Authors: Charles Ferguson
Source: Adapted from Adair Turner/UK Financial Services Authority
In effect, during the bubble the banks and the shadow banks were part of a single, highly leveraged organism. But only one side was open to regulatory scrutiny, and even the supposedly
regulated sector got precious little of it. As assets were shifted back and forth between the two sides, leverage typically grew sharply, and the interconnections
tightened. When one piece of the system cracked, like a flooded safety device in a nuclear plant, a global financial crisis was under way almost before officials noticed. In
response to the failure of Lehman, the shortterm funding market shut down, and the crash was on.
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And if AIG had failed, all of those credit
default swaps that provided “protection” wouldn’t have been worth the paper they were written on.
Toxic Incentives Again
In 2008 Paulson and Geithner were certainly correct to save AIG, guarantee money market deposits, and hand out $250 billion to strengthen the banks a month later. Their
culpability lies in having allowed the bubble to build and having been unprepared for the crisis, and then in saving the banks without getting anything in return, either then or later, from those
who had created the problem. This last issue is perhaps the most dangerous for the future. Letting them get away with it wasn’t just morally obscene; it was also destabilizing, because it
signalled that they could do it again. One can take comfort from the fact that airline pilots need to be careful because they too would die in a crash—but exactly the reverse holds true in
high finance. When the plane had engine trouble, we looked out the window to see the pilots gliding to earth with the only parachutes in sight. But where else can we borrow and invest? The
American financial sector has a captive audience.
This, in turn, explains much of the risk taking and dishonesty that we have just catalogued. If volatility, leverage, concentration, and systemic interdependence are so incredibly dangerous, why
would rational people construct such an industry? There are several reasons, but primary among them is that the architects and contractors don’t have to live in the house. There are
other reasons for regulation too. There will always be some people willing to do dangerous things, and they need to be kept away from the controls. There are public goods/collective action
problems: individuals are powerless to change the system, so they might as well go along for the ride (i.e., if New York State prohibits
something but California
doesn’t, then it just moves to California—or London). This means that only broad regulation can be effective. But the single most powerful driver of risk taking and fraud was clearly
the fact that all the benefits were appropriated by those running the financial system, while the costs were borne by everyone else.
Recall our earlier dissection of how the toxic incentive structures of financial firms led traders to destroy their own firms. Something similar holds true at the systemic level as well. First,
the lesson from 2008 and since is that those who destroy the system will be bailed out and won’t be punished. But second, even if you don’t bail them out, and even leaving aside little
details like criminal prosecution, there is a vast disproportion between the financial sector’s financial pain and the pain that it has caused to society at large. Of the trillions of dollars
that the financial crisis has cost, only a very small portion, surely less than 5 percent, has been paid for by the financial industry itself.
In the end, then, unregulated finance isn’t that different from unregulated medical practice, aircraft maintenance, offshore oil drilling, high explosives, nuclear power (or, perhaps, even
regulated
nuclear power), or military weapons. Do you think that it would be fun to live in a country where absolutely anyone can claim to be a doctor—if you can find such a place? Or
perhaps try a country with no real police force, in which everyone has assault weapons and explosives. Try a few years in Iraq, Afghanistan, or Somalia. See if you like it there.
Is Modern Finance a Parasitic Industry?
LORD ADAIR TURNER,
chairman of the British Financial Services Authority, is one of a growing number of economists and financial experts who have raised
the question of whether the modern financial sector is a burden to society even when it isn’t generating crises. Others who have raised the same issue include Burton Malkiel, a professor at
Princeton University, and John Bogle, the founder and former CEO of the investing firm Vanguard Group. Both Malkiel and Bogle have
pointed out that the overwhelming majority
of investment managers do no better than someone throwing darts at the wall.
The problem, furthermore, is more general than mutual funds. In a series of lectures and papers, Lord Turner asked whether modern finance has become a “rent-extracting” industry,
which is economicsspeak for “parasite”. By “rents”, economists mean earnings derived from your position as a bottleneck, or a leech, rather than from any real economic
contribution. Surplus cartel earnings, governmentsanctioned monopolies, bribes extracted by the powerful, and earnings from inside information are examples of economic “rents”.
Large parts of modern finance seem to fit this definition. In some cases, particularly the private equity sector and the tax avoidance industry, financial sector profits depend heavily on tax
loopholes and zero-sum exploitation of working people. The following are some examples.
The Portfolio Management Industry
It has long been known that low-cost indexed portfolios nearly always outperform active asset management. While indexing has been making inroads in recent decades, active
management still dominates in pension plans and endowments, and in almost all individually directed investment accounts. The high fees paid by many retail investors are a clear case of information
failure and/or market power, probably exacerbated by deceptive advertising and the industry’s concentration. Even the hedge fund industry, open only to wealthy and institutional investors,
has an unimpressive overall record. Net of the high fees that hedge funds charge, the industry has barely outperformed US Treasury bonds over the last twenty years. There are, of course,
exceptions: Warren Buffett, George Soros, and several others come to mind. But for every Buffett or Soros, there are many who don’t deserve their very high incomes.
High-Frequency Trading
Hedge fund billionaire Jim Simons, a former star mathematics professor at Stony Brook, has for years made extraordinary returns by using powerful computers and proprietary trading algorithms to
exploit tiny market trends invisible to humans, and which often last only a fraction of a second. The trading is entirely automatic—computers make all the decisions and execute all the
trades. The net effect is a small tax, a form of skimming, on the whole market. Normal investors who don’t own gigantic computer systems end up paying slightly more for stock trades and have
slightly lower investment returns, while Simons and his imitators pile up micro-pennies by the billions.
There is no social benefit at all from high-frequency trading; the positions often last only for milliseconds and have no economic utility. It is a pure drag on the economy, albeit a small one,
like spam e-mail. The massive trading volumes the strategy requires impose substantial costs, mainly for computer systems, and on at least two occasions high-frequency trading has caused market
disruptions called “flash crashes”.
Simons’s personal earnings are in the billions, making him one of the highest-paid hedge fund managers in the world. Naturally, all large players now emulate this strategy, and it now
accounts for the majority of total trading volume. Indeed, an increasing fraction of hedge fund management is game playing of this kind, exploiting very small, short-lived market imperfections to
pile up wealth while providing no social benefit.
Obscuring Debt, National and Otherwise
All readers of the financial pages know that Greece has been mired in a debt crisis. An initial question, naturally, was how much did Greece owe? A team from the European
finance authority reported in 2010 on “the difficulties in . . . [getting] complete and reliable information” on Greek debt. No surprise, because modern banking practices had been there
first.
Goldman Sachs arranged a series of highly favourable currency swaps for Greece, creating an immediate gain of 2.4 billion euros, which was applied against the
country’s apparent debt. Normally, such a trade should have triggered a cash payment from Greece to Goldman to cover the gain. But Goldman covered that by structuring another swap, but a
deferred long-term one. The entire transaction improved the looks of Greece’s books and also produced fees for Goldman. Several other investment banks have been criticized for doing
essentially the same thing for a variety of domestic and foreign companies and local governments.
Tax Avoidance
An unknown but clearly significant fraction of American tax attorneys and financial advisers obtain very high incomes from wealthy individuals and corporations for the sole
purpose of avoiding taxes. It is greatly to the benefit of these people that the tax code has become extremely complex and that it contains many provisions that can be used to avoid the payment of
legitimately owed taxes.
These activities, and their effects, have grown enormously over the last quarter century as a combined result of increasing economic inequality, legal and tax loopholes, and weakened
enforcement. In the early 1980s, US corporate taxes equalled over 40 percent of corporate profits; in 2010, it was 26 percent. The effect for wealthy individuals has been even more dramatic. The US
Internal Revenue Service has reported that the effective tax rate of the nation’s four hundred wealthiest families, most of them billionaires, declined from 30 percent in 1995 to only 18
percent in 2005, the last year for which data are available (as of early 2012). Some of these declines in tax payments represent changes in tax rates; for example, the Bush tax cuts. But a major
fraction of the declines, both corporate and individual, have come from tax avoidance.
On 27 November 2011, the
New York Times
published a long article on the tax avoidance schemes of the billionaire Ronald S. Lauder, who
inherited a fortune from his
parents, the founders of the Estée Lauder cosmetics firm. According to the report, Mr Lauder’s own contribution to the American economy has been, let us say . . . unclear. Although Mr
Lauder has a net worth of over $3 billion, he and his family have used a series of highly aggressive tax shelter strategies implemented by their lawyers and financial advisers. These strategies
have included offshore corporate structures in tax havens; trusts that shelter stock tax-free for long periods; forward contracts for the eventual sale of stock, permitting immediate and tax-free
access to cash; derivatives strategies such as “shorting against the box”; tax-free borrowing against unsold stock; “fractional donations” of a portion of an artwork whose
possession he retained; and others. It was a family affair. The company, its owners, and their heirs have used aggressive tax avoidance since Estée Lauder went public in the 1980s.
Many American corporations now behave similarly. When the transformation of American finance began in the 1980s, very few American corporations used even the tax avoidance methods then
available, such as registering subsidiaries in offshore tax havens. It was, quite simply, considered both unseemly and unnecessary. Now, however, most large multinationals do this. Some, such as
General Electric, correctly regard tax strategy as a major driver of profits, and maintain large permanent staffs of attorneys and financial planners dedicated purely to tax avoidance. In addition,
of course, these companies make extensive use of investment banks and outside law firms.
No matter what you think about tax rates—even if you think that taxes should be lower for billionaires—this is pointless, wasted activity. And if you think that billionaires, and
companies with billions of dollars in profits, probably should pay more taxes than construction workers and secretaries, then it isn’t simply wasteful; it’s highly destructive.
The Private Equity Industry
Private equity companies may be the most efficient money-seeking organisms in the world. The campaigning journalist Matt Taibbi has immortalized Goldman Sachs as “a great
vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.” Maybe. But in 2006, when Goldman’s Lloyd Blankfein earned
$44 million, which made him Wall Street’s highest-paid investment banker, Blackstone’s Steve Schwarzman made $398 million, or twice as much as the top five Goldman earners combined. On
top of that, due to the “carried interest” tax loophole, most of Schwarzman’s income was taxed at a 15 percent rate, equivalent to that paid by ordinary workers in the bottom
income tax bracket. Blackstone and all the other major private equity firms use the same fee structure—they charge 2 percent per year of assets under management, plus 20 percent of all
profits, with no responsibility for losses.
The best that can be said about private equity companies is that they might not be any worse than many of their publicly owned peers. They are very rough on their rank-and-file employees, but
many companies are today—perhaps in part because of the pressures from private equity firms. They do cut costs—at least operational costs. But they often greatly increase the financial
costs of the companies they own. They are brutally expert offshorers and outsourcers of jobs. Undoubtedly, there must exist some private equity deals that have produced real economic gains, when
incompetent managers are replaced through an acquisition. But there is abundant evidence that this is not the norm.
A great deal of the success of private equity firms comes from exploiting various hidden government subsidies and tax loopholes. A considerable number of companies acquired by private equity
firms go bankrupt even though the private equity buyers make money. This is not a marginal matter. Of the ten largest leveraged buyouts made by Bain Capital when Mitt Romney was its CEO, four went
bankrupt,
even though Bain made money
. Private equity owners have no liability for a company’s debts, so they face relatively little risk. Therefore, they
often
force the company to borrow huge amounts of money, which the company then pays to the private equity firm as fees and/or dividends. The result is often bankruptcy, as the company runs out of money.
But it doesn’t stop there. Bankrupt companies are legally prohibited from paying dividends, but they can pay “fees”. And, not infrequently, the same private equity firm buys the
company again,
out of bankruptcy
, after many of its debts have been reduced or restructured.