These costs come in two forms. The first is that the industry is now inherently destabilizing, not just to the financial system but to the entire economy. This is essentially the problem described by Raghuram Rajan in the paper he delivered at the Jackson Hole conference in 2005, now grown even larger and more threatening. Financial leverage, volatility, structural concentration, toxic incentives, and (often deliberate) information failures have caused the reemergence of increasingly destructive financial bubbles and crises, often intensified by widespread fraud. Since the 1980s, these crises have grown in severity and have increasingly spilled over into “Main Street”, causing enormous economic and human damage. Indeed, rather than speaking of systemic risk within the financial sector, we must now speak of the systemic risk of the financial sector.
The second form of economic destruction caused by the industry is that even when markets are temporarily stable, finance has become increasingly parasitic. A high fraction of financial sector revenues and profits—when there are profits—now come from sophisticated forms of skimming, looting, or corruption, unethical activities with no economic value. The profitability of these activities (and even sometimes their existence) depends upon legal and tax loopholes, concealment of information, artificial legal barriers to market entry, the absence of protection and recourse for victims, cartel-like collusion, and political corruption—circumstances permitted only by the industry’s wealth and power. Yet because these activities are enormously lucrative, they attract many highly educated people, as well as massive amounts of capital and investments in information systems. The result is an enormous diversion and waste of potentially productive assets and human effort, as well as worsening inequality.
Unregulated Finance and US Economic Performance: An Overview
MODERN ECONOMIES UNQUESTIONABLY need a sophisticated financial services industry. Globalization requires currency exchange, hedging, and payment systems. Wealthier citizens need greater varieties of savings, investment, borrowing, and retirement products. Venture capital has funded enormously productive high-technology firms including Google, Apple, Cisco, Intel, eBay, and Amazon. Some financial innovations are hugely beneficial—examples include debit cards, cashpoints, microlending, index funds, Internet banking, and America’s venture capital system.
But the uncontrolled hyperfinancialization of an economy is a serious problem. Over the last thirty years, the US financial sector has grown like a malignancy. Many of its recent “innovations” are no more than tricks to evade regulation, taxes, or law enforcement, and some of them have proven profoundly destructive. The extraordinary spikes and declines in financial sector debt and profits—in stark contrast to its modest contribution to GDP—suggest that it has become a bloated, destabilizing force.
Nor has the hypergrowth of American finance been accompanied by improved real economic performance—quite the contrary. The next two charts show that the recent ballooning of the financial industry has been accompanied by a steady decline in GDP growth and a shocking spike in income inequality, to a level not seen since 1929. Most of the real growth in US productivity and GNP over the last two decades has been due to information technology, particularly the Internet revolution. If one removes IT, US growth has been poor indeed during this period. Moreover, the financial sector’s contribution to economy-wide wage and income growth has been modest, even if we ignore the damage it has caused. And this has been the engine of the global economy?
Finance Share: GDP, Debts, Profits
Source: Bureau of Economic Analysis
Growth in Finance, GDP, and Inequality
Facundo Alvaredo, Tony Atkinson, Thomas Piketty, and Emmanuel Saez, World Top Incomes Database, http://g-mond.parisschoolofeconomics.eu/topincomes/
If we subtract the financial sector, real wages in the US have been declining. And if we look inside the financial sector, we find that its income gains have been heavily concentrated in the top 1 percent of the industry. Its contribution to the welfare of the other 99 percent, even within the financial sector, has been minor at best. Moreover, as we shall see, the profitability of some financial sector activities—especially investment banking, asset management, and private equity—frequently comes at the expense of average people’s incomes and investments.
But can we measure the total economy-wide effects of deregulation of financial services since the 1980s? Yes, in some ways we can, and it’s not a pretty picture. To be sure, there have been some benefits—lower commissions for purchasing stocks and bonds, nationwide and global banking for those who need it, slightly lower interest rates for some consumer borrowing (certainly not for credit cards!). But most of those benefits could have been obtained with very limited regulatory changes. In contrast, the costs of American-style deregulation have been truly staggering.
Consider, for example, the costs of the recent housing bubble and financial crisis. To paraphrase US Senator Everett Dirksen of Illinois (speaking of military budgets, long ago, in mere billions): a trillion here, a trillion there, and pretty soon you’re talking about real money.
We’ll start with the damage inflicted by the binge in residential lending. On paper, the value of Americans’ net equity in their homes more than doubled from $6 trillion in 2001 to $13 trillion in 2005. It wasn’t real, of course, but nobody knew that, and Americans borrowed heavily against their homes’ supposedly higher values. Then came the crash, which lowered their equity values but not this debt. Over the next five years, as the bubble collapsed, Americans’ net home equity plunged all the way down to $6 trillion, roughly the same as at the decade’s start, and less than half its 2005 peak.1 As of early 2012, approximately 20 percent of all US mortgages are still “underwater”, meaning that owners owe more than their homes are worth. The economic whiplash from that will take years to heal.
The effect was all the worse because the lenders were pushing second-lien home equity loans—of the “Unlocking Your Home’s Value” variety. From 2000 through 2007, US consumers withdrew $4.2 trillion in cash from their homes—four times as much as in the 1990s. Since much of the money went into imported consumer goods, it fed a worsening US trade deficit, which ballooned by over $4 trillion in those same years (see the chart on page 213). The total US trade deficit in the 2000s was five times bigger than that of the 1990s.2
By 2005, housing and related industries, such as new furniture and appliances, accounted for half of American economic growth. Much of this activity was pure waste, leaving America with excess and badly located housing, much of it very energy-inefficient. Large-lot construction requires expensive extensions of water and sewer services; big interior spaces and poor insulation are inherently energy-inefficient; and sprawl necessitates multiple-car households. Millions of these homes are now foreclosed upon or vacant, or have been sold for less than their construction costs.3 Even if they are once again inhabited, they will cause excessive costs for energy and public services.
Net Home Equity Withdrawal and Trade Deficit: 2000–2007
Source: Bureau of Economic Analysis; Federal Reserve
But the costs don’t end there, and the crash didn’t just hurt homeowners and property developers. The federal government spent huge amounts of money saving the financial system from itself, and then saving the economy from finance. Estimates vary widely (do you count the $2 trillion in Federal Reserve securities purchases, or not?), but the cost to taxpayers of the financial sector rescue was certainly in the hundreds of billions of dollars, setting aside the outlays made by other countries’ governments. (For the record: Fannie, Freddie, and AIG alone have cost well over $200 billion.) And anyone who owned stock in AIG, Lehman Brothers, Merrill Lynch, and Bear Stearns, of course, lost nearly all of it. Then the entire economy went into recession, hammered by the collapse of lending. One year after the financial crisis began, the American car makers GM and Chrysler were bankrupt, and unemployment was officially at 10 percent (in reality probably higher), the worst rate since the Depression. Yet even as most people
contended with unemployment and sharply lower home values, they had a household debt load 80 percent higher than at the start of the decade. Only the fabulously wealthy new elite were immune.
So then the US government spent $800 billion in emergency stimulus at a time when tax receipts were sharply contracting, while Republicans blocked efforts to return taxes for the wealthy back to their pre-Bush levels. As a result, deficits continued to widen and the US national debt has grown by roughly 50 percent as a result of the crisis (again, depending on how you count it).4 Then, with the end of federal government stimulus spending, many local governments went into crisis, leading to severe cuts in education, child care, and other services critical to economic welfare. And the pain continues. Poverty rates have soared, millions of American homes are in the midst of repossession—with only friendlier laws keeping British homes out of banks’ hands. As of early 2012, official unemployment remains at more than 8 percent, US economic growth is anaemic, and Europe is slipping into recession.
Europe was forced into massive stimulus spending too, which increased their debt loads and contributed significantly to European sovereign debt problems. Indeed, the effects of the US housing bubble and financial crisis deserve far greater attention in the debate over the Eurozone debt crisis. It is true that the EU system and many Eurozone nations have various structural rigidities that have reduced growth and increased borrowing. It is also true that some of these nations, particularly Ireland and Spain, experienced property bubbles of their own. However, it is also true that, with the exception of Greece, most of them (including those whose indebtedness is now so extreme) had perfectly manageable debt levels until the financial crisis.
At the beginning of 2008, Greece had the highest ratio of debt to GDP in the Eurozone—and its ratio was less than 110 percent. Italy’s was slightly lower, just over 100 percent. Ireland’s debt to GDP ratio was under 70 percent; Spain’s was about 40 percent; and Portugal’s was only about 25 percent—far lower and more conservative than the US, Germany, or most other developed nations. But by the start of 2012, Greece’s debt level was 170 percent of GDP, Ireland’s was over 100 percent, Spain’s was over 60 percent, and, stunningly, Portugal’s debt to GDP ratio had more than quadrupled to 110 percent. These catastrophic increases were not caused by sudden, simultaneous outbreaks of lavish spending—nothing like, say, the borrowing and spending binge that characterized the US during the bubble. Rather, this huge, sudden increase in Eurozone debt to GDP ratios was caused by the Great Recession, combined with the need for emergency stimulus (deficit) spending to avert total economic collapse. In other words, it was caused by the US financial sector.
As of this writing, we do not yet know how the Eurozone debt crisis will play out. But its effects have already been horrific. Much of the Greek population now lives in misery, with rioting increasingly frequent. Youth unemployment in Greece, Spain, and Portugal now exceeds 50 percent. Several nations in Eastern Europe, including Hungary and Latvia, were economically devastated, and the crisis pushed Hungary into an extremist government that is threatening its status as a democracy. Extremist political movements have gained surprising strength across Europe, including in France and even Scandinavia, especially Finland.
Asia was less affected. Even so, ten million migrant workers in China lost their jobs virtually overnight in 2008–2009. But China recovered more quickly than other nations, in part due to a $500 billion emergency stimulus programme initiated by the Chinese central government.
It’s impossible to come up with a single, reliable number for the cost of all this, but it is certainly trillions of dollars, probably tens of trillions. Beyond the economic costs, there has been a great deal of human suffering, and America’s financial and economic institutions and reputation have been discredited in the eyes of the world.
And who benefited from the predatory bloating of American finance? Mainly a relatively small number of people in the financial sector—maybe fifty thousand, a hundred thousand at the very most—became very wealthy on the backs of your pain. At the peak of the bubble, the average annual income of a Goldman Sachs employee was $600,000; and even within investment banking, incomes are heavily skewed toward the very top. (Recall Mr Thain’s bonus decisions at Merrill Lynch, where about half of total bonus payments went to the top thousand people.) Over the course of the bubble a larger group of people, perhaps half a million in total, made some money, perhaps averaging $500,000 each, by accident, petty dishonesty, and speculation—lowerlevel bankers, dishonest appraisers, mortgage brokers, house flippers, subprime mortgage loan officers, estate agents in bubble regions. But this was not an industry or an endeavour that benefited millions of honest, average Americans. Only the suffering was widely distributed.
If nothing else, the experience of the 2000s should squelch the fantasy that an unregulated financial industry inevitably channels capital to its best uses, or that bankers’ concern for their sacred reputations would prevent them from putting their institutions or customers at risk for mere money.
But perhaps the housing bubble and financial crisis were just a once-in-a-thousand-years tsunami, one of those random perfect storms that you can’t predict or control? Or an epidemic of abuse that won’t be repeated now that everyone has learned their lesson?
Not so. First, recall the historical record since deregulation began: the S&L and junk bond bubbles and crises of the 1980s; the 1987 stock market collapse; the derivatives-driven fiasco at Long-Term Capital Management; the Internet/technology stock bubble of 1995–2000. If we include other nations that undertook similar deregulatory experiments, we can add bubbles and crashes in Iceland, the UK, and several other countries. So while the US housing bubble and financial crisis were worse than others, they were far from alone.
But second, if you look under the hood, as Rajan started to do in 2005, it turns out that America’s new, unconstrained financial services industry is inherently dangerous. The instability, dishonesty, bubbles, and crises are not incidental; they are the inevitable result of uncontrolled greed searching for private gain at public expense, intensified by the increased velocity and game playing created by information technology.
But why, exactly, is America’s financial sector now so inherently dangerous? There are five principal drivers of catastrophic risk in modern unregulated finance. They are volatility, leverage, structural concentration, systemic interdependence, and toxic incentives. When combined, they make for quite a wonderful high explosive. Or perhaps a better metaphor is a cocktail laced with cyanide.
We will start with volatility, particularly the industry’s recent shift to much greater reliance on short-term financing.
Rollover Roulette
Since deregulation began, banks—especially investment banks—have increasingly depended upon short-term borrowing from financial markets. In contrast, traditional commercial banks obtain money by taking deposits from consumers. This is borrowing, too, and in principle savers can request their money back at any time. But in reality, consumer savings are generally very stable (unless there is a panic leading to a bank run).
All financial institutions, including investment banks, also traditionally borrowed by issuing long-term bonds. But one of the striking features of the buildup to the financial crisis was the very marked shortening of the average maturity of financial sector debt. Instead of issuing long-term bonds, investment banks began borrowing ever larger sums from short-term lenders such as money market funds. The primary reason for this radical restructuring was simple: it was far more profitable, because short-term interest rates are lower than long-term rates.
But it was also risky and destabilizing. These short-term borrowings have to be constantly rolled over, or renewed, and if the financial system ever ran into problems, the renewals would stop, driving the system into crisis in a matter of weeks, or even days. The graph on page 218 shows the sharp increase in this short-term borrowing.
The big American investment banks accounted for a large share o
f this surge in short-term borrowing. They used it to take risks—to purchase assets, some intended for eventual resale, others that they gambled would be profitable to keep. Table 3 on page 219 shows the “trading books”—that is, the asset holdings—and short-term borrowing levels at the six US financial firms with the largest investment banking and trading operations as of year-end 2007, when the crisis began.
Global Financial Institution Borrowings, by Maturity
Source: UK Financial Services Authority
The crisis has numbed our ability to absorb large numbers. At the end of their 2007 fiscal years, these six institutions had $2.1 trillion in trading assets, a half trillion more than at year-end 2006. Their $1.7 trillion in short-term borrowing outstanding was equivalent to 12 percent of 2007 US GDP. But these are instruments that turn over every day, or week, or month. So the sum of their cash calls on the money markets was obviously much higher. Even if the average term was monthly—and it was probably shorter—the total of the annual cash calls would have been in excess of $20 trillion, just for these six banks. Any disruption, even for a short period, would be calamitous.
Moreover, note that astounding $357 billion in negative operating cash flow. Most of that reflected the constant growth of assets. But a second reason is that banks can count unrealized gains on their trading assets as profits in the current period, so there was often a big gap between reported profits and actual cash flows. This is another destabilizing force. In normal times, if the banks need some cash, they can sell some of their assets. But what if those assets suddenly plunge in value because they were overvalued during a bubble? What if a crisis forces all the banks to sell assets at the same time, causing a glut, forcing prices down? The banks loved so-called mark-to-market accounting during the bubble, but then frantically tried to ditch it during the crisis.
Inside Job Page 23