Thursday, March 31, 2016

Why Has Finance Gotten So Rich in a Competitive World?

This is what Kevin Drum logically asks.  I’m running off to a meeting, so my answer will be telegraphed:

1. Rent extraction from profit-making firms.  The wage share has fallen, but the profit share hasn’t risen correspondingly.  The reason is that finance has found ways to extract the difference.  Exactly how is a longer story, but it’s at the core of what “financialization” means in practice.

2. Externalities.  In a lot of trading activity there are external costs that are not accounted for, especially the cost of public backstopping in the event of insolvency.  Finance has gotten better at playing the risk/reward game by externalizing the risks.

Have to go.


jed said...

But why doesn't competition arise that gives customers a better deal? Easy to be cynical about this but we probably won't fix this without understanding it.

CrocodileChuck said...

1. Companies don't borrow from banks anymore in the US. They issue their own commercial paper [90 day bills] or bonds [longer term debt].

Look at the rise and rise of household debt-there's your answer.

Also, you missed the sheer size of the finance sector in the USA. In 2008, it needed to shrink-back to the size it was in 1998. It didn't.

Iron City said...

1. "Financialization". Is a company like General Electric an example (as well as General Motors and Ford and other companies) where they make locomotives, medical equipment, electrical machinery, jet engines, etc. and also have a financial arm (GE Finance) that also makes money financing the purchase/lease of the products GE makes. Over time GE looks and sees they make more money financing the things they make than making the things they make?

Another financialization that has always bothered me is the evolution since WW II of 2 income families. When both adults (parents or not) work outside the home they make more cash income. They spend some of this additional cash income to purchase services and to some extent goods that allow them to both work outside the home, such as lawn service, maid service, car washes, labor saving appliances, etc. Now maintaining ones own home, automobile, that was previously "free" or at lest not assigned a money value has one and the cash used to pay for it is earned from employment, taxed and then after tax money pays for the services. This monetization results in a windfall to taxing authorities that I've never seen discussed.

2. Making all the costs possible externalities while keeping all the income/benefits is done historically but it seems to be getting more evident. Any good real estate developer is instructive in this. Costs for schools, roads, utilities and other artifacts for the development are either made totally external by having an authority or other entity provide them or when this is not possible the costs paid by the developer are fixed (as low as possible) regardless of the cost finally incurred to provide the amenity/service. Shear genius when done smoothly, if not sometimes the peasants eventually show up at the developer's mansion witht he pitchforks and torches.

Les Baker said...

Understanding the question is helped by first identifying who is competing for what against whom in the "competitive world" under consideration.

Remember, the economic theory of pure competition posits that sellers must compete for customers, so sellers are pressured to offer customers the most favorable terms, which generate consumer surplus.

The questioner then assumes that financiers are "sellers" of "money" and borrowers are "buyers" of it. Money is assumed to be a commodity, so no sellers can only compete on price. Pure competition theory would predict that competitive pressures would drive the price of money down. This prediction is falsified by observation.

I look at things the opposite way. As I see it, financiers are not "sellers" of "money"; they are "buyers" of debt. Financiers are not constrained to offer debtors the most favorable terms; the pressure goes the other way. "Debt" is the commodity here. It doesn't matter whether the debt is structured as a secured transaction or a lease; in either case, financing is undertaken to enable a debtor to purchase something with borrowed money, and the promise to repay that money is the consideration that drives the transaction (and, in the aggregate, the economy). So the debtors have to offer the best terms to the financiers, to keep the debtor's businesses financed, and going.

The other thing financiers do is "investment banking," which is to say, they allegedly represent businesses in selling newly-offered securities in public markets. In the securities markets, businesses are either selling their debt, (commercial paper, bonds) or their even-riskier-than-debt claims to residual profits, but whichever form of promise they are selling, they are sellers and constrained to offer the best terms to their buyers. However, the market for investment banking services is not competitive, it is very concentrated, and the financiers exploit the concentration.

ProGrowthLiberal said...

My list includes marketing as in selling people things they neither understand nor need.

Robert said...

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reason said...

I thought that financialization means swapping equity for debt (not the other way around), so that you pay the bank interest (i.e. a rent) instead of paying distributed owners dividends from profits. This is done mainly to avoid paying tax, but has the side effects of shifting large amounts of de facto ownership to the banks, and pushing down the general yield of assets (and hence the interest rate that banks pay on deposits). This story seems to fit the observed facts to me, what is wrong with it?