Too Big to Fail? Wall Street and Main Street: How Big Are They
Guest post by Steve Roth
crossposted at Asymptosis
Too Big to Fail? Wall Street and Main Street: How Big Are They
People are forever talking about banks that are too big to fail. But you rarely hear about the larger issue: The financial industry is too big to fail. Click for larger graphic.)
Note that “Main Street” here includes government expenditures — 20% of the total. Remove those, and Wall Street money flow is 58 times the size of Main Street.
I haven’t pulled these numbers for past years,* but it’s clear that this disparity has grown hugely since the 80s, driven by credit issued by the financial industry, to the financial industry, with the money circulating in the financial industry. From Dirk Bezemer:
(FIRE is finance, insurance, and real estate.) The financial industry has spent the last 30 years inflating its own bubble.
So much for the flows. What about the stocks? This is harder to compile, and it’s also difficult to compare Wall Street and Main Street. I’ll explore this in future posts. But here are two numbers worth pondering:
The red bar on the left is the one I’m concentrating on here. (It’s probably a big understatement, because it doesn’t include assets held by financial corporations; see “tally stick,” below.) Divvy these financial assets between every household in America, and each one gets half a million dollars. Yow.
Think of that pool of financial assets as stored money. While they couldn’t all be turned into actual “money” at one time, they constitute the pool of money held by people and businesses, which money flows into (from personal savings and undistributed profits) and out of (for consumption, fixed investment, and tax-paying). This pool is also expanded by new credit/money creation, and increases in asset values. It is shrunk by loan payoffs and declines in asset values.
Now here’s the key point to understand: everything of value to humans is created by the people and businesses on Main Street producing, buying, selling, and investing (in productive assets and housing). Yes, Wall Street produces and sells some of that value: vehicles for investing business and personal savings in a variety of real assets (“intermediation”), safe storage (compared to your mattress), convenience, bookkeeping, advice, etc. That’s all paid for via fees and commissions, and those Wall Street fees and commissions are counted as part of GDP (aka Main Street). As they should be.
But you have to ask: did Wall Street deliver 35% or 45% of the human value of all American businesses in the 2000s? That was the “financial services” share of business profits — the reward received for value created. (I’ve seen some variance in this number, but 34% is the lowest number I’ve seen.)
Whereas the financial sector claimed less than 15 percent of total U.S. corporate profits in the 1950s and 1960s, its share grew to 25 percent in the 1990s and 34 percent in the most recent decade through 2008. —Testimony by Sheila Bair, January 14, 2010.
Here’s a picture:
You don’t have to imagine “evil actors” (though there is some proportion of those on Wall Street) to understand why a massive financial sector could be really, really bad for the real economy.
Imagine one of those super-hot racing sailboats that let you pump water from side to side as you switch tacks, to keep the boat upright, stiff, and stable. Now imagine all that water leaks out into the bottom of the boat, so it’s sloshing around with the wind and wave action. Every time you run into a big wave, all the water flows to the front of the boat. A big gust of wind heels you over, and all the water flows over in the same direction. It makes the boat really unstable.
That water is the money swirling and sloshing around in the financial economy. In the short term, those flows are are driven largely by people trying to predict what other people are going to do, so they can go in the same direction. Sound like our sailboat? With $55 trillion of financial assets in the U.S (4 x GDP), and those assets trading hands maybe twelve times a year, that’s a lot of sloshing.
It’s no wonder the sailboat gets knocked over periodically.
Now imagine that a whole bunch of your best and brightest crew members are spending their time with buckets pouring more water into the boat, and moving the water around from place to place (while furiously collecting as much as they can in little bottles in their pockets). Do you think you’re gonna win the race?
But here’s what’s weird: neoclassical economics basically ignores the motive effects of financial sector, treating it like a transparent, frictionless, and inert tally stick or bookkeeping system — like the bank in Monopoly. As Dirk Bezemer has pointed out, the model that the Fed uses to predict our economic future does not include the financial sector as an active entity.
The boxes indicate the variables included in the model. In the present context, the important observation is that all are real-sector variables except the money supply and interest rates, the values of which are in turn fully determined by real-sector variables. In contrast to accounting models, the financial sector is thus absent (not explicitly modelled) in the model.
Paper (pdf). A very nice summary here. You may take issue with Bezemer’s statements, but it’s certain that the Fed’s model does not consider the spectacularly large and highly variable flows within the financial economy, or model their effect on the real economy beyond the rather static notions of money supply and interest rates.
This is especially strange since the Fed is explicitly tasked with compensating for the business cycle. And the business cycle is largely driven by … the financial sector. (Main-street businesses’ cash flows, profits, and losses don’t display anything like the volatility of financial assets.)
Aside from those destabilizing money flows, which are pretty much inherent to financial economies (though their effects on the real economy depend crucially on plain old quantity), what other pernicious effects might we expect to see when a self-inflating financial sector does a very good job of inflating itself?
Moral Hazard. Because the financial economy is so massive, government has no choice but to bail it out if it gets in trouble. Financial-industry players know that, and they act accordingly.
Stagnant Growth in the Real Economy. As the pool of new financial assets (many of which are fabricated using finance-industry-issued credit) increases in value (in a boom or bubble), we see:
rising commitments for the real sector to finance asset transaction out of wages and profit, and rising actual debt levels. When the asset was sold at a profit, someone else bought the asset at the new, higher price. He or she financed this either by diverting liquidity away from real-sector transactions, or by borrowing – at higher levels than did the first buyer. Therefore asset price booms are accompanied by rising debt and by a slowdown in real-sector nominal growth.
Government Capture. Unlike welfare payments, for instance, which distribute money widely and hence are difficult to bring to bear on lobbying etc., the financial sector concentrates wealth, so it can be effectively used to capture government — which further benefits the financial sector, in a self-perpetuating cycle.
Misallocation of Resources. Since the financial industry provides rewards to employees and shareholders that are well in excess of the human value it produces (even considering its role as an intermediary delivering financial capital to the real economy, and its resulting second-hand contribution to delivering things that humans value), both financial and human capital are diverted away from the real economy that produces stuff we want.
I can think of several others (without even starting on things like fairness), but I’ll leave it to my gentle readers to fill out the whole set.
Supply siders, conservative politicians, and freshwater economists are fond of referring to financial capital as the “fuel” of the real economy. But if anything, labor, sales, innovation, or maybe natural resources constitute the real economy’s “fuel.”
Financial investments in business — whether in the form of equity or credit or some weird hybrid — are more like lubrication. A flow of financial capital is crucial to keep the machine running, but you don’t need all that much flow relative to output (43x? 58x??). (And Fama and French showed us long ago that it takes very few traders or trades to create an efficient market with reasonably accurate price signals.) This especially as business owners consistently tell us that investment is dead last on their list of business constraints.
Too much lubrication, in fact (I’m repeating my own line here), and the shop floor starts to get very, very slippery.
Truth told: we have truly oceanic quantities (both flows and stocks) of money, credit, liquidity — whatever you want to call it — far in excess of what’s necessary to lubricate the real economy. When somebody tells you that we need more savings to augment those quantities (and that we should, for instance, tax the rich less so they can provide those savings), I suggest that you go directly to Go, and look at the first three graphics in this post.
If I am correct, the financial sector is much larger than is necessary to lubricate the real economy, and as a result delivers far greater downsides than are necessary to fulfill its valuable purposes.
Is there anything we can do about that? Monsieur Pigou gave us the solution long ago: If you want less of something, tax it.
* It amazes me that these Wall Street figures are so hard to compile, and in fact are never compiled. (Google “financial industry profits” site:wsj.com. One useless hit.) The ratio between the financial economy and the real economy is not part of the everyday language of economic discourse. A kudos to Dean Baker and the folks at CEPR for putting these Wall Street numbers together.
This certainly agrees with my contention that we have given Wall Street more money than it can provide productive uses for. The result has been a series of asset bubbles. My question is how much of this giant pile of money is from reduced taxation on the wealthy*, and how much is from the Chinese and other trading partners repatriating their excess dollars. We agree on the problem, but until we have a better idea of the cause, we’re going to have even greater difficulty finding a solution.
*They save and “invest” a larger part of their income than the rest of us, and they are incentivised to seek more compensation for their work when they can keep a larger percentage of it.
All the more reason for the automated payment transaction tax. It is the appropriate solution if we are going to keep an economy that makes money from money.
Daniel
pretty sure i agree with you here. i doubt if that money is “real” but if we are going to play that it is, we ought to try taxing it.
time was when we understood that “Big” was dangerous.
I would add that such money concentration real or otherwise is dangerous for the world. It is what allows the detachment of the rich from any nation regardless of origin of citizenship. It allow the distruction of developing nation in that massive amounts of money can be pulled out at a whim. It allows the playing of one nation against another to the detrement of the people as capital in such large quantities look for the “best deal”.
Jim: don’t forget credit issuance/money-printing by the financial sector. It’s a huge part of the money that has flowed into financial assets. (Remember pre-’29? Massive credit issuance, with much/most of the money used to purchase financial assets.)
Daniel, I’ve read here and there economists pointing out that orthodox free-trade theory is fundamentally flawed because it doesn’t consider flows of financial capital, nor does it distinguish between the effects of real transcations (purchases/sales of actual goods and services) and those of financial assets. They’re very different entities, and one would expect them to have different effects.
Daniel: You said it. Check out the final link in the post for a lot of great thinking on the subject.
I stopped reading when the first graphic counted Futures and Swaps by “Notional Outstanding,” which was known to be silly twenty-five years ago.
Sadly, the rest of the piece appears well worth reading: the trends are identified accurately and the conclusion is inescapably spot-on (especially the “if you want” part–though it might be more accurate to say, “If you want another crisis that makes 2007-2009 look like a walk in the park, don’t tax it,” since that would more clearly identify the interests workign against).
The financial assets created by the financial sector are mostly fake assets. A large percentage of which are credit instruments. They are make believe whose prices are kept inflated now only by government borrowing and printing. Which borrows and prints in hope the financial sector can resume creating more fake assets. Or something like that.
The system cannot stand. Don’t get me wrong I am no Austrian or gold bugger but the only thing keeping it sort of afloat is the debasement of the currency. The only way to pay off the claims on phoney assets is to print the money to pay them. We are reaching a sort of end game and even as it happens it is impossible for most to comprehend the cause. While the cause of that Depression was unsound financial structures it is now the recieved wisdom the cause was not enough money printing, in the end that is what Freidman, Bernake et al say. I suspect when it comes crashing down they will still say that. Well Bernake will since he will still be alive, mabye. And as we know it is impossible for him to err.
I wrote once that Wall Street could not absorb the money from Social Security if SS was privatized. I was taken to task by a reader who pointed ant the 55 Trillion Dollar figure.
But that’s not real money. When it comes time to cash out those stocks and buy groceries the real money is going to be just about what GDP is.
It may be that by thinking of it as real money and tapping it a little at a time it can serve the function of real money… but I have my doubts. What may be more important is that by waving around Trillion dollar accounts, the Big Players can assert leverage far beyond their real means, or their real worth to the real economy.
I wrote once that Wall Street could not absorb the money from Social Security if SS was privatized. I was taken to task by a reader who pointed at the 55 Trillion Dollar figure.
But that’s not real money. When it comes time to cash out those stocks and buy groceries the real money is going to be just about what GDP is.
It may be that by thinking of it as real money and tapping it a little at a time it can serve the function of real money… but I have my doubts. What may be more important is that by waving around Trillion dollar accounts, the Big Players can assert leverage far beyond their real means, or their real worth to the real economy.Today, 10:38:43 AM PST– Reply – Delete
Ken: re: swaps, notice that this is a measure of flows, transactions — purchases and sales — not the stock or aggregate value of those instruments.
MO MONEY MO MONEY MO MONEY!
Ooooh, this annoys me.
That first pie chart set.
It is comparing the turnover of Wall Street with the Value added of Main Street.
Yes, GDP is value added, US GDP is $14 trillionish.
To compare turnover with value added is simply insane. Nuts. Doolally.
I have no idea what the turnover of Main Street is but it’s a hell of a lot larger than GDP. Many multiples of.
Sorry, but anyone who starts from that point made above is lying to deceive with statistics.
I know I disagree with many Angry Bear posts but this is much more than that. This is simply nonsense.
BTW, just to show how nonsensical this comparison is, clearly, of course, the $651 trillion turnover of Wall Street is included in the total GDP of the US. Because what we measure in GDP is value aded, and the value added by a constituent part of the US economy must be included in our measure of the total value added in the US economy……
A better measure is that outstanding debt (not counting stuff like SS and medicare) is about 45 Trillion. Household is about 10, financial is 11.6 the feds 9 state and local about 2 non financial business about 9, private business 2.4. The financial chart is like adding the gross revenue of the retail store the wholesaler the manufacturer, the transport providers and any suppliers. That a lot of multiple counting. Stock total value is in the neighborhood of 16 trillion, not the 45 t implied by the figure. So the two charts are like comparing apples and potatoes not really comparable.
Other figures imply a total asset value of the US at around 200 T 3/4 in financial assets.
That would be akin to legal marijuana and taxing it.
If the US taxed it they may go Galt with their fictional economy.
Tim
i think that’s the point. the turnover is not value added. yet it operates as though it were real.
Uhoh, you’ve trotted out another “I know a really big number” argument with the first pie charts (as in this mid December Mike Kimel post at Asymptosis: http://www.asymptosis.com/fundamental-fallacies-taxing-investments-reduces-investment.html#comment-1231).
Again, notional values mean squat for swaps and futures. And we’re talking about almost one third of your 43 X GDP. But then, that still shows a bodacious amount of money being shuffled around on Wall Street.
@ Tim Worstall. You make a good point. But it’s a bit like saying “Well, our boat is made of wood while the ocean is made of water. So if the ocean is going crazy no worries”. Look, Wall Street, and especially the shadow banks, went on a maturity conversion binge (borrowing short and lending long) that brought the whole financial system to a grinding halt. And that has indeed had a big effect on how much value is being added to GDP by the rest of the economy. (Ask anyone in the 18-25 range who is starring down the barrel of a 19% unemployment rate.) So, though it is technically apple and oranges, it gives a good idea of how out of all proportion the paper shuffling has gotten.
This is not a very good post. Comparing number of transactions? Really?
1) With the growth in GDP, international trade, and the money supply http://www.marketoracle.co.uk/images/2009/Jan/global_money_supply_trend.png , I would EXPECT an exponential increase in the number of transactions.
2) One of the reasons for the growth in transactions is advances in information technology. They transact because they now CAN, to take advantage of smaller spreads and more sophisticated financial strategies.
fictitious capital and credit schemes
http://thecommune.co.uk/2009/08/05/fictitious-capital-and-credit-schemes/
“[The Crédít Mobilier’s] tendency is to fix capital, not to mobilize it. What it mobilizes is only the titles of property…The whole mystery of the Crédit Mobilier is to allure capital into industrial enterprises, where it is sunk, in order to speculate on the sale of the shares created to represent that capital.” (Marx 1856: 133)
For Marx, this sinking of French society’s floating capital in order to speculate on the stock market played a fundamental role in the French economic crisis that began in 1856. The savings of small agricultural producers were increasingly transferred to the Mobilier, which pressed this money into the stock and bond markets. This removed capital from agriculture, causing a decline in agricultural productivity. This was exacerbated by bad seasons, causing a spike in the price of agricultural products, and raw material shortages in certain spheres of production. This entire process therefore resulted in disproportions between industries and an overexpansion of fixed capital.” … ….
Fictitious Capital and Today’s Global Crisis a talk by Loren Goldner
http://vodpod.com/watch/1078237-fictitious-capital-and-todays-global-crisis-a-talk-by-loren-goldner
BIS Derivative Stats, which does provide [estimated] gross mkt value as well as notional:
http://bis.org/statistics/otcder/dt1920a.pdf
Incorrect. There has been no real currency debasement and that is the point. They make you “believe” but don’t show the “real” currency.
Considering the “Austrian” was based off of Ricardo, you should know that the ‘Gold bugs’ and Austrian fantasy of a one world system(I would call government) of plutocracy is the real goal. Considering in 1895 the gold standard bankrupted the US and relied on the bankers “bailing” it out in a slow aqusition toward dictatorship, you should know much much better. Printing? Not on your life.
And voilà, as juan shows, the actual market values of derivatives are a small percentage of the notional amounts.
But your point still stands up. Wall Street is moving around way too much money to be cut loose to do what they like. It is, in the end, and libertarian free banking fantasies aside, all our money.
I had wrote about Pigou taxation for the finance industry in 2009 at
http://mgiannini.blogspot.com/2009/11/taxing-financial-transactions-why-not.html
http://mgiannini.blogspot.com/2009/03/polluter-pays-principle-in-financial.html
Now in Europe we are discussing it again at:
http://apps.facebook.com/sayyestofttineurope/