Friedrich von Blowhard writes:
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]
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 [site requires a cookie], 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 . 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”[PDF]:
Whatever the benefits of the  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.