Sunday, August 25, 2013

Money for nothing.

Wall Street's hold over the nation's politics ultimately lies in the power of its narrative. As MIT economist Simon Johnson wrote in the wake of the 2008 financial collapse, the power amassed by the finance industry over the past quarter century is not simply a function of the corrupting power of its political contributions, but rather its success in the creation of a belief system within the halls of power. Johnson sums up his observation about the power of Wall Street as follows:

"It did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were crucial to America’s position in the world." 

The power of this narrative is demonstrated by the continued obeisance paid to industry chieftains even as the nation continues to struggle with the economic fallout of the banking crisis and bank lending continues to lag. Members of Congress might publicly decry the "too-big-to-fail and too-big-to-jail" culture that has evolved, but they continue to line up in pursuit of lucrative seats on the finance industry oversight committees and bid for their cut of the billions in contributions made by the finance industry to Congressional campaigns. Five years after the historic financial collapse, the essential narrative remains intact and the power of the largest banks remains unchallenged. Despite deep public support, legislation to break up the banks or to reimpose Glass-Steagall restrictions—even when offered on a bi-partisan basis—is still not taken seriously.

But Wall Street today is not the Wall Street of prior eras. Over the past quarter century, financial services deregulation has led to increased concentration and profitability in the banking sector. As measured by FDIC data, the asset share of the largest banks has more than doubled from below 30% in 1984 to over 80% today, including a strong uptick since the 2008 financial collapse. During this same timeframe, profits in the financial services sector increased significantly. Based on Bureau of Economic Analysis data, in the decades prior to deregulation, the financial sector share of total domestic corporate profits fluctuated from below 10% to as high as 16%. Beginning in the mid-1980s—as deregulatory efforts gained momentum—the financial sector share of domestic corporate profits increased steadily, finally reaching 30 to 40% of total domestic corporate profits following the comprehensive deregulation of financial services under President Clinton in 1999 and 2000. This increase in the share of total private sector profits is significant, and it reflects the emergence of finance from an essential function in support of the broader economy—a notion central to the narrative that Johnson describes above—to an industry increasingly in service of itself.

Increasing concentration in the financial sector brought with it the realization that the largest institutions were too big to fail. This had significant ramifications both for those institutions as well as for the broader competitive landscape. Those institutions that were viewed as too-big-to-fail were accorded preferential borrowing costs in the capital markets because of the implied federal backstop, resulting in an effective public subsidy. Recently, two economists—Kenichi Ueda of the International Monetary Fund and Beatrice Weder di Mauro of the University of Mainz—estimated that prior to the 2008 collapse, the largest banks had a borrowing cost advantage, including the interest rate paid on their bonds and customer deposits, of 60 basis points relative to their competitors, and that cost advantage increased to 80 basis points after 2008. In a world of already low interest rates on bonds and bank certificates of deposits, 80 basis points, or almost 1%, is a substantial benefit.

Bloomberg used the Ueda/di Mauro data to calculate that the annual benefit to the largest banks totaled $83 billion, and reached the stunning conclusion that the annual benefit to the top five banks—JP Morgan, Citigroup, Bank of America, Wells Fargo and Goldman Sachs—totaled $64 billion, or an amount "roughly equal to their typical annual profits... In other words, the banks occupying the commanding heights of the U.S. financial industry -- with almost $9 trillion in assets, more than half the size of the U.S. economy -- would just about break even in the absence of corporate welfare. In large part, the profits they report are essentially transfers from taxpayers to their shareholders."

The Bloomberg conclusion directly contradicted the industry narrative that concentration within the banking industry is a natural market phenomenon that itself promotes efficiency and is—central to the Johnson narrative—essentially a public good. The central irony of this massive public subsidy as laid out by Bloomberg should not be lost: The larger a financial institution is, the more disastrous their failure would be, and therefore the more certain it can be of a public bailout in the a crisis. In turn, the greater the certainty of a bailout, the lower the institution's borrowing costs and the greater the competitive advantage that it garners through the implied federal guaranty. The result is that massive, hidden subsidies flow to those institutions that present the greatest risks to the larger economy, and in turn give those institutions a competitive advantage that ultimately leads to even greater market concentration—and systemic risk—over time.

If this attack on the dominant banking narrative were not enough, a 2012 Bank for International Settlements research report further undermined the core presumption that a growing financial sector is good for the overall economy. The BIS report authors conclude that growth in the financial sector suppresses economic growth and productivity. The rationale for this conclusion is fundamentally simple and observable: a growing financial sector ultimately drains scarce talent and other resources from the productive sectors of the economy.

Over the course of a quarter century, the leading firms on Wall Street have successfully used their political clout to promote deregulation to their own financial advantage. They have garnered an increasing share of the economic pie, secured a massive public subsidy and undermined the competitive marketplace, while magnifying systemic risk and providing less value to the real economy along the way. The societal problem that ultimately must be confronted is not simply the growth of the financial sector, but its evolution from a competitive industry essential to the efficient allocation of capital to the productive sectors of the economy to a highly concentrated "rent-seeking" oligopoly that uses its political power in pursuit of ends that are increasingly self-serving, and—if the BIS data is to be believed—a drain on the larger economy.

The public has long since turned a deaf ear to claims regarding the essentiality of the too-big-to-fail banks and the critical contributions of modern finance to the common weal. As the belief system that Simon Johnson described as essential to the power of Wall Street lies increasingly stripped of its essential credibility, members of Congress and the administration will be left to choose between the money—the billions upon billions of campaign cash—and the stark reality that there is no longer justification for continuing to support the status quo.