This is the second part of a three part interview with regular Triple Crisis contributor Gerald Epstein, of the Political Economic Research Institute (PERI) at the University of Massachusetts-Amherst. This part focuses on the performance of the financial sector, against the key claims that are made by mainstream economists about its socially constructive role, during the era of “roaring” banking. Part 1 is available here.
Dollars & Sense: How does the performance of the financial sector measure up, during this most recent era of deregulated finance?
Gerald Epstein: If you look at the textbook description of the positive roles that finance plays, basically it comes down to six things: channel savings to productive investment, provide mechanisms for households to save for retirement, help businesses and households reduce risk, provide stable and flexible liquidity, provide an efficient payments mechanism, and come up with new financial innovations, that will make it cheaper, simpler, and better to do all these other five things. If you go through the way finance operated in the period of “roaring” banking, one can raise questions about the productive role of banking in all of these dimensions.
Taking the first role, channeling finance to productive investment, in the early post-war period, nonfinancial corporations on average got about 15-20% of their funding for productive investment from outside sources, from banks and from the capital markets. For the rest, they used retained earnings. In the latter period, after around 1980 or so, this was cut more or less in half—to 7-10%. So finance didn’t really provide a huge percentage of funds for nonfinancial corporate investment in the age of roaring banking. So you have this paradoxical situation where the income going to finance grew significantly while the real contribution to providing funding for investment went down. During the 1960s, finance got about 40 cents for every dollar they gave to nonfinancial corporations for investment. By the 2000s, it was up to 66 cents.
What was finance doing instead? As Juan Montecino, Iren Levina, and I point out in a paper we wrote, they started lending to each other, instead of to the real economy or nonfinancial corporations. So we looked at intra-financial sector lending as a share of total lending from 1950 to 2010 and we found that, from 1950 up to around 1980 or so, they were only doing about 10% of total lending to each other. Just before the crisis in 2008 or so, they were doing almost 30% of all lending to each other. This lending to each other really was a way of providing finance for derivatives trading and other kinds of betting, rather than financing real investment.
The second role is providing mechanisms for households to save for retirement. There are a lot of studies that show that banks didn’t do a very good job in the period of roaring banking. Part of the problem is that the savings vehicles that finance provides for households come at a very high cost. If you put your money in a mutual fund, say, with Fidelity or one of these other companies, oftentimes the fees that you have to pay are very high, and the returns that you get aren’t any better—sometimes worse—than if you put your money in a broad portfolio of stocks, like the S&P 500 or something like that. There are a lot of studies that show that the returns that you get from putting your money in these active funds is more than 2% less than if you just put it into a broad stock portfolio. Well, this 2% is going directly to the company, to Fidelity and the people who work for them, so it’s a way that finance is overcharging.
The way in which finance has failed in helping households save for retirement is even more stark if you realize that, for most households in the United States, most of the wealth that people have is in their homes. If you think about what the financial sector did to people’s savings in their houses in that period, it’s a pretty dismal record—especially for African American and Hispanic and other minority households, much more so than for white households. Already, African Americans’ wealth is just a fraction of white wealth, and most of their wealth was in their houses. The financial crisis of 2006-2007 pretty much wiped out a large percentage of African American wealth during this period. So clearly, roaring banking didn’t do much to help households save for retirement.
The third role is to reduce risk. You just need to look at the kinds of financial products that banks were selling under the guise of reducing risk—like credit default swaps, mortgage-backed securities, asset-backed securities, etc. These products lost enormous amounts of value during the financial crisis, and would have lost almost all of their value if the government hadn’t bailed them out. The financial sector was a source of enormous risk, rather than a source of reducing risk.
The same can be easily said of the fourth function, providing stable and flexible liquidity. If you look at the housing bubble and the tremendous run-up in asset prices provided by the tremendous increase in liquidity from the financial sector—through asset-backed securities, subprime lending, and so forth—you realize that it was not stable. It was actually what led to the asset bubble and crash. So private banking does not provide stable or flexible liquidity. In the end, in 2008, the Federal Reserve had to come in and provide enormous amounts of liquidity to the system to keep it from melting down entirely.
For the fifth role, to provide an efficient payments mechanism, we see a similar kind of thing. The only thing that kept the payments system operating after the financial crisis was the enormous amounts of liquidity that the Federal Reserve flooded into the financial system. Moreover, if anyone has ever tried to transfer money from one bank to another, or overseas, you realize that our payments mechanism—even in normal times—is very inefficient. Banks can hold onto your funds for two or three or four days before making them available to you, when you try to transfer from one bank to another, just as a way of extracting more money from households. Both in abnormal times and in normal times, the payments mechanism in the period of roaring banking is very poor.
Finally, that brings us to banking innovations. Paul Volcker famously told a group of bankers in 2009 that the only financial innovation that he could see in the last 20 years that had been at all efficient was the ATM. There’s no evidence that financial innovations have led to more economic growth. Jim Crotty and I did a literature survey that showed that at the minimum 30-40% of financial innovations over the last 20 years or so are used at least to some extent, if not largely, to evade regulations or to evade taxes—that is, to shift around pieces of the pie from the public to the banks, rather than to increase the size of the pie.
In short, roaring banking has done a pretty dismal job of providing any of these functions that the textbook case says finance should provide.
D&S: What would you think of the characterization that—within the context of U.S. capitalism becoming reliant on asset bubbles for achieving anything close to full-employment output—finance played the role of being the “bubble machine”? So, finance as an essential cog of a bigger dysfunctional system.
GE: My colleague Bob Pollin wrote a great book about this called Contours of Descent, about the Clinton administration and its role in creating this bubble machine. One of the impacts of all this roaring banking and this “pro-cyclical” liquidity creation—massive liquidity on the way up and then withdrawal of liquidity on the way down—was that it did have a huge levitating effect on wealth and, through this wealth effect, led to significant consumption particularly among the wealthy. And that helped to propel the economy forward in the 1990s.
Sometimes, people talk about this as if capitalism needed this to survive and that’s why it’s happened that way. I don’t like that type of thinking methodologically. The question is: What is the counterfactual? What would have happened if the bubble machine weren’t operating? Would the economy have slid into a long period of stagnation, or would there have been economic and political forces that would have generated a much healthier type of growth? These are things that we can’t know, though which are certainly worth asking. But the characterization that bubbles had that kind of effect—of generating these booms, particularly during the Clinton years—is certainly correct.
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