Wall Street’s 2010 results were disappointing and the howls of banker anguish over shrunken bonuses have reverberated through the better Manhattan restaurants, bars and clubs. The rise in financial services’ share of the economy, seemingly so inexorable, has at least paused. Is this merely a blip, or is it the beginning of a reversal, in which financial services returns to its historically modest position in our economic life, and other forms of wealth creation take its place?
The increasing share of financial services in GDP has been inexorable since World War II. Taking the “finance and insurance” sector of the national accounts as a benchmark, its share of GDP rose from 2.4% of GDP in 1947 (the first year available) to a local peak of 4.3% of GDP in 1972. Then it was flat for a few years, surged during the 1980s to 6.0% of GDP in 1987 and surged again in the 1990s to a peak of 8.2% in 2001. That later peak was not surpassed during the housing finance boom of the mid-2000s, surprisingly, but was finally topped in 2010, in which the sector represented 8.5% of GDP. Thus the surge in financial services activity is consistent and long-term, nearly quadrupling as a share of GDP over the last 63 years.
At first sight, that makes it appear as though financial services’ growth is an inexorable feature of a modern economy. However if you go back further, recognizing that GDP figures before 1947 are not very accurate (the concept was only invented in 1934) you will see a further surge in financial services, from a low of about 1.5% of GDP in 1880 to a peak around 6% of GDP in 1929 – followed by a catastrophic drop during the Depression and World War II.
The 1930s decline in financial services income is not surprising. Stock brokerage and investment management, which had been becoming major businesses by 1929, were decimated by the downturn. The Glass-Steagall Act, separating commercial from investment banking, may have been useful safety legislation, but it resulted in the de-capitalization of brokerage and underwriting businesses, leading to a dearth in public debt and stock issues in the late 1930s such as had not been seen since before the Civil War. Home mortgage lending, conducted in the 1920s without government guarantees, but on unsound principles of 10-year maturities and inadequate amortization, was equally decimated by the decline in house prices. Deposit banking was badly damaged by the disappearance of one third of U.S. banks in 1932-33.
Only insurance remained a stable and reliable financial services product, and seems likely to have maintained its share of GDP, more or less. However the decline in other financial services was not just a product of poor markets (thought it was to an extent a cause of them) but represented a reorientation of the U.S. economy away from finance – egged on by populist politicians who found it easier to blame the Great Depression on finance rather than on their own errors.
It has to be said therefore that Barack Obama has so far failed where FDR succeeded, in that finance has not yet declined as a share of U.S. GDP. That may however be about to change. (Incidentally, the massive Wall Street contributions to Obama’s 2008 campaign surely represent in its purest form the adage, supposedly coined by Lenin, that capitalists will sell you the rope with which to hang them!)
Once the current period of artificially low interest rates ends, its stimulus to asset prices and leverage will also end. At that point, many of the products and services that have pushed up finance’s salience will become unprofitable.
One such product that has already declined from its peak is securitization. In its initial incarnation, securitization seemed a useful way to remove excess home mortgage assets from bank balance sheets and transfer them to investors who would welcome this new low-risk asset class. The business was greatly facilitated by the availability of quasi- government guarantees from Fannie Mae and Freddie Mac. However after the subprime debacle it became clear that securitization could be used by unscrupulous operators to originate mortgage loans that should never have been made.
Today, much of the demand for securitized products comes from mortgage REITs, leveraged up the eyeballs and gambling on the spread between short-term and long-term rates. Once that spread disappears, there will be a gigantic glut of this paper on the market as the mortgage REIT losses wipe out their capital bases. The home mortgage market will be disrupted, and will operate only at considerably higher interest rates in relation to Treasuries. Finance’s intermediation profits will be correspondingly diminished, or wiped out altogether. Fannie Mae and Freddie Mac will report losses so large that they may prompt even a spineless Congress to put those useless behemoths out of business.
The derivatives sector is largely responsible for the financial services growth of the last three decades. One of the changes that have boosted derivatives’ salience has been the practice by industrial companies to treat their finance departments as profit centers, thereby encouraging speculative game playing by finance staff claiming to “hedge” exposures. As innumerable investors can attest, the principal effect of such hedging is to make financial statements completely impenetrable, so that hedged oil companies, for example declare huge profits when prices fall, the reverse of their economic reality. A little shareholder pressure and reformed corporate governance should eliminate much of this activity.
While it seems likely that interest rate swaps, currency swaps and their associated options will remain a modest part of the financier’s toolkit, the same cannot be said of their eldritch cousin credit default swaps. The principles of the Life Assurance Act of 1774, which forbade taking out policies on unrelated lives and then arranging accidents, must be applied to this market, so that counterparties cannot take large naked short positions on credit. The legal and payment uncertainties surrounding these instruments in any case make them almost pure gambling contracts. There will doubtless be another financial crash shortly, in which CDS are heavily implicated; it is to be hoped that regulators don’t neglect this area after the next crash as they did after the last one.
Fast trading, whereby institutions position their machines at the stock exchange in order to get earlier information of trading flows, on the basis of which they trade, is pure rent-seeking and a form of insider trading. The various Tobin tax proposals being mooted, while they may do other damage, should at least cut off this illicit source of financial services revenue.
Hedge funds and private equity funds have been major beneficiaries of loose money, attracting institutional capital by promising superior investment returns unlinked to the conventional equity market. It should already be clear, and is becoming increasingly so to the dumbest state pension fund and even to the Harvard endowment, that both these claims are untrue. In the long run, the returns of hedge funds and private equity funds are not superior, especially net of their excessive fees. Second, those returns are highly correlated to the stock market, since they depend crucially on the readily available and excessively cheap money on which all bubbles are built.
Finally, in Europe especially, financial services companies have sought to be universal dumpsters for government debt. While the pre-2008 belief that government debt was risk-free was nonsense, in general financial services entities (unlike some unleveraged global manufacturing companies) are not better credit risks than the governments under which they operate. Hence it makes no sense for them to hold government debt, other than as part of their underwriting function. They have been encouraged to do so by the spuriously steep yield curves of recent years, which have encouraged them to invest in long-term paper, while funding it in the short-term market. Like the unfortunate First Pennsylvania Bank in 1980, some of them will pay the ultimate price for this folly, while others will merely suffer large losses and be forced to sell off operations and fire staff in order to survive.
However, the principal factor cutting back financial services’ share of the economy is the tsunami of regulation that has been and is being imposed on the industry as a result of the 2008 crash. This also happened in the 1930s: the SEC and the Glass-Steagall Act deflated financial services inordinately, doing great economic damage thereby. It is now clear that the damage from Dodd-Frank’s 848 pages arises not from the Act itself, which was fairly anodyne and missed many of the better legitimate targets among the industry’s bad practices, but the regulations it encouraged, which contain a large multiple of the complexities of the Act itself. Much of the financial services industry will be engaged in battling those regulators every inch of the way, while other parts of its business will be severely hampered by the rules they produce.
There are thus three factors cutting back financial services’ share of the economy. First, there is a natural reaction against the excesses of recent decades, in which some of their more egregious business practices will no longer work and will be abandoned. Second, an end to the current excessively loose monetary policy will result in a dampening of speculation and a reduction (much of it the hard way, through bankruptcy) in systemic leverage. Finally, the surge of regulation through Dodd-Frank and the equivalent EU regulations will itself dampen activity in the sector, forbidding some practices and making others uneconomic. Just as deregulation from the 1970s encouraged the growth of the financial services sector so new regulations, imposed ineptly, will cut it back as they did in the 1930s.
The financial services sector may not fall back to the 2.4% of GDP it represented in 1947, but it could easily fall back to the 4% or so of GDP it represented in the 1970s, about half the current size in terms of the overall economy. The moral is thus clear: don’t put too much money in bank stocks, and above all, don’t waste the lives of your intelligent offspring by encouraging them to enter this currently overblown sector, prone to parasitism in bull markets.
(Originally appeared in The Bear's Lair.)
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005)—details can be found on the Web site —and co-author with Professor Kevin Dowd of “Alchemists of Loss” (Wiley – 2010). Both now available on Amazon.com, “Great Conservatives” only in a Kindle edition, “Alchemists of Loss” in both Kindle and print editions.
... written by Someone who knows what they are talking about , February 28, 2012
"leveraged up the eyeballs and gambling on the spread between short-term and long-term rates"
This statement is not only completely mis-informed but patently false and reckless. REIT's have MUCH lower leverage ratios these days than in prior years and they also HEDGE their exposure to NIM compression due to funding cost increases and good stacking of risk vs. prepayment risk. Get your facts straight buddy.