An Excellent NYT Column on Financialization

Every writer knows the feeling of reading something you wish you’d written yourself. That’s what I got with Floyd Norris’s column today on why the financial industry pay is so huge and what to do about it.

For one, rather than try to whack the mole, something we’ve been frustrated with at The Audit, Norris looks to the root of the problem—the financialization of the economy. Regarding financial-industry profits, he points out that:

In the six decades from 1929 through 1988, those profits averaged 1.2 percent of gross domestic product — and never went above 1.7 percent.

Then they shot up in the 1990s and went up further in the current decade, peaking at 3.3 percent in 2005. Even now, the figure is higher than it ever was before 1990.

Norris notes that the function of the financial industry is to best allocate capital in the economy, spurring long-term growth for everybody, but:

Unfortunately, there is little evidence that the financial industry’s success has done much for the rest of us. Capital was not well allocated during the recent bubbles, to say the least. The fact we had bubbles testifies to that.

Indeed, and financial capital isn’t the only thing misallocated by the financial industry’s huge growth.
With the vast riches to be had on Wall Street in the last three decades—and let’s be clear, there were always vast riches to be had on Wall Street, but the last thirty years have been something else entirely—our human capital has been misallocated toward making money rather than making things or ideas that benefit society.

As recently as 2007, half of all Harvard graduates went into finance and consulting, according to a good Wall Street Journal story we wrote about here. Half! Forget medicine, teaching, engineering. At MIT, 30 percent of all graduates went into finance—even the folks with engineering degrees.

No, financial engineering is not the highest and best use of their talents.

Norris goes on to explain why this has all occurred, noting that fees have soared, most importantly in the hedge-fund field, which helps build that pyramid of debt that also boosts the financial industry (at least for a while).

Critically, because I think this is ill-understood, Norris point out the role gigantism has played in gilding financial-industry paychecks:

“In 1990, the 10 largest financial institutions had 10 percent of financial assets in the United States,” says Henry Kaufman, an economist and author of a new book, “The Road to Financial Reformation.” “Last year, the figure went over 60 percent.”

See, there can only be ten CEOs of those ten largest financial institutions, which each funnel huge profits into one till. The CEOs and executives get paid from that till that’s much bigger than it was twenty years ago when there were far more companies divvying up that revenue, and—crucially, as Norris points out—competing for business, which tends to lower profit margins by keeping money in customers’ pockets rather than executives’.

Also important is the information-asymmetry thing.

Richard Bookstaber, a former hedge fund manager and risk manager whose 2007 book “A Demon of Our Own Design” warned of the crisis that soon erupted, suggested in his blog last week that banks profited from “constructing informational asymmetries between themselves and their clients. This gets into those pages of small print that you see in various investment and loan contracts. What we might call gotcha clauses and what the banks call revenue enhancers. And it also gets into the use of complex derivatives and other innovative products that are hard for the clients to understand, much less price.”

Mortgages, anyone?

Another thing that’s great about this column is that it not only identifies what went wrong, but suggests simple ways to fix things: Reduce profits by forcing institutions to hold higher capital reserves. Boost competition by busting up giant banks or incentivizing them to bust up themselves. Simplify the industry’s complex products.

Excellent stuff.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.