Revolving doors also exist in Europe. José Manuel Barroso, former president of the European Commission, was criticized when he moved to Goldman Sachs in 2016, just two months after the end of his mandated cooling-off period. Four of the five former officials who headed the European Commission directorate responsible for financial regulation between 2008 and 2017 have gone on to work for financial industry companies or lobbying firms that represent them (Vassalos, 2017).f
However, European competition authorities do not seem to be subject to the same revolving-door effect. A look at the data for revolving doors over the past ten years turns up eighteen cases involving finance and only four cases involving DG Comp. The same is true with the national competition authorities in Europe. They appear for the most part to be made of committed regulators. Consistent with our theory, antitrust lobbying plays a smaller role in the EU (at least so far), and revolving doors are less common.
Will Europe Remain Insulated?
US campaign finance has changed dramatically over the past twenty years. In their 2003 survey, Stephen Ansolabehere, John M. de Figueiredo, and James M. Snyder Jr. asked why there was so little money in politics.
Much of the academic research and public discussion of campaign contributions appears to be starting from some misguided assumptions. Campaign spending, measured as a share of GDP, does not appear to be increasing. Most of the campaign money does not come from interest group PACs, but rather from individual donors … It doesn’t seem accurate to view campaign contributions as a way of investing in political outcomes … Because politicians can readily raise campaign funds from individuals, rent-seeking donors lack the leverage to extract large private benefits from legislation.
It is tempting to compare this statement to the “permanently high plateau” prediction for US stocks that Irving Fisher made in October 1929. To be fair, however, they did not claim to make a prediction about the future, as Fisher did. They were instead reflecting on the common wisdom at the time and, based on their reading of the evidence, they suggested a reorientation of research away from its focus on rent-seeking donors.
Much has changed since then, and Luigi Zingales, an economist at the University of Chicago, worries in a 2017 article about a diabolic loop between economic power and political power. Firms can use their economic power to acquire political power, and then they can use their political power to prevent entry and competition. Zingales argues that we have seen that movie before. The Medici dynasty of Florence, Italy, used their lending relationships with the Roman Catholic Church in the fifteenth century to gain political influence in Europe. Is the United States going to look more like late medieval Florence or more like an open society?
One of the most surprising facts that I have uncovered while doing this research is that most EU markets are freer that their American counterparts. As Mario Monti, the former EU commissioner, explains, “In competition policy, for example, the E.U. embraces not just antitrust but also controls how much aid a state can provide a business and provides other forms of oversight for how national governments intervene in economic and financial markets.”
One reason for the weakness of competition policy in the US is that its framework is outdated. There are two federal agencies with overlapping competencies and conflicting objectives and fifty state attorneys general. Europe, on the other hand, modernized its competition architecture in 2004. National cases are decentralized to national competition authorities under effective oversight by the European Commission.
The other reason for weak competition policy is that US enforcement agencies are directly influenced by the electoral cycle. The administrative system of European enforcement is better shielded from political pressures.
As we have seen, one of the main goals of those who donate to politicians in the US is to change the rules that regulate state aid to companies and government intervention in the markets. One question for Europe is whether its relative insulation from the influence of money in politics will continue. There are two views on this issue.
The pessimistic view is that it simply takes time for institutions to become corrupt, but eventually they do. Europe, then, is headed the US way, only with a ten-year lag. DG Comp is still new and strong, but this will not last.
The optimistic view is that Europeans were lucky when they set up their institutions, that they made them more independent than anyone would have imagined, and that this quality will persist. Much of the research on institutions shows that they have long-lasting effects and a life of their own, so I tend to be in the second, more optimistic camp, but this is in no way an assured outcome, and there is no room for complacency.
* * *
a Henry Ford lost the US Senate race in Michigan to Truman Newberry. Ford alleged Newberry exceeded the $100,000 limit during his campaign. Newberry was convicted in 1921 and appealed his conviction to the US Supreme Court, which sided with Newberry and struck down the spending limits.
b A PAC must register with the FEC within ten days of its formation, providing the name and address of the PAC, its treasurer, and any connected organizations. Affiliated PACs are treated as one donor for the purpose of contribution limits. Although commonly called PACs, federal election law refers to these accounts as “separate segregated funds” because money contributed to a PAC is kept in a bank account separate from the general corporate or union treasury.
c Since June 2008, leadership PACs reporting electronically must list the candidate sponsoring the PAC, as per the Honest Leadership and Open Government Act of 2007. Leadership PACs are often indicative of a politician’s aspirations for leadership positions in Congress or for higher office.
d Applying intermediate scrutiny, the district court held that limits on contributions to committees making solely independent expenditures serve important government interests by preventing actual and apparent corruption. Looking to the past behavior of so-called “527 groups” that did not register with the commission, yet had close ties with the major political parties and made millions of dollars of expenditures influencing the federal elections of 2004, the court found that such “nominally independent” organizations are “uniquely positioned to serve as conduits for corruption both in terms of the sale of access and the circumvention of the soft money ban.”
e See Issue One, “Dark money illuminated,” https://www.issueone.org/wp-content/uploads/2018/09/Dark-Money-Illuminated-Report.pdf.
f See also Corporate Europe Observatory, “Revolving door watch,” https://corporateeurope.org/en/revolvingdoorwatch.
[ FOUR ]
AN IN-DEPTH LOOK AT SOME INDUSTRIES
The first three parts of this book propose a broad analysis of the evolution of economics and politics in the United States over the past twenty years. I can summarize my thesis in three points. First, US markets have become less competitive: concentration is high in many industries, leaders are entrenched, and their profit rates are excessive. Second, this lack of competition has hurt US consumers and workers: it has led to higher prices, lower investment, and lower productivity growth. Third, and contrary to common wisdom, the main explanation is political, not technological: I have traced the decrease in competition to increasing barriers to entry and weak antitrust enforcement, sustained by heavy lobbying and campaign contributions.
I have also tried to give you, the reader, an understanding of how economists think about free markets, regulation, and political economy. I have shown you some of the tools that we use to analyze economic developments. You understand the fundamental law of investment, the dynamics of entry, merger reviews, and the impact of wealth on the price of domestic goods and services (remember, haircuts versus Ferraris).
Let’s use these tools to think about a few controversial industries: finance, health care, and the internet giants. In all these cases, we will see the same economic forces at play: lack of competition, barriers to entry, and lobbying. But the details vary, and this is what makes these industrie
s interesting. Finance will teach us that efficiency and complexity are not the same thing and that deregulation is easier said than done. Health care will teach us how oligopolies can spread from one side of an industry to another. Finally, the internet giants are particularly relevant because they are often presented as examples of efficient concentration driven by “network” effects. While there is some truth to this argument, it is widely overrated. The data will also teach us that the stars of today may be no match for the stars of yesterday. This sounds like fun, at least to me … but then again, I am an economist.
CHAPTER 11
Why Are Bankers Paid So Much?
I would rather see Finance less proud and Industry more content.
WINSTON CHURCHILL, 1925
FINANCE IS THE one industry that (almost) everyone loves to hate. And it would be somewhat peculiar to write a book about rent-seeking oligopolies and political capture without dedicating at least one chapter to banks. For better or for worse, however, no country has ever become prosperous without a well-developed financial system. So, we might as well try to understand what these bankers are doing.
Economists have disagreed about the proper role of finance for as long as capitalism has been around. British economist Joan Robinson (1952) viewed finance as a sideshow. She argued that “where enterprise leads, finance follows.” Financial economist and Nobel Prize winner Merton Miller (1998), on the other hand, wrote that the idea “that financial markets contribute to economic growth is a proposition almost too obvious for serious discussion.”
These statements seem to support Winston Churchill’s dim view of economists. Churchill famously quipped that “If you put two economists in a room, you get two different opinions, unless one of them is Lord Keynes, in which case you get three opinions.”
As you can see, the debate is not new. But I would argue that we have made progress and that the range of disagreement has narrowed substantially. My generation of economists is less interested in ideology, and we have a lot more data. That is not a sufficient condition for success, but it’s a better starting point, in my opinion.
The history of finance is replete with financial crises, followed by changes in regulations, followed by periods of relative calm, followed by new crises. From the outside, finance seems to always be changing. Moreover, one would think that, with the advent of computers, financial services would have become a lot more efficient and a lot cheaper. I am going to show you that this did not happen and that, in fact, little has changed over the past 100 years, at least until very recently.
What Does Finance Actually Do?
Financial intermediation arises from the need for expertise in channeling capital from savers to borrowers. In the absence of financial intermediaries, households with savings would have to interact directly with borrowers. That would not be easy.
Borrowers typically need long-term, committed capital. Prime examples are mortgages and corporate loans. If you finance the purchase of a home or a factory, you want to spread the repayments over many years. In addition, these loans are fundamentally risky: good borrowers can be unlucky and lose their jobs or their customers, and bad borrowers can pretend to be good.
Savers, on the other hand, want less risk and more liquidity. They don’t want to buy rotten eggs, they don’t want to put all their eggs in the same basket, and they want to be able to sell their eggs if they need to. These issues have names in economics: rotten eggs are moral hazard and adverse selection; placing one’s eggs in different baskets is called diversification; eggs that can be sold are called liquid assets.
The trouble—and the opportunity for financiers—is that borrowers and savers have conflicting demands. This creates the need for financial intermediaries. Without intermediaries, information costs would make it difficult for households to screen and monitor corporations and for corporations to pool household funds to raise sufficient capital. These costs would also make it difficult for households to diversify their investments and obtain liquidity when they need it. Financial intermediaries specialize in these tasks and in turn are compensated for acting as brokers between savers and borrowers, for providing means of payment, record keeping, insurance, and liquidity.
Here is how Finance 101 works. Figure 11.1a shows a simplified banking system with $100 in deposits and $100 in loans. The banks offer 5 percent returns on deposits and charge 7 percent on the loans that they make. At the prevailing borrowing rate of 7 percent, borrowers (firms or households) want to borrow $100. At the prevailing savings rate of 5 percent, savers are happy to save $100. The money flowing back and forth between savers and borrowers goes through the banking system. The income of the banks is the difference between the interest revenues from their loans and the interest expenses on their deposits. This income is called net interest income.
Where is that money going? Banks, like all firms, have labor and capital expenditures. They need to maintain their branches, ATMs, and IT systems, and they need to pay their employees. The banks therefore retain $2 to pay their wage bills and capital expenditures. When we look at the banking system in Figure 11.1a, we would say that the quantity of intermediation is $100, the intermediation cost is $2, and the unit cost is 2 / 100 = 2 percent.
Modern finance has evolved beyond the simplicity of the traditional banking model. Figure 11.1b presents a different, yet fundamentally equivalent way of organizing financial intermediation. In traditional banking, intermediation occurs under one roof: the bank makes a loan, keeps it on its books, and earns a net interest income. This income compensates for the costs, including screening and monitoring the borrower, managing the duration and credit risk of the loan, and collecting payments.
The originate-and-distribute model, in contrast, involves a daisy chain of intermediation. Many transactions occur inside a black box. There is no simple measure of net interest income as in the traditional model: there are origination fees, asset management fees, trading profits, and the like.
Here is the tricky question: how can you measure financial intermediation over time when it is a changing mix of the two models?
The answer is to focus on what goes into the box, what comes out of the box, and how much the box costs. There is a sense in which the latter, more complex model and the traditional model are the same. The sum of wages and profits for all intermediaries is still $2, and the quantity of assets intermediated seen from outside the black box is still $100. And the unit cost of intermediation is still 2 percent.
At some fundamental level, finance deals with information. One would therefore assume that the advent of computers and information technologies would make finance cheaper and more efficient. Surprisingly, this did not happen.
FIGURE 11.1 (a, b) Two equivalent financial systems
Finance Still Costs 200 Basis Points
As we have just explained, the sum of all profits and wages paid to financial intermediaries represents the cost of financial intermediation. In Philippon (2015), I measure this cost from 1870 to 2010, as a share of GDP. As you can see in Figure 11.2, the total cost of intermediation varies a lot over time. The cost of intermediation grows from 2 percent to 6 percent of GDP from 1880 to 1930. It shrinks to less than 4 percent in 1950, grows slowly to 5 percent in 1980, and then increases rapidly to almost 8 percent in 2010.
Why are we spending more on financial intermediation today than 100 years ago? To answer that question, let us construct the amount of intermediation. For the corporate sector, we need to look at stocks and bonds, and for stocks, we want to distinguish between seasoned offerings and IPOs. We also need to look at the liquidity benefits of deposits and money market funds. The principle is to measure the instruments on the balance sheets of nonfinancial users, households, and nonfinancial firms. This is the correct way to do the accounting, rather than looking at the balance sheet of financial intermediaries. After aggregating the various types of credit, equity issuances, and liquid assets into one measure, I obtain the quantity of financial assets interm
ediated by the financial sector for the nonfinancial sector, displayed as the shaded line in Figure 11.2.
FIGURE 11.2 Income of the finance industry and intermediated assets. Both series are expressed as a share of GDP. Finance income is the domestic income of the finance and insurance industries, that is, aggregate income minus net exports. Intermediated assets include debt and equity issued by nonfinancial firms, household debt, and various assets providing liquidity services. The data range for intermediated assets is 1886–2012.
The solid line with circles in Figure 11.2 is the share of GDP that we spend on financial intermediation in the US. It is literally the equivalent of the $2 paid to intermediaries in Figure 11.1. The shaded-line series is built by adding the series of debt, equity, and liquidity services with the proper theory-based weights. It is the equivalent of the $100 in Figure 11.1.
FIGURE 11.3 Raw unit costs of financial intermediation. The raw measure is the ratio of finance income to intermediated assets, as shown in Figure 11.2. The 2012 data are from Philippon (2015), while the new data were accessed May 2016. The data range is 1886–2015. Source: Philippon (2015) with updated data
Notice that the underlying data sources for both series are entirely different. The fact that the two series track each other very closely is not a coincidence! We are now ready to compute the price of finance by dividing how much we pay (solid line) by how much we get (shaded line).
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