlated with real wage stagnation for at least 3/5 of all wage earners, the dramatic increase of female labour force participation (it takes 2 wage earners to support a household with dependents), the shift for those who even have pensions from defined benefit to defined contribution – hence far greater risk, and the dramatic rise of debt per capita. I suspect that these are far more telling relationships than the illusion of “growth”.
    I also think these trends (financialization of the economy) ought to be viewed in historical perspective. They coincide with the attack on New Deal legislation – in U.S., Thatcherism in U.K. [remember the iron lady announced early-on that, "society doesn't exist"]). What may be worth tracking (a propos Johnson’s earlier piece) is changes in which elites have decisively shaped policy in the U.S. over the last 30 years. Automobiles, steel, heavy manufacturing used to be in the corridors of power – no longer. Now its F.I.R.E with players from other than the elite (e.g. rise of Southern centers such as Charlotte) and what we used to call “cockroach capital” from the west and southwest. The other big players are in international petroleum.
    A useful little ethnographic experiment you all can perform is to read the wedding announcements in this coming Sundays’ NY Times. Note carefully the bride and grooms’ place of origin, parents occupation and any prestige geneology adduced. Then note their post-marital occupations (for males 60% in financial management, or a JD plus financial management, for females, perhaps 45%}. Now do the same for September in 1990,1980, 1970, and 1960.It provides a fine tracking device for changes in elite composition – and recruitment. Might be some correlations worth examining

  64. The 19th century american economy did not have health care at 16% of GDP and growing and government at ??? % and growing. It seems like a lot of risk to compare social systems separated by 100 years of cultural change.

    What I would like you to tackle is the issue of the Federal Reserve and the claim among the right that it should be terminated and a new form of currency(gold and silver) be used to keep the government from creating paper money. We had precisely that kind of system in the 19th century and the Paulinistas believe the average American was much better off.

    We had the Populist Andrew Jackson who destroyed the existing Central bank and the Populist William Jennings Bryan who railed against hard money policies( “Do not crucify us on a cross of Gold”)

  65. Doesn’t this exclude the nature of our demand for funds?

    We collectively borrowed huge amounts of money to fund a war and severally borrowed huge amounts of money to put granite countertops and Viking ranges in every subdivision in the land. Neither of these made us more productive.

    Had we raised rates and run balanced budgets, the dollar may well have strengthened on the back of eastern capital flows. But those capital flows would have gone into productive capacity of some sort, and we would be facing something much more like the pharma company bubble or the internet bubble: an exuberant surge of investment that yielded low real returns to the investors but positive externalities for the rest of society.

  66. I would like to see someone trying to correlate house prices or capital costs of non-financial companies with finance sector profits as a share of gdp or other indicators. If someone talks (talked) about cheaper mortgages thanks to securitization (it may still sound logical with exclusion of pre-crisis ‘system design flaws’), an opposite might have happened with house affordability exactly due to the oligarchic size of finance sector. Is (e.g.) house affordability negatively correlated with financial sector’s share of corporate profits?

  67. I’ll add one more question following a possible positive answer to the previous question:
    Shouldn’t central bank’s growth and inflation policy only target money supply and interest rates for banks then and could finance sector profits somehow be targeted as well?

  68. It’s funny you use the word “predator class”, since it does remind me of a nature film I saw. The zebras and wildabeasts would stand around completely oblivious to the fact that lions were going to pounce on them and tear their flesh off their bodies.

  69. Cheaper mortgages? You mean the interest-only ones where the rates reset higher after a few months?

  70. Maybe the most frightening question (in the light of the financial de-regulatory fanaticism that gained steady momentum for 30 years) is what would the percent of GDP devoted to finance alone be currently headed toward had we not had the credit markets themselves shatter to pieces under their own weight? 10%? 25%? 60%? What are the implications for the organism when certain cells turn cancerous and start turning everything else into themselves?

  71. It’s probably important to remember, in the middle of all the very real consequences of the bust of the Great Credit & Consumption Immoderation, that additional U.S. Gov’t debt is not (contrary to all the speeches) a threat to any future generation. The U.S. prints the world’s currency, eliminating the need for higher taxes or currency devaluation to pay any of the debt back. If you don’t believe me, ask Ronald Reagan or George W. Bush, both of whom increased spending at the same time as cutting taxes. Or better yet, ask Dick Cheney – who accurately noted that “Deficits don’t matter” (meaning not only that the world still needs our dollars and the U.S. electorate will not penalize your increasing the national debt as long as you keep cutting their taxes). Unlike Argentina, the U.S. is not vulnerable to currency runs (because the dollar is the reserve currency and everyone on earth gets screwed if it collapses), and doesn’t need to default. The national debt will not be paid back, ever, by anyone, and represents no threat to anyone’s children.

  72. I think the good and evil for finance, or any industry, is in the multiplier effect on the economy (measured lots of ways good and bad). Good ideas find capital more effectively with technology and finance. Risk is spread through distribution. But the process starts with effective finance mechanisms.

  73. To put it another way, just as “Borrow and Spend” replaced “Earn and Spend” by the consumer, “Borrow and Spend – commencing in 1980 – has replaced “Tax and Spend” by the government. The government, unlike the consumer, creates the money supply (itself a type of non-callable credit) and can borrow forever.

  74. The term “Ponzi Finance” is being thrown around a lot, but its originator, Hyman Minsky, laid out the criteria for evaluating the difference between productive and ponzi very simply and clearly: debt for the purpose of capital investment, which is paid back by the proceeds of the investment, is productive. Debt for the purpose of ongoing operations, and which must be re-financed regularly to sustain operations, is unproductive. Debt for the purpose of making interest payments on existing debt is Ponzi Finance and always self-destructs. You can apply these criteria at both micro and macro levels and you will get the same results. The only mystery is why the delusion was sustained as long as it was.

  75. In case no one noticed, for some time the following sectors (combined) have accounted for more than 60% of GDP, with their share on a steady increase:

    Entertainment, Defense, Finance, and Health Care.

    The problem goes beyond rent-seeking to the attitude that we need produce nothing of inherent value in the pursuit of our own pleasure and security, since that’s what the peasants in the rest of the world are for.

  76. The percentage is everything. Funding a chunk of the world’s carry trade at multiples of her own GDP financially destroyed Iceland when that trade collapsed.

  77. Or, as Galbraith put it, almost all financial “innovation” is just the same old leveraged gambling schemes seen again and again clothed in the latest jargon and math.

  78. Thank you. There is no financial reason on earth (other than to promote the expansion of F.I.R.E.) for mortgages to be cheap. There are other, socio-political reasons (with which one can agree or disagree), but they are not financial. The fact that, going into the Great Depression, mortages were the exceptional – not the normal – form of home ownership, with downpayments averaging 35% meant that the government could successfully (including a profit at closure) buy all the delinquent mortgages from the banks and refinance them for the homeowner on its own terms, to save both the homeowners and banks. Probably the most impressive government financial crisis intervention in all of history. Now we have the pathetic sight of the government pleading with the mortgage creditors,and throwing money at them, to try (generally unsuccessfully) to get them to re-finance negative equity loans. Oh yeah, and the government isn’t buying mortgages, its buying wothless financial instruments (MBS) on hope that this will keep morgages cheap (the original problem).

  79. Of course, but anybody can find them. What I want are the sources Simon Johnson would use, not available in WikiPedia. That’s how we learn, by study!

  80. Can anyone commenting here give me a definition that would explain the difference between single-entry bookkeeping and double entry bookkeeping?

  81. Larry Kudlow is Giddy

    Looking at the last nine months through this perspective, it’s hard to understand many of the decisions the Obama administration has made. Has improving conditions for the greatest possible number of Americans really been its goal? If not, why not? And if yes, what a funny way to go about it!

    Take the bank bailouts. The dust is finally beginning to settle on that front, and what we are seeing doesn’t bode well for the ongoing health care fight.

    Two days after Senator Kennedy’s death, and thus not given much attention, there was a shocking piece in the Washington Post about how America’s “too-big-to-fail” banks have gotten even bigger since the meltdown. Four banks (Chase, Bank of America, Wells Fargo and Citi) now issue 50 percent of America’s mortgages and control two-thirds of the nation’s credit cards. According to FDIC chair Sheila Blair, this kind of consolidation of power “fed the crisis, and it has gotten worse because of the crisis.”

    And the consolidation isn’t over. As WaPo’s David Cho points out, these mega-banks now get even more favorable treatment from creditors because the creditors know the banks will be bailed out by taxpayers if they take on too much risk. This favorable treatment includes lower borrowing costs than other banks are able to get. This, in turn, will put even more of these smaller banks out of business, furthering the concentration of wealth and power. And Democrats are ceding the populist field of trust busting to Republicans.

    Though the big four banks have all recently announced multi-billion dollar profits (with a bottom line handsomely padded by all of us), three dozen smaller banks have gone under in the last two months.

    As Mark Zandi, chief economist of Moody’s Economy.com puts it: “the oligopoly has tightened.” Which is what oligopolies tend to do when left untended.

  82. Single entry bookkeeping is for oil-autocrats who just register the asset with no need of registering to whom it belongs… as in a chavez saying “all this cash is mine to do as I please with”

    Double entry bookkeeping instead is for us mortals in an oil revenue sharing scheme, on the asset side, first entry, “there are billions in oil revenues” and on the liabilities side, second entry, most of it belongs to my fellow citizens but a couple of these dollars are mine.

  83. I’m not sure that this is the way to address the question of the moment. The chief problem is not finance but the way it is practiced. Even for those of us without access to the opaque or forensic tool can easily see that a lot of what went wrong wasn’t so much finance per se. It was overreach, magnified by unethical behavior and massive fraud in the face lax regulation and willfully blind regulators in a political system captured by the financial industry. then, people got so giddy on the money, they just didn’t do the simple math that would show how much of the debt they were underwriting could never be repaid. “No job, no income, no problem.” “Got a problem? Not to worry. We’ll just change the accounting rules.”

    If this problem is corrected, the financial industry will shrink of its own accord as the easy money dwindles. If it is not corrected, who is going to bail the Fed out of the next bubble bursting? The Treasury?

  84. “If most of finance as currently organized is a form of electricity, then we obviously cannot run our globalized economy without it.”

    Finance is a lot like electricity, but the question really should be, is finance as it is currently like a very efficient smart electrical generation and transmission system, or is it like a largely socially inefficient system that’s grossly overpriced and subjects the country to the devastating and high risk of massive and prolonged failure. And that because of it’s bloated size has a great deal of control of the political system that it uses for its benefit at the great cost of everyone else, and to prevent increases in efficiency.

  85. Please add to my comment above, after “prolonged failure”, “as well as common electrocutions of citizens and their families, and blow ups of their homes”.

  86. “Debt for the purpose of ongoing operations, and which must be re-financed regularly to sustain operations, is unproductive”

    What does that mean? Additional borrowing just to stay afloat, without generating any future returns, is trivially a bad idea. But it is perfectly sensible for firms to be debt-financed, and to service that debt (and re-finance it) as part of their ongoing operations. It’s renting capital. You could argue it’s prudent for firms to repay the principal on loans that were taken out to fund capital investment, but there’s nothing “unproductive” about choosing not to.

  87. Thank you. How would you define a gambling bet, as single or double entry. In other words can one double-enter a gambling bet if there is no artifact as asset value at stake?

  88. I paid 10 dollars for this lottery ticket where my expected return (probability times the prize) is only 2 dollars. If accounted real time, before the drawing, on the asset side Cash minus 10 Expected Lottery profits 2 and on the Liabilities side a loss of 8. But then, if you have a financial model that supports the theory that you are guaranteed lucky and will win the jackpot perhaps you could record a huge profit instead.

    But, just in case, the current crisis was not really about investors taking bets. They read the lottery conditions and there it was imprinted, in AAA letters that they would be repaid 100% of whatever they invested plus interests, and this simply turned out not to be true.

  89. Many of you are pointing in the right direction. In the extensive Basel regulations for the banks there is NOT A SINGLE WORD about the purpose of the banks because the only purpose of them for the regulators is to avoid a bank failure. I have been screaming about it for years now (since 1997) because I do not care one iota for a bank that survives but brings nothing good with it and I do not mind at all seeing a bank fail because it took the right kind of risks a society wants it to take.

    And we now have to bail out the banks because they financed the wrong kind of mortgages mostly because they followed those credit sentries that the regulators basically imposed on the banks. Oh what a waste!

    This crisis is the direct consequence of allowing a group of nerdy wimps (the schemers as the Joker would call them) to gather in a mutual admiration club and decide on bank regulations as they wish and please. And they still do so, in almost splendid isolation.

    Any person with experience on the streets could have told the regulators that if they gave so much power to the credit rating agencies these would, sooner or later, be captured. But no, they had to know better. Regulatory arrogance should be put in jail, at least over one weekend.

  90. Returning to the original post, I suggest this audience read The Long Twentieth Century by Giovanni Arrighi which traces the epochal shifts in the relationship between capital accumulation and state formation over a 700-year period. What we are experiencing now in the US is simply the final stage of a cycle where we can make more money lending our capital out than in the original activities which created the capital in the first place.

  91. This holds true only in so far as investors continue to treat US debt (the promise of future dollars) as nearly equivalent to present day US dollars – you are essentially arguing that US debt is almost like an expansion of the money supply.

    The problem is if US debtholders at some point want to convert back to dollars (or some other currency or asset) en masse, or simply stop buying new debt – that is, the US can’t rollover its debt obligations as they come due.

    Even the FEAR of this happening in the future creates massive swings in expectations about the inflation rate (how much money will they need to print if investors stop buying US debt?). This can force interest rates higher… making it more expensive to borrow, and forcing the government to engage a tight money policy (which crimps the economy and lowers tax revenue) right when it needs the extra tax revenue to pay that debt back.

    Generally, you are right that we probably overestimate how bad off the US is relative to the rest of the world in terms of debt (most of the EU, and Japan), but I suspect that Cheney is wrong here. (His track record isn’t great.)

  92. Right, but the AAA turned out to be worth .30 on a dollar because the artifact was miss-valued in the first place. Nonetheless, when the paper moved fast, someone along the line, got the full dollar value out of the bet and move the paper on to the next unfortunate person. And, of course, this was done in epidemic proportions.

  93. Dan and Per, enjoyed reading your comments. I am not an accountant but Dan seems to be on to something. A “sleight of hand” by modern financial engineering that lead to accounting practices without accountability.

  94. BRUCE E. WOYCH

    (The address location is a big help…please continue that link for comments).
    In retrospecr, the Economist did a great summary job on evaluating the threads of emergent disaster in our instrumental institutions (see: http://www.economist.com/displaystory.cfm?STORY_ID=12415730

    Historically, however, the hypocracy of liberalization is that somehow it portrays itself as freeing individuals from “government” when in fact (starting with Nixon, Reagon and certainly the Bush Dynasty) this misnomer of pure privatization under libertarianism has been a stratified system of elite anarchism supported by direct political capture. Political intervention has simply changed over to a libertarian republic and finance is the glue and the grease to that machinelike dictates and doctrines.

    The discernment of finance must begin with defining the term in context (vivo) over the clinical (en vitro) applications (or apparatuschick over instrumentalism).
    Finance, however, is more commonly addressed in an increasingly impotent context of institutionalism. “The Process of intermediation between savings and Investment…” is certainly a nice phrase. Finance, therein, is a powerful tool for a catalytic conversion and possibly even an instrument of fission and fusion that promises critical mass solutions to world poverty and creative wealth. LETS GET REAL! People mobilize finance and finance mobilizes people. Today, real politik, finance mobilizes politics and politics mobilizes finance. Purpose and intentionality underscores the who, what, where, and why; while economists and business simply concerns itself with the “how” it is done. When Nixon floated currency off the gold standard it was to essentially to restructure debt.(That particular debt was largely military and political). There were, at that time, assets grounding finance (capital / asset ratio). Vital interests were linked to those assets and the float was grounded by self preservation.
    Today Finance has become like language itself, it is a “universal” contrivance to convey values that shoulod exist. But just as language can become jibberish, finance can become worthless with its expansive abstract of universality. When finance has, as its primary objective, the production of finance we end up with more and more “obscurity” and with less and less “security”. Finance in the abstract is not only allowed to cross natural boundaries of self preservation, but can even evade ( and decommission) conventional firewalls that were put in place to prevent overexpansion and blind intensification of interdependent risk. Finance, in some sense, has created its own currency of symbolic wealth in securitisation and collateral debt obligation instruments that ultimately impact the very carry trade of global monetary standards. The trasfer and translation between financial instruments of wealth and real time currency; and the proportionate ration (ratio) between real currency and authentic assets (linked to both ecological and environmental / geopolitical constraints) is where the gross international crisis is spinning out of control. When you put this all off shore, the business office of global finance, it is impossible to say who is truly dictating the power economics of political finance and or where the global conformity is being driven. The standard rhetoric does not do justice to reality. Freedom and democracy is being franchised to a global republic with a corporatist constitution. Americans had better keep a very careful eye on their constitution because “justifiable dissolution” is the name of the game. The arrangement, meanwhile, is between buyers and losers. Moral Hazzard? Perverse Incentives? Nice words.

  95. Tom, you are right : Why are we still lamenting the symptoms (size, bonuses etc.) at this point?

  96. but that’s because Zebras etc relied on their smell to figure out where the lion is and the lion is smart enough to operate shielded by the direction of the wind
    - once the Zebra will have learned to use more than one sense for danger alert the lion will have to come up with something smarter too or change his food habit and so on and so on
    - by the way almost the worst I ever saw was not lions going after Zebras but wild hounds tearing chunks of flesh out of the hind quarters of a fleeing Zebra – somehow I fear that this is going to turn out a more apt image

  97. Yes Dan and the fact is had it not been for the AAAs not one single of this securities would have been purchased and, with no buyers, not one single of the bad mortgages would have originated.

  98. Hi Tippy, the issue here is between single and double entry bookkeeping. Double-entry, if properly tracked, cannot track gambling bets because there is no artifact to record as the right of capital potential. So some of the owners of the bonds could not have been doing double-entry bookkeeping. They had to be recording data in a single-entry mode. The question this brings up is whether financial institutions should be required to keep their books in a proper double-entry manner.

    A typical single entry example is a bookie who records a slip for each bet he accepts. If the bet wins he pays it off and if it loses he keeps the money. Many institutions are clearly using the bookie’s form of bookkeeping

  99. Thanks Dan. Bookies did you say? All very fascinating.

  100. Oh no. This is climbing up the wrong tree when the fruits hang low.

    That is not where the problem lies. Of course all bondholders “accounted correctly” for the bond holdings as would your bookie also be doing since without it he would have no chance of checking up on the odds he was offering and so would not have remained a bookie for a long time.

    I am sure that even Madoff kept a very correct set of” books” perhaps with triple or more entries, without which it would have been impossible for him to juggle for decades.

  101. “The only mystery is why the delusion was sustained as long as it was.”
    that’s the least of the mysteries
    - once something has been elevated to the level of dogma or doctrine and you have confessed to be a believer it is extremely hard to admit that you were mistaken that you have fallen for a fraud
    When I have trusted somebody’s teachings, tried to convince others to see the light also and then I find out that I fell for a false prophet I feel humiliated for quite some time before I pull myself together and get furious and vocal – or I may choose to stay mum for fear of being ridiculed

  102. I’ve heard corporations keep two sets of books. One for their shareholders and regulatory purposes. The other for internal use. Is this true?

  103. “that’s what the peasants in the rest of the world are for”

    that will not go on and on and on either
    in the 70s I was told what a great progress for mankind it was that you could now produce ten times as many sweaters with one tenth of the workers thanks to this superfabulous machine
    - the question who would still have the money to buy this 100x output the answer was the laid-off would find other sources of (much higher) income
    so far this has worked less badly then simple paper-and-pencil-style-calculation seemed to predict
    - but nothing that has happened in the past 30 to 40 years has convinced me that the above question is not a basically unanswerable one – maybe to hide that fact the economists have created their lofty jargon

  104. Once upon a time the Fuggers financed the Kaiser against interest and influence – now the government finances the banks (Fuggers) against almost no interest and zero influence?
    If I got that right then the world is truly upside down

  105. because as long as the symptoms persist it is reasonable to assume that the disease that caused them in the first place is alive and kicking

  106. Financial Sector Profits: Markets Self Correct?

    On a trend basis, financial sector profits as a share of domestic corporate profits, peaked at 39.3% in the second quarter of 2003. That share steadily declined to 23.3% in the first quarter of 2009.

    The following are some of the trend percentages over the time period 1984Q2 to 2009Q1:

    1984Q2 17.7
    1987Q2 23.4
    1990Q2 28.6
    1993Q2 29.7
    1996Q2 27.6
    1999Q2 32.1
    2002Q2 38.4
    2003Q2 39.3
    2005Q2 34.5
    2008Q2 25.6
    2009Q1 23.3

    Technical Note:

    Corporate Profits are pretax domestic( without IVA,CCA) from Fed Z1 releases.

    Trend is calculated with a Hodrick-Prescott filter.

  107. You are correct, we are now moving into a different domain, which asks: “What constitutes a proper set of double-entry books?” I will be arguing this point in the future. Keep in mind that Goldman and Paulson had shorted mortgage bonds as early as 2006.
    http://www.nytimes.com/2007/12/06/business/06hedge.html?ex=1354597200&en=ee60a359ac7f1a9c&ei=5088&partner=rssnyt&emc=rss
    According to this story, Goldman packaged more than $6 billion in bonds after they shorted the first batch.
    A question might ask how soon was this information was made available in the marketplace? These are question, I predict, will be a part of what constitutes a fair and accurate double-entry accounting. And most of all, will future derivative activity be transparent. Your point is correct, but there is a lot more to the bookkeeping story that will come later on.

  108. I think you language has become jibberish

  109. That would not be unusual if for no other reason than book value differs from market value. There is bad book-keeping going on, for sure. But most people are honest. If the bookkeepers and accountants are honest, they can use today’s software to keep a fair and accurate set of book.

    The bad part is that most bookkeeping software that I have studied lets the dishonest fudge the books almost at will. In a computer age, it ought to be the reverse. That the bookkeeping program, as a control language, ought to be keeping cleaner than ever.

  110. the argument that the program allows “adjusting to the special needs of the company buying it” was a main feature in the sales pitch of the computer programs offered to “my” department
    - Of course as I have never sat in on the presentation of an accounting program I can. after savouring your comment, only guess how this argument would go down there, maybe not on the cubicle level, but for those who have to keep more important problems in their focus than something as simple as 2 + 2 = 4
    - thank you for enlarging the meaning of a very familiar sentence

  111. do you guys mean I have to give up on the Times obituaries (lots better than those of the NYT, a paper which apparently is still permitted), Charles Bremners blog, Rod Liddle’s soccer comments and the TLS? (and my most guilty feeling read Mary Beard’s blog)
    or can I become somehow absolved of this sin by some kind of indulgence (no money promise that one)

    If Jeremy Clarkson’s tirade in favour of the (highly socialistic ;-)) British NHS after having experienced Canadian health service is part of Rupert Murdoch’s disinformation campaign then he must consider British readers to be very capable of twisted logic
    - OK maybe you’re right, those weird islanders are addicted to riddles, just look at all this incomprehensible stuff in the otherwise wonderful Harry Potters

  112. Wow, I’m late to the party.

    Well, I’ll give it a go anyhow. If we are looking for causation, a reason to believe that what happened in the finance sector was actually bad for the rest of the economy, may I suggest the “Dutch disease” as the model of choice.

    This is not a new idea. I am merely identifying the model associated with an argument that others have been making. By running up wages in finance, we have pushed young minds away from other endeavors and into finance. That’s the direct de-industrialization side of the Dutch disease. The indirect side can be seen in the rise in housing prices.

    Now, our hosts point out that the work done on this issue has in general shown that richer countries devote more GDP to financial activity. That is not really new news. Another way of saying pretty much the same thing is that advanced economies are more monetized than less advanced economies, and we’ve known that for a long time.

    I think causation in the general case is interesting, but the general case misses what is important about this case. Did rapid growth in the finance sector accompany above trend growth in the rest of the economy? Put another way, is there evidence that devoting an extraordinary share of resources to finance did the rest of the economy any good?

    If not – and the pace of growth in the last expansion suggests it did not – then did it do any harm? Here, I have been too lazy to look, but I can guess. If overall growth was nothing special, and growth in finance was strong, growth elsewhere was necessarily not strong. Ah, yes…that’s the most consequential symptom of Dutch disease. Resources are pulled into the “resource” sector so rapidly that other sectors are depleted of resources and grow poorly.

  113. Oh, sorry…

    So in conclusion, at least at the level of monetization the US reached in the past decade or so, additional finance is junk food.

  114. You are not that far off, in fact you are very close

    Countries rich in natural resources when receiving the income from selling those resources and which have little to do with their internal productivity level see the currency strengthened and that in its turn makes it more difficult for other sectors of the economy to remain internationally competitive. That is what is normally known as the Dutch Disease. If you the compound the previous with like all the income from the natural resources sold are received by the government… well that is when you graduated into truly “cursed” areas like the oil-curse we suffer in Venezuela.

    The US has its own very particular natural resource it is selling now, namely the “safe havens” which means it attracts a lot of foreign funds to be invested in mortgages or lent to the government, and which produces the same effect. Little by little the US is becoming a “safe-haven cursed country”. Good luck!:)

  115. “safe-haven cursed country”

    but Per, if that should happen then the dollar would become just like a commodity, a marketable item the production of which requires little manpower measured against its value?

  116. For the time being, isn´t it? Have you not seen the Bureau of Engraving and Printing? Not a lot of manpower there!

  117. They tried that in Weimar Germany and look where they ended up.

  118. Low interest rates and “excess lending from east to west” are not inconsistent factoring in mercantilist deferred labor compensation. Unable to earn enough to consume at a rate necessary to sustain consumption, labor need borrow to consume. To provide the capital necessary for increased borrowing, producing countries need buy U.S. securities, subsidizing their own production.

  119. Tom Frank (“Wrecking Crew: How Conservatives Rule”) makes the point that a core Republican strategy has been to defund the left by spending public funds on private projects without raising taxes to pay for them – “borrow and spend” Republicans, the party of fiscal responsibility. Clinton’s chief economic advisor, Joe Stiglitz, wrote that the Clinton administration was handcuffed in their plans to pursue social programs that required fiscal outlays by the deficits they were handed by the Reagan administration. As responsible governors, they managed policy to reduce the annual deficit and, eventually, to produce a surplus while foregoing social programs they wanted to pursue.

    We are faced with this situation, again. The Bush/Cheney administration has distributed tax dollars to their friends and cronies while they ignored Rome (New York) burning. This distribution was accomplished directly by “outsourcing” to the private sector (especially via war-driven defense spending), by reducing taxes overall, flattening the rate of graduation of income taxes still further, legislating loopholes targeted at industries in which the major players are their friends and co-conspirators, reducing funds available for the IRS to collect taxes while outsourcing more than half of collection activities and directing the IRS to focus on the low-hanging fruit for abuses, that is, the Earned Income Tax Credit (which, btw, benefits the working poor and lower middle class), while ignoring evasion schemes and downright lying by upper class and wealthy tax payers.

    The claim that “deficits don’t matter” is disingenuous. “Reasonable” deficits don’t matter; this debate isn’t new and there is plenty of research on the topic. Deficits approaching 100% of GDP do matter, even when you monetize the debt with the world’s reserve currency. Ask the Japanese, the Argentinians, and the Thai, among others.

    This issue is politically important. For example, the conservative establishment and press are co-opting the discussion about health care/health insurance reform by making it a discussion about deficits and claiming that our children and grandchildren will pay for the profligate socialist programs that the Democratic Party wants to “ram” through Congress.

    Michael has one thing right – the national debt, if kept to levels expected to result from current policy initiatives, will not be repaid in full and represents no threat to anyone’s children or grandchildren. But, it can’t be sustained at very high levels and although the dollar is the world’s reserve currency, today, this condition may change. From the early 19th century until WWII, the pound had that role. We shouldn’t be so certain that the dollar will play this role forever. I wouldn’t be surprised to see a basket of currencies or the Renminbi assume this role in my lifetime.

  120. Actually, one famous negative correlation is between the Dow Jones Industrial Average and the average length of women’s skirts…:-). It was good for the entire post-WWII period through 1980 (which is as far as I know it was followed).

  121. Yes and no. It’s really a matter of one data set that enables many reports built for different purposes and different readers (employees-as-managers, the IRS, the SEC, family members who own shares, investors, employees-as-shareholders, etc.). The issues are complex and specialized, which is why “full disclosure” is impossible (they would have to tell you everything – too much info sharing!) and doesn’t mitigate the ability of the reporter to manipulate the reader.

    Corporations that comply with the “rules” keep only one set of books that are capable of reporting results of operations (profits and losses) and financial condition (balance sheet) for different purposes. The “rules” originate from different bodies and serve different users of the information that is reported – SEC for the publicly held, Generally Accepted Accounting Principles – GAAP for everyone with shareholders who are not officers and anyone who wants to use it – it’s the gold standard of financial accounting practice, tax basis or cash basis for sole proprietors or closely held private companies.

    If a company’s owners want to cheat, then they keep two sets of books – the real books and the fake books. Basically, the fake books simply ignore transactions that auditors can’t expect to find paper support for – cash transactions.

    I managed (did not own) a granite fabrication plant for awhile. 90% of our work was commercial and had all the usual paperwork, but about $600k constituted sales of tile directly to consumers who, somehow, found there way to our factory showroom (not easy). About half $250k-$300k) of those sales were for cash or check. Because waste is very high in this business and consumers never had reason to report any of this on their taxes, you could deposit the checks and the cash (the cash quite safely) without reporting it on the financial records. Just put it in a separate account at a different bank and write off the tiles as damaged. This practice is quite common. Not my choice, but the owner loved it. And, it would be very hard for an auditor to discover the scheme. In the “real” books, you still record the cost to cut, polish and pack the tiles and the revenues from the sale, but those books stayed in the safe or off premise.

    Does this answer your question?

  122. You’ve got to be kidding. Aside from the financial drain on income represented by interest costs (which would be unnecessary if there were sufficient revenue to meet costs), and the many other reasons (including the oh-so-hard-to-imagine moment when credit tightens and you can’t refinance) funding operations with debt is unproductive compared with funding operations from revenue, take a look at the thousands of businesses who adopted your point of view and now CAN’T meet their interest payments because of declining revenue (because of declining demand for their products or services) and which are now delinquent or defaulting on their debt. It was precisely this misunderstanding of the stability of unproductive (and ponzi) debt that produced the credit crisis and the current recession.

  123. Dan you write: “But most people are honest. If the bookkeepers and accountants are honest, they can use today’s software to keep a fair and accurate set of book.”

    I’m not sure about this. Remember Enron and Arthur Anderson?

  124. What a great article. I think there is alot on manpower there.

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  125. I view a healthy economy in much the same terms as I view human health. Enough of most things proportionally as a diet or lifestyle; the secret is balanced living (i.e. enough food in the right proportions and amounts, enough sleep, enough exercise, etc.) to keep a person in peak health and the ability to perform. If one overdoes anything to spite other things (i.e., over or under eating, sleeping, working, etc.) then that imbalance will create problems, usually both physical and psychological. This is standard fare in the prescription for good health.

    Economies are much the same. America has at least two major parts of its economy that are far out of balance: finance and health care. There is too much of the GDP represented in each, and the benefits of the overage are not distributed to the broader economy in any rational way, but tend to serve the interests of a very small minority. I would note that the other side is represented by the shrinkage of “real” productivity in that manufacturing has shrunk to an all time low as a percentage of GDP. What this means to me that wealth is not being generated in such an imbalanced economy by creating value, but rather in “churning.” That is by leveraging financial assets against the rest of the economy, and thereby soaking up money without creating productivity in the traditional sense.

    The unfortunate fact is that the wealth has become so focused that it has the power to control its own destiny, for now. The greater unfortunate fact is that sooner or later what is in the interest of the moneyed few, if it continues in ever growing concentration, will act to the detriment of all, because such an economy will collapse eventually if not brought back to equilibrium. The final result will be actual revolution and social collapse. It is an inevitability.

    I was in hopes that the new President might have a strong enough mandate to coax the powerful to participate in a social and economic rebalancing. I now think that this is not possible. I hope that I am wrong.

  126. Of course it is possible to find oneself reliant on credit then find access to credit withdrawn. But it is also possible to be prudently debt funded. I agree lots of businesses were too vulnerable. But otherwise, I think we are talking at cross purposes. You talk about there being “sufficient revenue to meet costs” – if there wasn’t, you’d be loss making, and if you are loss making, how are you servicing your debt? All I am saying that it can make sense for a profitable company to choose not to pay down its debt but to be debt financed on an ongoing basis, paying interest. A firm generates profits, and it can choose to use this profit to pay down its debts, to re-invest in the business or to distribute to shareholders. I interpret you as saying a firm should always pay down debt because being debt financed on an ongoing basis is “unproductive”; I am saying this is not so, and that putting profits to other uses may be preferable. I think the choice you present of funding a business from revenues or funding it from debt is a false choice – revenue is a flow of income into of business, nobody is suggesting that a business ought to try and survive on a flow of funds from additional borrowing – by “debt funded” I simply mean maintaining a stock of debt, which is serviced.

  127. Outstanding commentary, – as always Bayard. You articulate in far more eloquant terms exactly what I and many Americans are feeling and wanting. The haunting problem however is that many of us, are not so balanced and reasonable, or patient. Many of us are facing dire circumstances. There is no-one representing our interests. The only constituency that recieves any recognition is the predatorclass.

    Push enough people to the bitter brink (exactly what is happening now despite all the rosy babble of bottoms and greenshoots, and recovery around the corner) and – well – desperate people do desperate things. The “inevitability” you speak of, is much closer than anyone may care to recognize, and this is perhaps the next “Black Swan”, the predatorclass is missing – because I promise you – some of us will never go peacefully or silently to the flame of those Homelandsecurity detention centers, – there will be blood, and predatorclass blood, and the day of reckoning is fast approaching.

  128. Simon, what would you say on an argument that US financial sector serves client world-wide, so measuring its as a percentage of US GDP would be underestimation of this international operations?

  129. getting to know the finances of American expats of the department head level and higher in detail in the 70s I concluded that the dollar was the equivalent of 2 DM (and not the 4 DM of a long time after WW2) which today figures as 1 €.
    If I read about incomes of “normal” people in the US and what you seem to consider necessities for a decent life I still conclude that the dollar in everyday life should equal 1 €. Is there an explanation (comprehensible on the pencil and paper level) why it doesn’t?
    … and does this imbalance between value of the dollar in relation to cost of life in the US and its value in international trade explain why your Bonds are still so much in demand … because they are a bargain for the holders of (overvalued?) currencies?

  130. Charles,
    it probably HAD to be abandonned because not too long after the mini-skirt craze when we had reduced length to the width of belts was followed by a short period of the extreme maxi-skirt we forever fickle women decided to wear all kinds of lengths – no couturier after those extremes has ever been able to dominate women’s preference for the length of her skirts again. I doubt that today you’ll find many women who have not all kind of lenths in their wardrobe (something unthinkable in the 70s) – maybe this is as telling on the formerly perceivable correlation as the times of pretty uniform lengths were

  131. “This is standard fare in the prescription for good health.”

    if you show me one person just one single person alive who is actually living that balanced life you are describing and that I cannot show to be a chimera with very little effort I will undergo training to be able to stand on my head. A lot of good health if not most of it is a gift from nature and it is not becoming for those who were lucky enough to have gotten it to lecture the less fortunate ones

    Balance is an impossiblity, even dancers on a rope keep their balance by constantly swaying from one side to the other – the only thing one can do is hoping for the counter forces being able to keep the victors in check and vice versa – if one group gets the chance to make off with too much of the goodies it has to be brought back down or at least to sustainable levels
    - it will never ever voluntarily do so, trying to make them is called appeasement and rightfully has acquired a bad odour
    - a lot of those implicated in the mess have justified their exorbitant incomes by promising hugely beneficial incomes for all of us. They didn’t deliver and they should be treated like all businessman who have sold stuff that didn’t match its promised features

  132. Most people are honest. The leaders of Enron and many in Arthur Anderson were not honest and decided to take advantage of poor control integrity that exists in our software driven financial system. I would add that the confusion that poor control software has created in today’s culture is making it difficult for the honest to maintain their individual integrity.

  133. Charles R. Williams

    Hypertrophy in the financial sector is the result of 1) high levels of marginal taxation 2) the constant threat/reality of inflation in a fiat currency regime 3) complexity in the tax code 4) off-balance sheet financial activities by government and 5) a financial regulatory scheme that creates opportunities to profit from leverage by generating moral hazard and simultaneously under-regulating schemes to profit from moral hazand.

    Part of the growth in the financial sector represents real value and part of it is a response to government policy.

  134. Simon should have paid more attention in his science classes. He would then have understood that money is the electricity and the financial institutions makes up a grid for funds to flow on. If he had paid even closer attention, he might have remembered that the longer the conductor is, the more loss you will have from A to B. If he had chosen science instead of economics, he would also know that if you do a lot of change of the voltage on the way, and changing back and forth between AC and DC, every such action will cause a loss of energy.

    Very similar to when you are advised, for a small percentage, to put your money in fund of funds X (charging 2/20) who place it in hedge fund Y (charging 2/20) who buys some CDOs created by bank Z to the cost of 1,5% of the underlying assets, which again is handed down through some originaters/banks what ever and finally ends up in the hands of a house buyer who promise to pay 7% interest on the money. (I know it ends up slightly wrong telling the story that way).

    Transformed to electricity: How big loss of energy do you have in the grid from A to B? In the physical world it ends up like heat in the air. In the financial world it ends up as revenue for the middle men.

    So why do we do it this way? Probably because then it will be someone else and not me who is to blame for the losses. After all, I was careful and hired an expert.

  135. Methinks, as one earlier comment suggested, that you are too kind by several orders of magnitude. The system, sadly, seems broken. There was a time one had to DO or MAKE something in order to receive a wage or profit. Now it seems the mere shuffling of papers or the click of a few computer keys is deemed sufficient to be called productivity.
    It often seems all the finance industry does is feed on itself to create growth; something akin to using credit card A to make payments on credit card B. There is no product made, no good produced here. It is a pure and simple shell game using a stacked deck that favors an elite few at the cost of the many. Wasn’t there something about that written in the opening lines of that U.S. Constitution thing?
    We need a return to the ideas of thinking folks who are committed to the promotion of the General Welfare as opposed to the Corporate Welfare. I’d nominate folks like Schumacher with his “Buddhist Economics,” and Marjorie Kelly with her “Divine Right of Capital.”
    Who knows? It might even be time to bring out the pitchforks again.

  136. On Mondays – like electricity.
    On Fridays – like junk food.

  137. Thanks, Mr. Taylor.

    1. Early civilizations? You mean like, say, France in the 1780s?

    2. I’ve considered “private tax” as the popularization.

  138. I seem to remember that the ancient Romans already liked it and why not?
    once you name it collecting tax via representation it seems to be appropriate for a parliamentary democracy ;-)))

  139. Can we make comparisons of junk food to financial products then? And kinds of finance are like new kinds of junk food! That works really well. I’m going to say that CDOs are the KFC ‘famous bowls’ of the finance world, all of the unhealthy things that banks and investors shouldn’t really be consuming piled into one bowl. And I think that financial innovation provides similar benefits to those provided innovation in processed food- most of it is recycled ideas from before in order to sell more unhealthy products, some of it is actually useful.