Friday, December 19, 2008

The mysteries of the financial 40 pct profit share in the economy

One of the aspects of the financial crisis that still gets little attention is how big the financial sector has become. According to this lecture (See the pdf for graphs)from Kemal Dervis:

In the early 1980s the share of the financial sector in both, corporate value-added and profits in the American economy, was about 5 to 6 percent. The share of financials in value added has steadily increased and has reached about 8 percent in 2006-2007. The share of profits, however, climbed to reach an extraordinary 40 percent and more!

If you see the graph (page 9 in the pdf) you will see that historically that share of the profits has been about 15% and that it has been growing for decades, but in a very irregular way. The big question is:
how can a sector that is not really productive produce 40% of the profits?

Some ideas:

  • The financial boom started with the Reagan-Thatcher financial deregulation. In a time when it was difficult to find venture capital it seemed like an obvious solution. The same argument is still repeated nowadays allthough the problem is no longer there. Easy credit helps also good ideas.
  • The financial sector is protected. Financial loses are often covered by government. See LCTM in 1998 and the present bailouts. See also the way in which the IMF pressures countries to extreme savings when they default on loans.
  • Bubbles have created a casino mentality with investors. They may have lost with the Dot-Com bust but that they know that many others who stepped out in time make a lot of money. Just like gamblers investors tend to think that they are able to beat the average.
  • More and more sectors of the industry become target of the financial "wizards". Two of their tactics are the Leveraged Buy Out and the deregulation of traditional sectors of the economy, like energy. As these sectors are usually too important too fail they have considerable leeway to extort money from other parties (labor consessions, higher tarifs, government support, etc). The high leverage of these investments makes it possible to score enormous profits when things goes well. For the investors it is no problem to take irresponsible risks: what counts for them is only the chance for big gains.
  • The consumer is the victim. Easy credit may sound very attractive. But in the end the effect was that the prices rose and it was nearly impossible to buy a house without taking a huge mortgage.
  • The money gives the financial sector power as a presure group. We see ever more pressure for the creation of new "investment opportunities". One of the targets at the moment is financial deregulation in developping countries. In this demand in the context of the GATS free trade negotiations the Western countries ask for deregulation of the financial sectors over there. They wouldn't even be allowed to ask that foreign banks keep local reserves.

My expectation is that the present crisis will not enough bleed the financials to stop them. After things get back to normal they just will go on to create the next bubble. Until we have finally a crisis that is too big...

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