14 October 2009

Against Banking?

A lengthy post at the Naked Capitalism blog makes the case that bankers (really investment bankers and bankers on the high end side of big commercial banks) have been taking more from the economic for their own benefit than they have added to it. The striking argument in that post is that:

Corporate stock repurchases and grants of stock to officers have exceeded new capital raised by the U.S. capital markets this decade. That means that the capital markets decapitalize the real economy.

If true, this implies that either the banking sector is broken, or that our economy had previously invested too much in the real economy. While my gut reaction is to say that the banking sector is broken, the overcapitalization theory has more to it than one might think.

The United States federal income tax system has strongly and systematically favored unearned income over earned income since not long after the tax reforms of 1986. For two decades profits from capital gains have been undertaxed and deferred, while tax losses from depreciation have been intentionally allowed before the economic reality justifies it.

Is it really any surprise that well counseled businesses have responded to these incentives?

In the U.S. economy, as a consequence of our tax laws, it makes economic sense to replace a job with a robot, even if the robot is actually slightly less cost effective. It makes sense from a tax perspective to retain earnings, rather than distributing them so that investors can put the funds to more productive uses in other entities, despite the fact that this makes it tempting for senior management to raid excess corporate cash. It makes sense from a tax perspective to reduce equity relative to debt. It makes sense from a tax perspective to compensate senior executives in a way that has a huge upside for the executive, but shifts all the downside risk to shareholders and creditors.

Banking and corporate governance probably are broken. But, the more frightening prospect is that the problems may run deeper. Perhaps the financial sector, while somewhat flawed, has fundamentally been doing what they system has been created to give it an incentive to do. If that is the case, then unwinding the mess and creating a new positive set of incentives may take more understanding and political will than our nation has at its disposal.

The finance industry is made up of a lot of very competent people with extreme tunnel vision. Lots of people know a great deal about their piece of the elephant, but very few people understand the organism as a whole very well. Many of the most affluent people on Wall Street have only a dim understanding of what role they play in making our economy productive. They trust the system. They follow the incentives that they have from their vantage point. They learn to tell enough of a myth about their value to society to provide a fig leaf for the spouses, children and the people they encounter at cocktail parties. But, only a very small percentage of individuals within the finance industry have more than a vague sense of how their efforts indirectly contribute to economic activity.

Most finance industry participants are like members of a symphony orchestra recording a harmony part, alone in a soundproofed room with a view of the conductor but no ability to hear what anyone else is playing. Not many are conductors. How can there be in an economy dominated by few than a thousand companies, not all of which engage in major financial transactions in any given year?

This suggests that the notion that financial companies are simply following the incentives created by the system itself, and that the system is telling them to decapitalize the real economy, is quite plausible.

1 comment:

Michael Malak said...

Wall Street has never been small, and they have a role to play in brokering financial markets to make them more efficient.

But lately they've been taking too much money, and "too much" is due to:

1. Collusion with the government. Executives shuttle back and forth between Wall Street and high-level government positions. This allows Wall Street to establish laws and policies that shift even more money from the real economy to Wall Street.

2. Dependence on government bailouts. This is the "moral hazard" and "publicizing the losses while privatizing the profits". Tied in with this undue risk is fractional reserve banking. Glass-Steagall was supposed to mitigate fractional reserve banking by erecting barriers between demand-deposit banking and investment banking. Instead, the 1999 Republican Congress tore down this barrier, setting the stage for 2008.