Great Leap Forward

Wall Street’s Rent Seeking Vampires Kill Innovation

Here’s a nice piece from my friend Lynn Parramore at Alternet, summarizing a recent conference held in Rio: How Big Finance Crushes Innovation and Holds Back Our Economy.

Here’s the conclusion, which is very much in line with my post from Monday: “the U.S. financial sector no longer serves the productive sector—in fact, it may be killing it.” Here’s Lynn’s summary of one of the main papers presented at the Rio conference:

William Lazonick, an expert on the history of the American business corporation, points out that the U.S has enjoyed, over its history, an extremely productive economy. We still have important productive assets, but we’re now taking money out of our productive economy instead of investing in it. The shift has happened over time, but the mechanisms of extraction have become dangerously efficient. A giant financial sector and wealthy class are sucking money, vampire-like, out of the productive sector, where the goods, technologies and services that we want are created.

Yes, the rent-seeking Vampires are pulling out income that could have gone to financing innovations. Worse than that, Wall Street directs economic activity to rent extraction rather than production–so we do not even use the productive capacity and innovations that we already have. Instead, Wall Street buys up and dismantles the productive capacity. Or, like Goldman Sachs, they hoard scarce resources and shuffle them between warehouses. They layer households and firms under mountains of debt so that they cannot afford to buy the output that does get produced.

As you might remember, the last time that Wall Street ran the whole show was in the 1920s. That didn’t work out so well—financial institutions like Goldman Sachs buried the economy under mountains of debt and created financial scams that sucked away life savings in the Great Crash of 1929. Sound familiar? Yes, déjà vu all over again—read John Kenneth Galbraith’s The Great Crash and all of the financial shenanigans sound eerily familiar because those of the 2000s perfectly mirror the earlier episode. Indeed, you do not even need to change the names of the guilty—Galbraith titled one of the chapters after Goldman Sachs, as the investment bank had played a pivotal role in destroying the economy. And Goldman is doing it again, and will keep doing it until we euthanize the firm.

However, what is different this time around is the policy response. Last time, the New Deal drove a stake through the heart of Wall Street as financial reform completely separated commercial banking from investment banking, downsized finance, and prohibited financial institutions from direct ownership of our nation’s real productive capacity. Effectively, the real sector was “de-financialized” for the next two generations. And it worked. The economy grew rapidly, debt remained low, and the financial sector was repressed.

Here’s the deal. The natural tendency in modern capitalism is for finance to dominate. For a variety of reasons, financial markets are easy to manipulate. They sell ephemeral products that are hard to value. Judicious use of favorable accounting makes it easy to manufacture short-term profits and big rewards to management. Rapid growth is relatively easy to attain—unlike in, say, manufacturing where plant must be built and products produced and sold. In the financial sphere marginal costs are low, and lower still with the spread of powerful desktop computing. Inside information is easy to exploit and hard to uncover.

Successful financial practices spread quickly. They cannot be resisted because those who refuse to mimic the most profitable financial firms get trounced in equities markets. Finance’s tentacles spread to “industrial” firms through two avenues. First through financing take-overs, with Michael Milken’s leveraged buy-outs of “cash cows” a prime example. This encourages defensive leveraging-up debt ratios. Second through “diversification” of an industrial firm’s portfolio to include financial assets, and as well to use of the firm’s cash as a profit center. Soon, there is no real difference between a financial firm like Citigroup and an industrial firm like General Electric—both are highly levered firms that rely on net interest, fees, and capital gains for much of their revenues.

As Lynn put it:

Think about it: what GE product did you recently purchase that enhanced your life? In the era of financialization, big companies like GE have turned their attention to making quick Wall Street profits instead of fabulous products. In the 1980s, for example, GE’s Jack Welch rapidly expanded the company’s business into issuing credit cards, mortgage lending and other financial activities. It wouldn’t be long before financial operations accounted for almost half of the company’s profit.

The only effective barrier is government regulation and supervision to constrain finance’s reach. The problem is that the regulatory agencies have gradually but inexorably removed all restraints. In the 1930s the argument was that we need to keep finance out of the “real” economy because direct ownership of productive firms is too risky—when the economy turns down, those firms fail and bring down the banks. Over the past 30 years, as regulators evaluated finance’s proposals to increase its penetration into the “real” sector, the main consideration was over risk to the financial sector itself. In case after case, finance won the argument that by getting more heavily involved in the “real” sector, it gained information that made its financial activities less risky.

On face value, that is often true. If I’m going to trade financial futures in, say, commodities, the more information I can obtain about real commodities markets, the better. If I know, for example, that inventories of copper are growing, I am better placed to project near-term price movements. More importantly, I use the inside information to manipulate the market, to take advantage of my customers, and even to defraud them. Since fraud is always the most profitable game in town, Gresham’s Law dynamics ensure that “fraud pays” and that fraudsters dominate.

Is there a solution? Well, I like the stake through the heart, or Keynes’s euthanasia. Here’s Bill Lazonick’s recommendation:

  • Understand that markets don’t create value, but that organizations investing in productive capabilities, like business, governments, and households do.
  • Ban stock repurchases by U.S. corporations so corporate financial resources can be channeled to innovation and job creation instead of wasted for the purpose of jacking up companies’ stock prices.
  • Realize that the shareholder value ideology is destructive and will cause us to lag behind other countries that don’t subscribe to it.
  • Regulate employment contracts to ensure that workers who contribute to the innovation process get to share in the gains from innovation.
  • Create work programs that make use of and enhance the productive capabilities of educated and experienced workers whose human capital would otherwise deteriorate through lack of other relevant employment.
  • Move toward a tax system that channels some of the money made on the gains from innovation toward government agencies that can invest in the public knowledge base needed for the next round of innovation.

I recommend that you take a look at Lynn’s piece and also follow the research that was presented at the Rio conference: “Financial Institutions for Innovation and Development,” sponsored by the Ford Foundation Initiative on Reforming Global Finance, the Multidisciplinary Institute for Development and Strategies (MINDS) and the Brazilian Development Bank (BNDES), where economists discussed innovation and how financial markets, business enterprises and the state interact with and invest in the process of creating and producing useful things.

11 Responses to “Wall Street’s Rent Seeking Vampires Kill Innovation”

JMarcoJuly 26th, 2013 at 3:42 am

Good piece.

Wall St/Bankers are not in the business of lending money to help someone else make money or create a new product/service. They would rather create their own money-making enterprises-the hell with rest of USA. And boy! Once they find an easy game they go hog wild. So we can only wait for next financial depression (my prediction is 10 yrs). Most American will not bother to demand an end to this madness. They are too busy looking at their cellphones or they throw up their hands and say "What can I do?"

For last 20 yrs all I have heard is how high is some corp.'s stock price as measure of success (not its product or service). To me one of US great electronic innovators-Apple is moving in this same direction (since Steve Jobs death) by spending millions of dollars on stock buybacks and dividends.

Andrew_M_GarlandJuly 26th, 2013 at 3:53 am

Yes, we need more government control, and more resources taken and invested by government. Then, we might be able to catch up to the soaring standard of living in Russia, Venezuela, Cuba, and many other frankly socialist countries.

But, why wait? Organize a fund which will follow the above principles. Fund and create some businesses using exactly the philosophies you propose above. Avoid Wall Street blood sucking financiers. Don't repurchase stock. Announce from the beginning that shareholder value is second, while productive employment is first. Include workers in the innovation process with hefty bonuses for great ideas. Enhance the productive capabilities of educated and experienced workers so their human capital doesn't deteriorate doing their jobs. Announce that 20% of all profits will be donated to government programs. Or, eschew profit to deliver even more value to the public. Combine your expertise with the greater expertise of government to train the workers you need, and retain the first right to hire those people.

You will soar above the competition with healthy, happy, loyal, trained workers. The profits will fund rapid expansion and the takeover of entire industries. Or, if there are no profits, the support of clear thinking idealists will make profit unnecessary. The capitalists don't understand, but you do. These successful examples would lead to a business and political revolution.

What is stopping you?

jackstrawJuly 26th, 2013 at 4:35 am

i believe strongly that the fraud only works if it's private (read "no bailouts.") once you come crawling on your hands and knees to the Government they demand something in return. not all banks and financial institutions are "rent seeking." the bulk must live by the old stand by of lending at a profit. only the media makes it seem like "the parasitic class" is winning. the facts in my view speak FAR differently. those that have fled to Washington for protection from their creditors (the totality of Wall Street) i think have boxed themselves into a social contract: "start paying the piper." i don't see the wiggle room…especially with war as a backdrop but "financial repression" as its means of payment. in other words by hammering interest rates down to zero "as policy" the Fed has in a sense "equalized" everything. we know what the rules are now don't we? this is all about RETURN….and i would argue Wall Street does NOT excel at this business at all even though it happens right under their noses. "they're all about the deal" just like you said. but who needs one right now?

L. Randall Wray L. Randall WrayJuly 26th, 2013 at 12:17 pm

Jack: I think you are probably right for the longer run. What was it that Prez Bush said about fool me once….?

Eventually no one will trust Wall Street’s blood suckers; the USA will be shut out of global business because no one will believe it is a country of rules and laws.

dannyb2bJuly 27th, 2013 at 2:48 am

Just regulate banks so they cant create money when they lend. Force banks to act as intermediaries by sourcing funds before lending. That way banks cant crush innovation because they will serve the interests of the people they need to source money from.

George N. WellsJuly 27th, 2013 at 1:22 pm

We have a distorted sense of history. The latest crop of: "Financial Managers" will read the histories of the Great Depression and their response to the detailed descriptions of the tactics that caused the depression isn't: "that's terrible"; rather they salivate considering that scheme to be: "the next best thing."

The unfortunate victim is the middle income sector of the society. Banks, Credit Unions, and S&L's are paying next to zero interest on demand deposit accounts; if you want or need a reasonable return on your cash you are forced into highly risky: "investments" sold to you by some broker pushing a product that you probably don't understand along with the idea that you will: "make a killing."

Will we see a repeat performance of 1929? I don't know, I just hope that I don't live long enough to see it happen — again.

jackstrawJuly 28th, 2013 at 1:17 am

the USA already has the global businesses. what i mean to say is "Wall Street" has shut itself out of its own game. foreign banks historically have played a far greater role in domestic finance that the domestic ones…and it would seem that ancient paradigm is returning with a vengeance. Coke, Exxon, Microsoft, oracle…the companies aren't going anywhere but higher for the forseeable future. yet they can't get a loan while Wall Street squanders billions if not trillions in a collapsed Europe, and exploding Middle East and a melting down Japan. it really is quite the folly in my view…and it works provided you don't ask the Government for money. once you do that then Uncle Salami "begs the question" what's "in it for We the People." suddenly…Wall Street becomes small…both literally and figuratively. "let he who is without sin cast the first stone" Wall Street!

L. Randall Wray L. Randall WrayJuly 29th, 2013 at 12:50 pm

Danny: banks lend their own IOUs. The “money” is created simultaneously with the “loan”.

DismayedJuly 29th, 2013 at 6:54 pm

Wahat a absurd reply! Instituting some level of oversight is not the same as a government take-over of the entire economy. But then some level of moderation would conflict Andrew_M's extreme ideological views.

Ellie KAugust 19th, 2013 at 8:14 pm

Yes. You are right, Professor Wray of Kansas City. The SEC tried to regulate J.P. Morgan. At one point, maybe from 2009 – 2011, there were SEC auditors in permanent residence at J.P. Morgan, though not with the Chief Investment Officer's area, where the supposed Value-at-Risk mistake was overlooked (or something). The SEC isn't staffed like a local law enforcement agency. There must be willingness on the banks' part (not to mention hedge funds, who contribute even less than the post-Glass-Steagall banks!) to behave, do what they know the regulators want them to do. Or if they want to do things differently, go through the due process of justifying it, and accepting "no" for an answer, if that is what they are told.

If our wonderful liquid, transparent capital markets lose credibility, domestically, due to all of the influence peddling and greed, no one will trust us globally. They'll be afraid to do business here, because of protected interests, corruption, arcane rules that are arbitrarily applied. If this is apparent to you, and to me, and to lots of other people, I don't understand why it just goes on and on, until the something finally happens that is beyond the power of the Fed, or the tax-payers to repair, as they have nothing left to give.

Ellie KAugust 19th, 2013 at 8:27 pm

Professor Wray is correct. Look at what's happening now, I just read this in the Wall Street Journal:
Half of all homes are being purchased with cash. This is a report from Goldman Sachs, so you know that it isn't biased against Wall Street! The only people with money to make home purchases are very wealthy people who want investment properties to rent out, or to stow away their heaps of income without paying capital gains. Also, wealthy foreign investors are buying up property in the U.S. No, China is NOT taking over! They have their own worries. Who knows who is buying up property? There aren't any mortgages for banks to track.

This is not a good situation for banks, because they can't make any money when no one needs loans; rather, when no one who needs loans has any collateral for a down payment. So the good banks, the ones that do contribute value to the economy (unlike investment banks), are not prospering either. I am on shaky ground now, as this is from memory, but I believe that as a result, the velocity of money will decrease, or maybe the money supply, and there won't be the multiplier effect, and the economy will revert to the stasis of feudal times, with no upward mobility, no middle class, no, well, you get the idea.