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January 23, 2008

The New Class and Its Government Nexus, Part I

Friedrich von Blowhard writes:

Dear Blowhards,

Almost a year ago I wrote a post, Risk, Reward & The New Class, in which I asked the question: “What permits the New Class to float above the risk-reward curve that the rest of us are tied to?”

For those of you who haven’t read that immortal screed, the New Middle Class or, for brevity, the New Class, consists of financiers, senior corporate and government bureaucrats, and professionals (doctors, lawyers, accountants, etc.), all of whom collect high incomes without being required to put their own money at risk. These people make up most of the people in the top 10% of the income distribution, and a very high percentage indeed of people in the top 1% of the income distribution. (Another, much smaller chunk, of the people in the top 10% and the top 1% are entrepreneurs, who are assuredly not members of the New Class; they are economic experimenters and risk takers, as their high bankruptcy rate demonstrates.)

Now, as any economics textbook will remind you, the risk-reward curve represents the definitional relationship of a capitalist society—that is, if you want big returns you’ve generally got to take big risks with your capital. No upside without a possible downside. Contrawise, if you refuse to put your capital at risk, you are likely not going to end up rolling in dough. And yet we find that there is this unusual group, the New Class, which mysteriously doesn’t live by the same rules as the blue-collar worker or the entrepreneur. Hence, my question above: what gives? If we live in a capitalist society, as our editorial pages and our elected leaders and our economics professors assure us daily that we do, why is it that so much of the economic pie ends up in the mouths of people who are neither capitalists nor laborers, exactly?

This question is rarely asked in this fashion (which might possibly have something to do with the fact that people who tend to ask questions like these, otherwise known as economists, are themselves charter members of the New Class.) However, lots of people ask a closely related question: why is the top 10% of the income distribution (as we have seen, heavily populated by the New Class) doing so well relative to the rest of the population?

To take one example out of a myriad, in "Income Cap is Widening" of March 29, 2007 David Cay Johnson of the New York Times sets the stage by reporting that:

Income inequality grew significantly in 2005 [the last year for which data is available], with the top 1 percent of Americans…receiving their largest share of national income since 1928, analysis of newly released data shows. The top 10 percent, roughly those earning more than $100,000, also reached a level of income share not seen since the Depression…average income for those in the bottom 90 percent dipped slightly compared with the year before, dropping $172 or 0.6 percent.

Mr. Johnston then inquires on why that might be of Brookly McLaughlin, the Chief Treasury Department spokeswoman, who passes along a theory from her boss:

Treasury Secretary Henry M. Paulson, she noted, has acknowledged that income disparities have increased, but, along with a "solid consensus" of experts, attributed that shift largely to "the rapid pace of technological change [that] has been a major driver in the decades-long widening of the income gap in the United States."

With all due respect to our Treasury Secretary, who as a former Chairman of Goldman Sachs is one of the leading lights of the New Class and who has, according to this Wikipedia article a personal fortune of some $700 million to prove it, I would suggest a different or possibly supplementary explanation for this phenomenon: the tight nexus between the New Class on the one hand and the government on the other.

To support my no-doubt-outlandish claim, I thought I’d look at the financial services industry as a microcosm of the New Class and its impact on the rest of society.

I thought I’d begin with a brief overview of how the financial sector is doing in contemporary America. The financial blogger Hellasious from Sudden Debt pointed out in a post from December 5 2007 the extent to which the financial sector in recent years has successfully captured the strategic heights of the American economy in the past quarter-century:

After-tax corporate profits as a percentage of GDP have now grown to an all-time high (see chart below)...But that's not the whole story, because it wasn't the entire corporate sector that made such record profits. Rather, it was the financial industry that made out like bandits...whereas non-financials only recently managed to recoup amid the general rise in profitability. In the past 25 years profits of the financial sector went from 25% of total corporate profits to 50% (see chart below), a condition frequently called the "financialization of America". Lending and shuffling money around has become by far the biggest business in America...[emphasis added]

sectors2.jpeg

Granted, some portions of this industry have been taking their lumps over the past few months (much more on that later), but you might notice that mostly the industry hasn’t found any difficulty in raising additional capital for itself despite this temporary little bump in the road. And, of course, you might note that the current problems in the financial services sector and some of its more ill-advised investments are having a tremendous impact on the economy -- which just illustrates how "financialized" America has become. Today, when Wall Street chokes on subprime mortgages, all of America gets a stomach ache.

Of course, much of the financial sector’s activities are conducted through public corporations. Maybe the worker-bees have been laboring in the salt mines all these years and just shipping all their vast profits off to their shareholders and investors? Well, not exactly.

According to Gwen Robinson of the Financial Times on January 15, 2008, a very big -- indeed, astoundingly big -- chunk of the profits (er, 'net revenues') of Wall Street are actually reserved for the staff:

Morgan Stanley, for example, reported a huge Q4 loss and raised $5bn in new equity from a Chinese state investment fund, but paid out $16.6bn in compensation last year — an 18 per cent increase. This pushed the ratio of compensation to revenues -- a closely watched measure of cost discipline -- to 59 per cent for the year. Most investment banks aim for a ratio below 50 per cent. Morgan Stanley is unlikely to be alone. Citigroup and Merrill Lynch...face a similar dilemma...Merrill’s compensation ratio -- pay and benefits as a percentage of net revenues -- is expected to rise to more than 70 per cent as it seeks to cushion key staff from feeling the pain of the bank’s losses. Some observers believe it could exceed 100 per cent if the bank reveals fresh losses on subprime securities.

The remarkably favorable position of Wall Street technocrats vis-a-vis their risk-taking ownership -- I’m referring to the shareholders that actually suffered those multi-billion dollar write-offs -- is something I’ll just point out right now, but we’ll be getting back to that later.

Anyway, if you got the impression that Wall Street employees are highly rewarded, you’re right, at least according to September 1, 2007 story in the New York Times by the aforementioned Mr. Johnson:

Top money managers earn such huge incomes that even when their compensation is mixed with the much lower pay of clerks, secretaries and others, the average pay in investment banking is 10 times that of all private sector jobs, new government data shows. [emphasis added]

And it’s not like investment bankers are even the cream of the crop as far as compensation goes. As Steve Rosenbush of Business Week pointed out in January 2007:

...senior executives at private equity firms and hedge funds can earn even more than investment bankers. "Investment management is the most lucrative profession in the world. There's nothing like it. Investment banking is a poor cousin to hedge fund investing," said one senior executive at a financial-services firm, who declined to be identified. He said the founder and CEO of a large hedge fund, such as Steven Cohen of SAC Capital Advisors, can earn hundreds of millions of dollars a year.

In fact, people who study income inequality have postulated that the New Class members atop the financial services sector are a bigger reason for the rise in income inequality than their much-abused New Class brothers, corporate CEOs:

In their study, Steven Kaplan and Joshua Rauh, who teach at the University of Chicago’s graduate business school, set out to identify who is represented in the richest of the rich. Surprisingly, they conclude CEOs have only marginally increased their representation. Looking at just the top 0.01% of earners, executives of non-financial companies comprised 4% in 1994 and 5% in 2004. Who accounts for the rest? They surmise a sizable portion is “Wall Street”: executives of financial companies, employees of investment banks, hedge fund managers, venture capitalists and private equity investors. This group, they conclude, has significantly increased its presence among the richest of the rich...Fees to hedge fund investors [i.e., managers], for example, have grown seven times in real (inflation-adjusted) terms to $25.4 billion since [1994]. Fees to private equity firms have risen four times to $18.4 billion, and fees to venture capital firms have risen seven times to $10.9 billion. Profits earned by partners at the top 100 law firms rose 2.6 times to $18.1 billion.

Financial Sector Donations and Lobbying

Okay, we’ve established that financial managers and technocrats are doing well as individuals—far better on average than ever before. But, you ask, what is this sinister-sounding ‘tight nexus with the government’ that I keep yammering about?

Well, it’s pretty simple, really. From 1998-2006 (the only years in which I have data, although I’m confident the pattern has held good for far longer than that), the finance industry, including commercial and investment banks, savings & loans, private equity firms and insurers (other than health insurers) has held the the Numero Uno spot in the political influence game. The sector made $933 million in campaign contributions and spent $2,077 million on lobbying, giving them a grand total of $2,941 million. This puts them to the very top of the list of industry donations and lobbying that I presented in my previous post, Auctionocracy.

Heck, even nouveau, if tres riche, players in financial services are eager to pour money into politics. As Landon Thomas Jr. reported in the New York Times a year ago:

Hedge fund money, which now exceeds $1 trillion, has emerged in the last several years as a potentially powerful force in politics, as underscored by the significant role it is playing in the presidential aspirations of Mrs. Clinton and Mr. Giuliani.

Somewhat surprisingly, from the point of view of the standard left-right dichotomy that is supposed to define American politics, Wall Street, the heart of modern American capitalism, has proved willing to do business with, er, the guys on the ‘socialist’ side of the street. In fact, Wall Street is apparently throwing more money at the Democrats than at the Republicans, according to this International Herald Tribune story from October:

Obama, for example, has raised $4 million from the financial services industry, more than all other candidates, according to data provided by the Center for Responsive Politics, a research group in Washington that tracks political donations. And among other Democrats, Hillary Rodham Clinton, as a New York senator, and Christopher Dodd, as chairman of the Senate Banking Committee, also have deep ties to the industry.

In short, if you plan on voting Democratic in order to drive the traders from the temple of American life, I’d think a little longer.

Well, that leads us to an interesting topic: just what does the financial industry get back from the government in return for all that dough?

What Has the Government Done for the Financial Sector?

Martin Wolf, chief economics columnist of the Financial Times gave some thought to this very question in a column from November 27, 2007. He begins by observing:

Perhaps the most striking characteristic of the banking sector is its profitability. Between 1997 and 2006, for example, the median nominal return on equity of UK banks was 20 per cent...In the US they were a little over 12 per cent. Returns in Germany, France and Italy seem to have been close to US levels...[in contrast,] long-run real returns on equity in the US have been a little below 7 per cent. Another study estimated the global real return on equity in the 20th century at close to 6 per cent. A starting assumption for a competitive economy is that returns on equity should be much the same across industries...

Golly, I have to jump in here because that is a darn interesting observation. Just how is it that one sector of the economy (and a 'secondary' sector, theoretically dependent on the primary, or 'real' economy) somehow got itself into a position to make such a radically outsized share of the loot? Why was it that Citigroup, making approximately 20% return on equity in 2006, was widely criticized for being a stumblebum, a laggard? How did Goldman Sachs make almost double that return (39.6%) on equity in the same year? How is it that Wall Street accounts for half of all corporate profits (and an even larger percentage still in, say, 2003 -- see chart above), while representing only a tiny fraction of total employment? Is it because, pace Hank Paulson, only investment bankers are smart enough to use computers or understand spreadsheets? Or is something else, something big and powerful, perhaps, at work here? To continue with Mr. Wolf, who is explicity describing the situation in the U.K. but might as well be talking about the U.S.:

[B]anks are also thinly capitalised: the core “tier 1” capital of big UK banks is a mere 4 per cent of liabilities...these high returns on equity suggest that banks are taking substantial risks on a slender equity base...How do banks get away with holding so little capital that they make the most debt-laden of private equity deals in other industries look well-capitalised? It can hardly be because they are intrinsically safe. The volatility of earnings, the history of failure and the strong government regulation all suggest that this is not the case. The chief answer to the question is that banks benefit from sundry explicit and implicit guarantees: lender-of-last-resort facilities from central banks; formal deposit insurance; informal deposit insurance (of the kind just extracted from the UK Treasury by the crisis at Northern Rock); and, frequently, informal insurance of all debt liabilities and even of shareholders’ funds in institutions deemed too big or too politically sensitive to fail.

Gee, you don’t think that all those government guarantees and safeguards might possibly be worth something in terms of cold hard cash, do you? Certainly all that would make your customers willing to keep their money on deposit with you no matter how iffy your investment portfolio of loans and asset-backed securities might be, no?

After all, the government bears down so oppressively on this sector that it enables, er, forces it to operate with ultra-conservative debt-to-equity ratios of, um, 2400%. (The more banks can fund loans with cheap debt rather than their own expensive equity, the more profitable they are, both in absolute terms and of course in terms of the profit they earn per dollar of equity invested.) I seem to remember Alan Greenspan actually remarking with a certain droll understatement that “Central bank provision of a mechanism for converting highly illiquid portfolios into liquid ones in extraordinary circumstances has led to a greater degree of leverage in banking than market forces alone would support.” (emphasis added.) It would, of course, be perfectly accurate to rewrite this passage to read: Central bank provision of a mechanism for converting highly illiquid portfolios into liquid ones in extraordinary circumstances has led to a greater degree of profit in banking than market forces alone would support.

One example of the kind of government guarantees referred to above by Mr. Wolf got its very own and rather catchy slogan way back in the 1984. That’s when the Comptroller of the Currency, C. Todd Conover, testified before Congress regarding the multibillion dollar Federal bailout of Continental Illinois Bank of that year. The Comptroller let slip that the government did not intend to allow any of a series of very large financial institutions to fail, and would intervene to prevent this from happening, because of the systemic risk such a default would pose to the entire financial system. (Oddly, or perhaps not so oddly, the obvious and simple remedy for such a problem—breaking up financial institutions that were “too big” so as to make Federal intervention to prop them up unnecessary—was never raised.) The congressional committee chairman conducting the hearings memorably dubbed this policy “Too Big to Fail” and it has never been repudiated by U.S. banking regulators. Nor have those same banking regulators prevented U.S. banks or other financial institutions from continuing to grow, often by mergers and acquisitions, despite the systemic risk that such growth entails; today’s large banks are many times the size of the biggest institutions of the 1980s.

The long term consequences of this policy were discussed in 2005 by Donald P. Morgan and Kevin J. Siroh of the Federal Reserve Bank of New York in their paper, Too Big To Fail After All These Years”:

Whatever the benefits of the [1984] Continental bailout (in terms of averted crises), the cost of the TBTF [“Too Big To Fail”] mentality it engendered is obvious: weaker market discipline. Insuring bond holders of very large banks turns them into yet another class of risk-indifferent claimants (like insured depositors) with little incentive to monitor and penalize (via higher spreads) risk taking by banks perceived as TBTF...Avery et al. (1988) found that bank bond spreads were barely related to ratings, and unrelated to accounting or bank balance sheet risk measures. Market discipline of banks, they concluded, is weak.

And, of course, Mr. Wolfe’s account of favors done above has only begins to scratch the surface of the things the government has done that turn out, by a remarkable coincidence, to be highly lucrative for the financial services industry. To take one example almost at random, let’s look at favorable tax treatment of capital gains, something that certainly motivates people to pursue passive investing opportunities such as stocks and bonds. Deborah Kobes and Leonard E. Berman of the Tax Policy Center lay out the recent history of such taxation:

...capital gains tax rates fell from a maximum of 39.875 percent including an add-on minimum tax, which was widely applicable in 1978, to 20 percent in 1982. The tax rate differential was eliminated by the Tax Reform Act of 1986 (TRA86) at the same time that top ordinary income tax rates were slashed to 28 percent. When tax rates on ordinary income increased in 1991, the top capital gains tax rate was held fixed at 28 percent. It was subsequently cut to 20 percent in 1997 and to 15 percent in 2003. In comparison, the top tax rate on ordinary income is now 35 percent.

In other words, the advantages of passive investing (or economic activity that can be made to look passive) are now at an all-time high relative to regular earned income. In a related move, of course, the same 2003 legislation that reduced capital gains tax rates also reduced the taxation of dividends to 15%. Hey, not bad for business if you’re a stock broker, huh?

And the wonderful advantages of capital gains aren’t just limited to providing incentives to average Americans to hand their savings over to Wall Street money managers. No, in some instances, those money managers get to tax their own income at those very favorable capital gains rates.

Both hedge funds and private equity funds are structured as limited partnerships in which the investment managers of the funds are the general partners and the investors (sometimes wealthy individuals but more commonly pension funds or other institutional players) are the limited partners. The general partners are paid in two ways: first by a fee, typically 2% annually of all invested money and taxed as ordinary income; second by receiving a share, typically 20%, of all investment profits (but not, of course, losses). This latter arrangement (known as a “carried interest”) looks an awful lot to the objective observer like an incentive payment for performance, something usually taxed as ordinary income. However, as a result of a certain amount of legal mumbo-jumbo in which the manager is declared to be the part-owner of the invested money, presumably after sacrificing a cock to the Olympian gods of good fortune, the carried interest is taxed as – you guessed it – a capital gain for the manager. This is of course despite the fact that the general partners typically have no skin in the game and nothing at risk if things go south. Hey presto! Thank God we live in a free-market capitalist system!

Some of you may have noticed that there was an effort to address this gaping tax loophole ongoing during most of the last year. It culminated in legislation by Charles Rangel which attempted to tax carried interest at ordinary income levels as part of a deal to lower the taxes that Uncle Sam collects from middle-class individuals via the alternative minimum tax. You may also recall the fate of this legislation just last month after the financial services industry flexed its legislative muscles:

House Ways and Means Committee Chairman Charles Rangel agreed to drop a proposed tax increase on "carried interest," a measure bitterly opposed by the private equity and hedge fund industries, from hotly disputed tax legislation. "Score one for the barbarians," The New York Post wrote, noting the intense lobbying from the largest buyout firms that helped defeat the measure, at least for now.

Don’t grumble about that as you prepare to fork over your AMT taxes; after all, lower capital gains rates hardly exhausts the tax and other benefits the government has bestowed on Wall Street money managers. For example, just think of how average Americans have been prodded by Uncle Sam to hand over their retirement money to Wall Street. It’s easy to forget how recent the trend of widespread stock ownership, usually as a vehicle for retirement savings, really is. According to “A Financial History of the United States” by Jerry W. Markham:

Only 4.2% of the population in the United States owned stocks in 1949. Eighty-two percent of families had life insurance. Twenty-one percent had annuities and pensions and almost 42 percent held United States savings bonds. At that time, 69 percent of American families with income over $3,000 opposed investments in common stocks. [emphasis added]

According to the Investment Company Institute(the mutual fund trade group), a full 31 years later—in 1980—only 6% of American households owned mutual funds—not that big a change from 1949. But the number that had risen to 37% in 1996, and today over half of American households own stock.

What caused this, um, remarkable change in attitudes? No doubt, as our Treasury Secretary would suggest, it had something to do with brilliant people on Wall Street and their burgeoning technological skills, right? Maybe not. The U.S. Congress Joint Economic Committee back in 2000 looked into this issue and concluded in a study that:

The rise in stock ownership over the past twenty years can be mainly attributed to three factors, all of which made stock ownership more attractive relative to consumption or other methods of saving. First, the increasing use of mutual funds as an investment vehicle allowed small investors to diversify and receive professional management at a fraction of its previous cost. Second, the creation and proliferation of the Individual Retirement Arrangement (IRA) and the 401(k) plan led to a general reduction in the multiple taxation on saving and investment, increasing its after-tax return. Finally, the emphasis of the Federal Reserve on price stability has lowered inflation, brought interest rates down...

Of course, if you read the entire report, you see that the first factor in the paragraph above is a tad misleading. Mutual funds had been around for decades before they started getting genuinely popular in the 1970s. It was our governmentally-induced bout of very high inflation during that decade along with then-current regulations that put a legal ceiling on the interest rate that could be paid out in savings accounts (hey, remember savings accounts?) that pushed households into money markets and stock ownership. The second factor listed above of course refers to the creation of tax-advantaged retirement savings plans during the 1970s by the U.S. government. The third factor refers to an interesting long term trend that we’ll encounter again in later installments of this post: the active policy of the U.S. government to reduce interest rates, thus essentially subsidizing borrowers, penalizing savers and rewarding the middlemen. But in any case, all three factors fall squarely in the realm of U.S. government action. Hmmm, another remarkable windfall for the financial services industry having, er, nothing whatever to do with the superior technical skills of bankers, excepting of course as lobbyists and campaign donors.

(By the way, looking at Hellasious' graph above, you might also note how the increasing use of stockmarket investing as the vehicle for retirement savings correlates with the increasing profitability of the financial sector. Pretty neat, huh? Although, sorry to be tiresome, I don't see a whole lot of technical wizardry in that correlation.)

That last point about U.S. policies which encourage low interest rates moves us back from our tour through the equity markets and back into the world of debt (or fixed-income investing, as it is often called.) Here I would point out just one more obvious source of the government-Wall Street nexus: the crucial role of government borrowing in U.S. debt markets. How many of us history buffs remember that the New York Stock Exchange actually began way back in 1792 as a bond exchange for the trading of government debt?

And things haven’t changed all that much, according to the November edition of the Research Quarterly of the Securities Industry & Financial Markets Association. The figures listed therein show that as of September 30, 2007, the U.S. public sector (the U.S. Treasury, federal agencies, municipalities and government-sponsored entities like Freddie Mac, Ginnie Mae, etc.) was responsible for at least half of the product in the $29.2 trillion U.S. debt markets. In comparison, the entire corporate world accounts for a mere 20% of the product in the U.S. fixed-income (debt) markets. Uncle Sam is a very large and immensely lucrative customer of this particular corner of the private sector, and has a lot at stake in keeping it healthy and happy. Indeed, Wall Street and Washington have a good deal invested in each other.

In fact, some people might even think that the government has a bit too much invested in the financial sector for, well, the financial sector’s own good. (For the effects of too much lovin’ on the financial sector, check out the current stock market.)

But if market discipline of the financial services industry in our capitalist system is weak, as demonstrated by Mssrs. Morgan and Siroh from the NY Fed above in connection with “Too Big to Fail” (and clearly visible in the subprime lending and mortgage-backed securities market over the last few years), it’s presumably because government policy-makers and their campaign donors want it that way. This was slyly highlighted by that great kidder himself, Alan Greenspan in his testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, on February 24, 2004:

However, the existence, or even the perception, of government backing undermines the effectiveness of market discipline.

Well, the originator of the Greenspan put should know, shouldn’t he? The topic of sloppy market discipline in a governmentally-driven sector like finance, often referred to as moral hazard, will be the topic of the next part of this series.

Cheers,

Friedrich

posted by Friedrich at January 23, 2008




Comments

Heroic posting! Double bravo. Looking forward to future episodes too. And so clear ...

I say that as a real dimwit, by the way -- someone who still believes in paying off the mortgage, and who struggles conceptually with the idea of "buying and selling debt." How and why *does* one buy and sell debt? Don't answer that question. As for "derivatives" ... What the hell?

So let me see if I've got this clear in the most general way: the New Class has basically leveraged the entire culture so that 1) they benefit hugely, 2) they do so with the minimal risk possible, and 3) the rest of us are left to bob around in a turbulent and uncertain ocean, swept whichever way the current will take us, struggling to keep our heads above water so that the New Class can continue partying on their yachts.

Is that more or less it? Sounds about right. Grrrrrrrr. Fuckers!

Posted by: Michael Blowhard on January 23, 2008 12:50 PM



No question that the government bailout/backing corrupts market forces. However, I think there might be one teensy link in the chain between "big campaign contributions from the New Class" and "bailing out the financial sector." It is actually true that the "financial sector" (defined in the broadest terms) does provide the grease for a lot of other economic levers to move. Try to start a company and get a line of credit or a mortgage for your building without a lender. Try to be US Steel or any other much-mourned provider of "manufacturing jobs" and be unable to issue stock or debt in the public markets. (You could say let them borrow directly from individuals who will lend to them, and cut out the banker "middle men". You could say that. And then come back in the..oh...three years it might take them to raise $100 million, let alone the crazy record keeping necessary for 5,000 different individual loans at different interest rates. This is not a small point. There really is a reason for organized public and private issuances. There really was a reason these firms came into being). Try being "Google" and trying to grow without being able to raise huge amounts of capital quickly and cheaply. Try living in today's world with no credit card at all.

So...there actually is an economic utility to functioning equity and debt markets (ask China who is trying to grow lack mad without them). Now...are there those who have totally rigged the game in their favor, etc? Yes. There are those who are ludicrously compensated for screwing up and getting it wrong, to no consequence to themselves and horrid consequence to the country. (Although, if the financial sector wasn't so important to the country, screwups wouldn't have such far-reaching repurcussions, and would not lead to "bail outs."). So your basic point stands. But let's not jump to the conclusion that the only reason anybody is "too big to fail" is because of campaign contributions. I do believe that is over-simplified.

And the financial sector is not the only bailout beneficiary. Chrysler was also deemed "too big to fail" in the late seventies. American steel companies have been systematically protected by high import tariffs when necessary. Small Business men are regularly subsidized by the government through U.S.-government guaranteed Small Business Association loans. And as I recall---small entrepreneurs are NOT among your defintion the New Class. Yet I can't borrow money as an individual with a government guarantee behind me unless I am a budding entrepreneur.

Yes, the "financial sector" has its corruption (see: "Interest on Credit Card Debt" for another scandal). Yes, they probably should pay a much bigger price when they are idiots than they do. But some of that is hardly limited to the "financial sector." And their protection on a firm-by-firm level is not just corrupt, but also perhaps beneficial. (but the cushion for on an individual-by-individual level is outrageous).

Posted by: annette on January 23, 2008 2:13 PM



Yes. This was the point I was making (not as well as you do here) in my reply to your last post.

The Federal Reserve serves to provide massive amounts of credit that swoosh through the financial markets, which support major speculation and speculators, that encourage huge amounts of borrwoing by speculators to increase their returns. Wall Street and the Federal Reserve are tied at the hip.

The Federal Reserve also creates credit bubbles and busts for their good buddies in the financial industry, so that as the unlearned specualate in the heat of investment bubbles at inflated prices, and after the bust comes and asset prices fall tremendously, the insiders come in and scoop up the assets for pennies on the dollar.

Of course, the vast amounts of inflation caused by the money supply by the Federal Reserve also leads to large rates of return required to keep up with and beat inflation. Its much easier for mutual funds and money managers to charge a 1-2% fee for their services on any given investment amount in a highly inflationary environment than it would be if money were stable, and only lower rates of return could be obtained.

Banks are great ways to make huge profits. If banks are legitimate businesses, then ask yourself this simple question--if its your deposits that they loan out, then how can they loan these savings, checking, and other funds out to others long term, while giving you the ability to withdraw those same funds at any time? Of course, in order to run this kind of business, they can't loan out your deposits--they create money to loan out of thin air! What a fraud this is! You could also make huge profits if you could create credit money out of thin air and loan it to people. And behind this system, underwriting it all is the Federal Reserve and the government, that will bail out (print money for) all depositors to the tune of $100,000, and use tax money to bail out speculators in the banking system (a la Japan, the US, etc.)

The whole existence of fiat money and a Central Bank is to steal from the general public by monetary inflation. This monetary inflation and easy credit are used to bail out and fund speculators in the markets, to create a priviledged and loyal class that benefits and promotes the existence of monetary inflation and a Central Bank, and to create booms and busts for the purpose of fleecing the public and consolidating assets and power.

These monied interests couldn't care less if you sink or swim in their system. They have no national loyalty either, so they couldn't care less if jobs and companies move overseas to escape the monetary inflation, leaving you high and dry.

It is the public's responsiblity to reign them in. Insist on sound money, the elimination of the Central Bank, and the elimination of "free trade" to restore health to this country.

Posted by: BIOH on January 23, 2008 2:52 PM



Here here to annette's point that there's a reason those in the financial sector are so well compensated. They oil the economic machine that makes an economically decent standard of living possible for all but those who willfully self-destruct. The rate of taxation on capital gains and dividends has been lowered to 15%? Good. What's obscene is that the rate on other personal income remains at 35%. I'm not going to ruin my life burning up with envy because someone somewhere is doing 100 times better than I am. The guy doing well is not doing me in. This whole notion that it's all a giant con is profoundly repellent.

Posted by: ricpic on January 23, 2008 8:24 PM



The "economic machine" is comprised of people who produce things that other people want, hence a market is made.

Fianance is a means of providing money so that direct barter isn't necessary, and as means of providing capital (or credit) for the expansion of industry. You know, industry--people that make real things.

The existence of a Central Bank and almost unlimited amounts of credit for investment speculation and monetary inflation is a GIANT cancer sucking the productive life out of the economy, by transferring the wealth from those who produce things to those who basically gamble for a living. Oh, and it also funds the profligate welfare/warfare government. Yea!

If you think the Federal Reserve is not an illegal private bank owned by individuals, I've got a question for you. If you answer my question, I'll concede that I am wrong. Deal?

If the Fed really is a part of the government, and its actually the government that has the power of the printing press to create all of our money, then why is the US 9 trillion dollars in debt? I mean, if you or I had the power to print money, would we ever have to borrow a red cent? We might print the money until it was worthless, but we would never be in debt, right? That is, we could print money until people stopped using it. But I guess that can't happen here, since the government mandates on pain of improsonment that we have to use the Federal Reserve's Notes, correct? If the US prints its own money, why are we in debt?

The whole notion that it is a giant con IS repellent. And its true too. Those two ideas are not mutually exclusive.

Oh yes, the financial guys are sooo necessary and important. A very productive group. Look how honest they are about the real situation. I mean, if all the easy money dried up, most of them might have to do something different and actually productive for a living. What a waste of talent that would be, making real things that people need, instead of gambling with other people's money!

Posted by: BIOH on January 23, 2008 9:19 PM



Annette and Ricpic:

The point of my post is NOT that the financial services industry does no good, nor that all financiers are crooks and charlatans. The point of the post is to discuss significant imbalances that we are seeing in our economy and culture. Maybe I should have just posted the chart that I borrowed from Hellasious; when I see the financial services sector making half of all corporate profits, I think: wait a minute, there's something wrong here. (I don't think, wait, let's utterly dismantle the financial services sector and outlaw banks.) I say the same thing when I see that the U.S. is running a trade deficit in excess of 6% of GDP: there's something wrong here. I say the same thing when I see that the healthcare sector employs over 12% of the workforce, and has added virtually all of the jobs in the economy over the past five years: there's something wrong here. I say the same thing when we have a huge productivity boom throughout the 1990s and during the earlier part of this decade, and I see that incomes for the bottom nine-tenths of the population are more or less stagnant: there's something wrong here. I say the same thing when I point out that in the very near future the retirement of the baby boomers and the funding of their healthcare will completely trash the financial health of the public sector in this country: there's something wrong here. I say the same thing when I see the enormous emphasis being placed on getting into Ivy League schools and graduate schools: there's something wrong here. I say the same thing when I see a completely unsustainable run-up in housing costs and the Federal Reserve patting itself on the back because high asset values prove that everything is best in this best of all possible worlds: there's something wrong here. I say the same thing when I see incompetent CEOs of public companies being fired and walking out the door with tens of millions of dollars in "severance": there's something wrong here. And I say the same thing when I read the newspapers and watch the news and nobody even considers it odd that these things are occurring or ponders what the consequences of such excesses or imbalances are likely to be in the long or even the medium term: there's something wrong here.

Well, I thought about all these "something wrongs" and it dawned on me that they're related: a group of people of very similar backgrounds benefit from each of these trends. Most of the population do not benefit from any of these trends.

Are you suggesting I shouldn't mention any of this out loud? Sorry if I disturbed your tranquility.

Posted by: Friedrich von Blowhard on January 23, 2008 10:27 PM



I'm not sure I would be quite so dramatic but yes, there's a lot of truth here. However, I look at things from the other end of the telescope.
The political donations from finance I don't see so much as the buying of influence, rather, as politicians shaking down those who are making money. Thus the recent news that Google is opening a DC lobbying office. Get big enough and no politician worth his salt is going to leave you alone.
That this leads to rent seeking and special favours? Sure, Adam Smith wrote about it, we're not observing anything new.
One point about dividends: The US has a very weird tax system. Profits are taxed first, then dividends paid, which are taxed again. In just about every other country *either* the profits aretaxed first *or* the dividends are taxed when paid. Only the US does both and thus the lower rate brings the US more into line with other countries (which, because capital is mobile, is a sensible idea).
Finally, the New Class idea. One line of thought is to think not just of financial capital (as you do) but of human capital. What those doctors, accountants, financiers etc have invested in the game is 10-20 years of education, training and competition for those jobs which provide those incomes. The competition can be brutal: I think it's only one in five of those who even join major law firms (that's after a top college and top law school) end up becoming partners and making that money.
If you think of the way in which human and financial capital are similar (rather than their differences) then hte rise of this New Class makes more sense.

Posted by: Tim Worstall on January 24, 2008 1:09 AM



This posting is indeed an Opus. Congrats, Friedrich.

Might it be simpler to replace "new class" with "political class"? In the sense that "they" are net recipients of the government largess (legal tender laws, "money" creation with a click of the Fed mouse, etc.).

I will no doubt be thought an alarmist to point this out, but no paper (fiat) money has ever failed to become worthless, and the way Congress is going in the hole (including the "off-budget" items, it's at least a trillion a year now, no?) we could be seeing triple-digit (or even Zimbabwe-level) price inflation in well under a decade.

I became a person of leisure a few years ago, having made a fortune buying a broad portfolio of gold and silver mining companies at the turn of the millennium. If you can't beat 'em, join 'em. No reason to feel guilty getting rich by performing the time-honored technique of fleeing into precious metals when the paper currency de jour is clearly headed for the woodshed (if not outright extinction). Metals and the companies that mine them are a bonanza in an inflationary environment, just look at the charts. Double-digit gains every year, and still very scant media attention. I'm guessing it won't be very long (two or three or four years?) before the public notices and piles in. Wish you had bought internet stocks in 1995? Here's your chance in a sector that produces real products.
http://www.321gold.com/editorials/russell/russell111703.html

Posted by: Yakking Guy on January 24, 2008 2:00 AM



I don't think anybody said you "shouldn't mention them out loud"??? I agreed with much of what you said. I just pointed out to people less learned than you who might read your post that there are other factors involved in "bail outs"---which actually is the part of your post I wish you had also said out loud.

I'm not quite sure what to make of "sorry I disturbed your tranquility." If anything, I knew quite a bit about this before your post, and my tranquility or lack thereof has little with a posting, nor do I think I said anything about my tranquility? Confused by the tone. I guess you didn't want a dialog about this?

Posted by: annette on January 24, 2008 10:19 AM



Sorry, Annette, my bad: the comment about tranquility was directed at Ricpic, who seemed to be looking askance at the critical tone of my comments. Frankly, I think you're one of the few people who has really engaged with what I'm getting at here. (I get the feeling I'm speaking Greek to many of the other commenters, which probably means I haven't been clear enough.) I look forward continuing our discussion.

As I do also with everybody else; thanks for your remarks.

Posted by: Friedrich von Blowhard on January 24, 2008 10:58 AM



Finance seems to have mastered the art of 'rent-seeking', if I understand the implications of the chart correctly. Consider that rent-seeking is really about seeking monopoly privileges, privileges often sought from, and granted by, the government (and achieved partly via the huge Finance lobbying effort). Gov't bailouts are as exquisite an example of monopoly privilege in action as anything I've read about in recent years.

I can't help but think that public choice theory (Tullock, esp.) would support a great deal of what FvB is saying here. It's not a question of capitalist rapacity, but rather the internalization of rent-seeking as a fundamental way of doing business. Rent-seeking in this sense serves as an enormously effective risk-mitigation strategy, with bailouts being the all-purpose answer to any genuine risk of blowup (or meltdown).

After all, perfection in rent-seeking is achieved when you a) make huge amounts of money; while b) adding nothing real to the economy. The Finance industry of today seems to have just that kind of profile.

Posted by: PatrickH on January 24, 2008 11:46 AM



Do you count Steven Cohen as purely "New Class"? As _founder_ of hedge fund he engaged in starting up a new business.

Posted by: Brent Buckner on January 24, 2008 11:52 AM



The biggest issue of it all, of course, is if Ordinary Citizens actually bothered to "band together" and vote and make campaign contributions in huge blocks. If you can't beat the special interests, join 'em. Look at the weight the recent union endorsements of various candidates in Nevada were perceived to have (C'mon---how many people had heard of the Culinary Workers Union before the last few weeks?). And even the Culinary Workers Union are behaving like poor schlobs---they need lobbyist to dangle the real meat---dollars---in Washington to all of a sudden see incredible preferential treatment for...huzzah...culinary workers!!!. Silly them---they thought their votes counted!! Only right this minute! In a year, they will be forgotten. But ongoing dollar contributions??? Hooweee! All of a sudden, Ceasar's Palace would be --yep---"too big to fail!".

But my point is, unions and more recently industries have bothered to organize and lobby and contribute. The rest of us could, we just haven't bothered to get organized. So...in some ways, we can't complain. However, John Edwards does have a point, being a New Class beneficiary trial lawyer guy, and all--the "special interests"--the New Class---isn't gonna jump up and do "what's good for the country." Somebody has to actually take them on. And the minute anybody actually wants to be re-elected...

Posted by: annette on January 24, 2008 12:12 PM



Stopped reading this site for a while, but these posts caught my eye. They are very good and I agree with most of what they say.

Michael, you are pretty secretive about your life, but I have gathered that you live in Manhattan, in walking distance of your arts-related job, and shop at the Union Square green market (sorry if remembering these bits from earlier postings seems creepy). I think you went to an Ivy League school. You also have little use for a lot of traditional middle class stuff like religion, sexual prudery, etc. What I'm saying is, I think you're a member of the New Class.

What Friedrich has not yet addressed in this series--I don't know if he will, though he alluded to it in the first post--is that there is such a thing as cultural capital, not just economic capital. The members of the New Class are ambitious, but their ambitions are not all the same. Some people in the comments in the last post called Friedrich out for pinning the New Deal and Reaganomics on this same class, but I think he was right; he's talking about different members of the class. Their personal preference for how society ought to be structured are different, but their right to determine the structure of society is unquestioned. And, in the end, it doesn't make a lot of difference, because both factions within the New Class benefit no matter what.

Anyway, you don't have boatloads of money and you don't invest in securitized debt (I don't either). But you have lots of cultural capital, thanks to your place in the New Class. This isn't your fault. A person who attains a reasonable degree of economic success and within a certain range of temperaments is drafted into the New Class and can't opt out except by doing something really radical like moving to a cabin in Maine and stockpiling firearms.

Posted by: BP on January 24, 2008 12:56 PM



Shouldn't this "New Middle Class" be called the "New Upper Class"?

Posted by: Intellectual Pariah on January 24, 2008 1:10 PM



BP -- I think of my position in the world as something like "the chauffeur for the Rockefeller family," ie., in and around these people but not of them. Professionally speaking, I serve. And I certainly command zero influence and make modest dough. But technically speaking you could well be right! I wonder how a good sociologist would classify me ... Anyway, how about yourself? Do you fit the New Class def, do you think? You've got me thinking that if I am indeed a member of the New Class, I wish I'd done a better job of nest-feathering! Good to see you visiting again, btw ...

Posted by: Michael Blowhard on January 24, 2008 1:29 PM



All the New Class people you are talking about here are service job holders (you could say "winners") in the New Economy--you know, the service economy. They are the elite of this group--the financial people, the lawyers, the academics, etc. The rise in eminence of these professions, and their share in the economy directly relates to the erosion of our manufacturing base. There's nothing new in organizations looking to the government to reduce their risks, as manufacturer's did in days of old (remember Chrysler?). Of course many entrepreneurs are left out of this group, as they are not organized. Government is at the center of the service economy, being the largest service provider of all with its ability to tax its income and borrow tremendously. Is it any wonder so many other service sectors are looking for a piece of that pie?

America has been running on debt for a long time, as have most countries in the first world as they lose their productive capacity to low-wage nations. Of course, that debt is now sinking us here.

You know, a number of those trends you are talking about started long before now, as long as 40+ years ago. They coincide with the government getting into health care, guaranteeing student loans, the loss of the manufacturing base, etc. Its only now that they seem to be coming to a head.

Posted by: BIOH on January 24, 2008 2:25 PM



Anyway, how about yourself? Do you fit the New Class def, do you think?

Yes.

Have you ever read Pierre Bourdieu's Distinction? Sort of tangentially related, but he talks about the relationship between social class and aesthetic taste in about as rigorous a way as you can talk about such a thing. And sure enough, my aesthetic tastes are pretty much exactly what he predicts they should be for my social class (even though he's writing about France in the 70s). This knowledge doesn't change the fact that I like what I like. I suspect you would find the same thing.

Posted by: Brendan on January 25, 2008 11:33 AM



A few points. The trend with finance being more profitable than "making things" is simply a continuation of a larger trend in the economy as a whole that being a "facilitator" is more important than being a "maker".

Even for those considered manufacturers, say Mattel, the money is not in the actual making of the item, but in facilitating the connection between the manufacturers (who get practically nothing) and the customer. Mattel captures the vast majority of the value, not the actual toy maker. Sure China may be becoming the world's workshop, but that's because being a workshop is pretty value-less anymore.

The finance industry has grown because it shuffles capital between the those who have capital and those who need it. Having capital is not all that valuable. What's valuable is actually getting it to people who need it. And that is richly compensated.

As for growing inequality, it is unfortunate, but a natural consequence of the fact that increased productivity is concentrated. While economists talk about increased "returns" to education and technology, education is not enough. You also have to be in an industry where you can take advantage of that education and technology.

For example, I'm a programmer, and better technology makes me about 3 times as productive as I was when I started out many moons ago. A financier, on the other hand, is probably controlling a hundred times as much cash as he was when he started - in other words, he's a hundred times more productive in terms of the value he provides. However, a school teacher, no matter how brilliant, no matter how talented, is still teaching 25 kids a year. There's simply no way of boosting his productivity much higher.

Likewise, it matters a lot about what industry you are in. I worked in education for many years and the reality is no matter how brilliantly my company could have been run, there's simply no way that we could have become rich - there simply wasn't the money there. On the other hand, once the company folded up (changing education policy made our core business non-viable), I ended up in financial services. I'm probably less productive than I was before (bank computing industry is ancient!) but my ability to generate value has gone up substantially simply because of *where* I'm working, so I'm somewhat better compensated.

I'll agree that increasing inequality is unfortunate, but I don't think you can effectively address it at the base level - i.e. by trying to change the economic rules. You need to address it by redistribution. i.e. let the economy be as productive as possible and then redirect the extra proceeds as we would like.

For example I'd rather see Jack earn $100K and Jim earn $25K, and Jack have to give $25K to Jim, than maul the market until Jack is earning $35K and Jim is earning $20K. Strangely enough though, option two is generally more politically acceptable.

Very interesting article! Thanks for taking the time.

Posted by: Tom West on January 26, 2008 8:39 AM






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