The views presented here do not necessarily represent those of Advisor Perspectives.
If it weren’t for the financial industry, in my opinion, the United States wouldn’t be suffering the serious social ills that have worsened in the last 40 years — primarily, the hollowing out of the middle class, and all the problems that have accompanied it and resulted from it. Prior to these past decades of financialization, engineers and scientists and technicians were revered and paid as much or more than financiers. If that had continued, the U.S. would have retained, developed, and perfected — as has China, a country where engineers reign supreme — what Dan Wang, author of the landmark book, Breakthrough: China’s Quest to Engineer the Future, calls “process knowledge.”
Oren Cass, the chief economist of the think tank American Compass, does not explicitly make this particular allegation in his utterly superb February 6 New York Times op-ed piece, “The Financial Industry Is a Grift. Let’s Start Treating It That Way.” But he does very clearly identify, in no uncertain terms and with no holds barred, all the things that are wrong with today’s financial industry and what consequences these evils have. Not for a long time — if ever — have I read something that caused me, as I was reading it, to nod my head so vigorously and repeatedly that I almost feared it might break off.
The original purpose of the financial industry was to convert families’, individuals’, and institutions’ savings into investments in support of the creation of useful building projects, products, and services. Cass makes this point by invoking a song from the 1964 movie “Mary Poppins.” In that song, a chorus of bankers at the bank that employs the father of nanny Mary Poppins’ charge Michael sings to Michael that he should give his money to the bank so that it can invest in “railways through Africa” and “dams across the Nile.” In 1964, that was the sort of thing that investment was about.
However, Cass describes the sad sequel:
Since Mary Poppins’s day, the financial sector as a whole — investment banks, hedge funds, private equity firms, cryptocurrency platforms and all the rest of it — has exploded as a share of the United States’ gross domestic product. It now claims the highest share of corporate profits and attracts the highest share of top talent from top schools, in part by offering the highest compensation. But actual business investment has declined, to an average of 2.9 percent of G.D.P. over the past decade from 5.2 percent in the 1960s, when the film was released.
Moving Money Around
Instead of funneling savings toward productive investments, the financial industry now makes its money primarily by moving large and small chunks of money from one place to another, usually with no actual productive purpose, while levying massive fees and rake-offs on each movement. Those rake-offs are large enough to make multitudes in the financial industry multi-millionaires and billionaires.
And the financial industry is able to get away with charging such fees for a variety of reasons, including:
- A misplaced reverence among the U.S. population for finance and a misplaced belief that it is doing something important.
- An atmosphere of misinformation about finance and investment, including the mistaken belief that it uses fancy mathematics to achieve superior investment returns, and industry-insider technical-sounding — but incredibly fraudulent — gobbledygook about elite investing.
- The automatic and ideological belief inherent in what has been called “market fundamentalism” that when financiers make more money that means they add proportionately more value.
- Participation in the enjoyment of the spoils by actors who are supposed to be overseers but who are paid out of the same scrapings from the huge transfers of funds, such as administrators, consultants, managers, and trustees of pension and endowment funds.
It is also easy for the financiers to extract large fees because those fees seem “small” as a percentage of the amount of money moved. At the same time, those paying the fees wrongly believe they’re getting what they’re paying for, for the above reasons, or because they aren’t even aware that they’re paying them.
Cass defines financialization as “the term for making financial markets and transactions ends unto themselves, disconnected from — and often at the expense of — the societal benefits that support human flourishing and are capitalism’s proper purpose.” He argues that (emphasis added):
Financialization has made American businesses less resilient, less innovative and less competitive. It has been a major cause of slow wage growth and rising inequality. It has fueled the loss of manufacturing jobs across the heartland. It has corrupted sectors in which the profit motive was never meant to reign supreme — veterinary practices, funeral parlors, campgrounds, residential treatment services, youth sports, hospitals and nursing homes, even suppliers for volunteer fire departments — consolidating and managing them with ruthless efficiency, squeezing their vulnerable customers and then pointing to the higher cash flow as “value creation.”
Those “vulnerable customers” are the ones who have little choice but to submit to the payments extracted by the financiers. They are sought out by financiers whose mission is to maximize profits. Hence, those financiers seek out vulnerabilities that enable them to rack up higher profit margins and charge higher fees. They will call this value creation. But it is only rent-seeking behavior — a transfer of funds from the financially weak to the financially strong in a zero-sum game.
The Consequences of Financialization
Cass goes on to highlight a parade of failures created by financialization — failures in all respects except that they provide rewards to the financiers collecting the fees. Among his long list of negative results for society created by financialization, Cass mentions “the discovery that your fire department’s software system is being shut down, the replacement will cost several times more, and the wait time for a new truck is now years.”
Coincidentally, I had recently viewed an amazing video from the Inside China Business channel on YouTube about the cost and delivery time for firetrucks from Chinese manufacturers versus the cost and delivery time from American manufacturers. Depending on size, Chinese-made firetrucks cost from $100,000 to $400,000 and are ready to ship within six weeks of ordering. Replacement parts, when needed, can be delivered virtually overnight.
The narrator then says that fire departments in the U.S. are paying five times as much for the same equipment and are waiting years to get it. The wait for replacements can be months or more. As the video explains, this is partially responsible for California’s inability to rapidly put out last year’s fires.
The problem was caused by a consolidation of the industry by private equity firms seeking to maximize their profits. It is worth watching the 12-minute video in its entirety.
The unavoidable conclusion: China drives down costs because it has competition; America drives up costs because it has private equity.
Modern Finance Fails Even on Its Own Terms
Cass says that “The problem is that the ‘best use of capital’ from the financial sector’s perspective means only the highest financial return.” That means, for example, that if a private equity group can connive to charge a colossally higher price for firetrucks because of the ways the buyers are constrained — constraints that have been largely created by private equity’s monopolization of the industry itself — then they must do it, thereby, as they would cynically say, “creating value.”
But Cass says, “Perhaps the most remarkable fact about modern finance is that it fails on its own terms. Mergers and acquisitions [typically funded by investment bankers and private equity capital] tend to destroy value even as they sate the appetites of empire-building chief executives.”
And they don’t even succeed in achieving the highest financial return — not for their investors, that is, only for the private equity and hedge fund managers themselves. As we know, or should know, investors in hedge funds and private equity have seriously underperformed a simple blend of stock market index funds with comparable risk. And yet major institutions like U.S. public pension funds and Ivy League endowments continue to invest in them, presumably because all the participants in the decision to do so partake of the drippings from the “dripping roast” of the corpus of the funds. Cass makes an allowance for venture capital — which does at least invest sometimes in productive companies — but it also fails on the measure of providing superior returns to its investors, presumably because the venture capitalists take too much for their fees.
What to Do
Whatever the other parts of the solution are, a sine qua non must be for the positive image of the industry to be turned on its head. As Cass suggests, the reaction to a friend’s news should be, “Your daughter has taken a job at Blackstone? My condolences.” The lie of this industry’s value and admirability must be counteracted if the U.S. is ever to be competitive again.
But disrepute is not enough by itself — as, for example, it was not and is not for the tobacco industry. More regulation will be necessary to reign the industry in. And it should be mentioned that Cass is not a pro-government leftist; he is a conservative, and his organization American Compass is identified as a conservative think tank. However, he is not afraid to propose more regulation where it is needed, and he does not shrink from it.
I was glad to see that among his proposals for regulation he advocates a measure that I also have advocated and written about — a transaction tax “to make strategies like high-frequency trading unattractive.” The industry — even, shamefully, including Vanguard — has ferociously pushed back on this initiative. But its pushback should be overcome by legislation that would be strongly supported by public opinion. It is particularly salutary that in his advocacy for a transaction tax, Cass negates the industry’s spurious argument that high-frequency trading is necessary to provide liquidity.
Cass’s article is not short, but it should be read in its entirety— not just once, but several times. It should be sent to and called to the attention of politicians, industry leaders, journalists, entertainers and commentators, even those in the financial industry itself. If this call to stop an insidious and extremely damaging industry is not heeded, it will be ultimately the end of the U.S.’s world standing, once-moral character, fair distribution of wealth, and economic leadership.
The stakes are very high.
Economist and mathematician Michael Edesess is an adjunct professor and visiting faculty at the Hong Kong University of Science and Technology. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, was published by Berrett-Koehler in June 2014.
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The views presented here do not necessarily represent those of Advisor Perspectives.
