Overcharged: The High Cost of High Finance

Gerald Epstein and Juan Antonio Montecino

Gerald Epstein is a professor of economics and Co-Director of the Political Economy Research Institute (PERI) at the University of Massachusetts Amherst. Juan Antonio Montecino is a doctoral student in economics at the University of Massachusetts Amherst. This is an excerpt from a report Epstein and Montecino wrote for the Roosevelt Institute. The full report is available here.

A healthy financial system is one that channels finance to productive investment, helps families save for and finance big expenses such as higher education and retirement, provides products such as insurance to help reduce risk, creates sufficient amounts of useful liquidity, runs an efficient payments mechanism, and generates financial innovations to do all these useful things more cheaply and effectively. All of these functions are crucial to a stable and productive market economy. But after decades of deregulation, the current U.S. financial system has evolved into a highly speculative system that has failed rather spectacularly at performing these critical tasks.

What has this flawed financial system cost the U.S. economy? How much have American families, taxpayers, and businesses been “overcharged” as a result of these questionable financial activities? In this report, we estimate these costs by analyzing three components: (1) rents, or excess profits; (2) misallocation costs, or the price of diverting resources away from more productive activities; and (3) crisis costs, meaning the cost of the 2008 financial crisis. Adding these together, we estimate that the financial system will impose an excess cost of as much as $22.7 trillion between 1990 and 2023, making finance in its current form a net drag on the American economy.

First, we estimate the rents obtained by the financial sector. Through a variety of mechanisms including anticompetitive practices, the marketing of excessively complex and risky products, government subsidies such as financial bailouts, and even fraudulent activities, bankers receive excess pay and profits for the services they provide to customers. By overcharging for products and services, financial firms grab a bigger slice of the economic pie at the expense of their customers and taxpayers. We estimate that the total cost of financial rents amounted to $3.6 trillion–$4.2 trillion between 1990 and 2005.

Second are misallocation costs. Speculative finance does not just grab a bigger slice of the pie; its structure and activities are often destructive, meaning it also shrinks the size of the economic pie by reducing growth. This is most obvious in the case of the financial crisis, but speculative finance harms the economy on a daily basis. It does this by growing too large, utilizing too many skilled and productive workers, imposing short-term orientations on businesses, and starving some businesses and households of needed credit. We estimate that the cost of misallocating human and financial resources amounted to $2.6 trillion–$3.9 trillion between 1990 and 2005.

Adding rent and misallocation costs, we show that, even without taking into account the financial crisis, the financial system cost between $6.3 trillion and $8.2 trillion more than the benefits it provided during the period 1990–2005.

On top of this is the massive cost of the financial crisis itself, which most analysts agree was largely associated with the practices of speculative finance. If we add conservative Federal Reserve estimates of the cost of the crisis in terms of lost output ($6.5 trillion–$14.5 trillion), it brings the total amount of “overcharging” to somewhere between $12.9 trillion and $22.7 trillion. This amount represents between $40,000 and $70,000 for every man, woman, and child in the U.S., or between $105,000 and $184,000 for the typical American family. Without this loss, the typical American household would have doubled its wealth at retirement.

These excess costs of finance can be reduced and the financial sector can once again play a more productive role in society. To accomplish this, we need three complementary approaches: improved financial regulation, building on what Dodd-Frank has already accomplished; a restructuring of the financial system to better serve the needs of our communities, small businesses, households, and public entities; and public financial alternatives, such as cooperative banks and specialized public financial institutions , to level the playing field.

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In Finance, Even Business as Usual Comes at Too High a Price

Gerald Epstein

A healthy financial system is crucial to a stable and productive market economy. But after decades of deregulation, the U.S. financial system has turned into a highly speculative system that has failed spectacularly at doing its job. My new report, Overcharged: The High Cost of High Finance,” written with Juan Montecino and published by the Roosevelt Institute, describes in detail the massive costs of this failed financial system.

The evidence of overcharging is all around us. The most obvious, of course, is the catastrophic financial crisis of 2007-2008 that wiped away $16 trillion—24 percent of household net wealth, led to more than 5.5 million home foreclosures, and caused skyrocketing, hope-crushing unemployment rates. When the government picked up the pieces and committed more than $20 trillion of taxpayers’ money to bail out the largest financial institutions, millions of Americans were left high and dry, angry and frustrated.

But the failures of our financial system don’t just arrive in one big bang. They occur on a daily basis, in more mundane ways, often hidden from sight. Asset managers overcharge and underperform. Private equity (PE) general partners earn massive incomes but pay low returns to pension funds and other investors while enjoying unjustifiable tax breaks such as the carried interest exclusion. They do this while, at times, breaking companies and laying off workers for no other reason than their pursuit of short-run capital gains. Payday lenders charge upwards of 400 percent annual interest because many poor people have nowhere else to turn. Meanwhile, many of these payday lenders themselves are tied to the major Wall Street banks.

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Taking the Blinders Off, Part 2

Susan Schroeder is a lecturer in the Department of Political Economy, University of Sydney, Australia, and author of Public Credit Rating Agencies: Increasing Capital Investment and Lending Stability in Volatile Markets (Palgrave Macmillan, 2015). This is the second part of a three-part article, originally published in the July/August 2016 issue of Dollars & Sense magazine.

Susan Schroeder

Instability in Capitalist Economies

A market economy is not completely unpredictable—it does have gravitational tendencies, such as a tendency towards a falling rate of profit. Those tendencies are created by the day-to-day activities of firms and consumers, and are further shaped by the contexts in which they are embedded, such as institutional configurations and social norms.

What is the source, then, of instability in capitalist economies? It emanates from firms’ quest for profit. Capitalism runs on profit. To enhance their profits, firms adopt production techniques that lower their per-unit production costs. As this occurs, each firm’s structure of production changes relative to industry norms. Firms that use lower proportions of labor relative to other inputs are deemed to be more efficient and will earn a better rate of return on their capital than firms that do not adapt.  Firms also switch from one industry to another, or enter new industries, in a quest for higher returns. Firms must change in these ways in order to survive, and thrive, in a competitive market economy.

Changes to productive conditions within an industry and capital flows between industries, however, are major sources of instability. The mechanization of the production process, for example, increases the presence of capital relative to labor. This process is also facilitated by mergers and acquisitions. As each firm changes its production process, the average conditions of production for each industry change. Capital flows between industries will also affect the industry averages as weaker firms exit.  Firms can never be exactly sure how they compare against the industry average at any point in time. The best they can do is try to lower the unit cost of output faster than their competitors. Moreover, economists have demonstrated that these activities create a third source of instability—a tendency towards a falling profit rate for the entire economy.

Debt exacerbates this instability. Firms use debt, supplementing their own retained profits, to finance investment that improves their structures of production. However, improvement comes at the expense of the increasing weight of debt service. As firms become increasingly fragile, collectively, the economy becomes less resilient, and more vulnerable to a debt-deflation process.

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Paul Krugman Crosses the Line

Gerald Epstein

In his recent New York Times opinion column, “Sanders Over the Edge” (4/8/16), economist Paul Krugman offers his readers a basketful of misinformation on important economic matters about which he should – and probably does – know better. The column contains a large number of snipes and a great deal of innuendo against Bernie Sanders and his supporters, but here I focus on his claims about “Too Big To Fail” (TBTF) banks, their role – non-role, according to Krugman –  in the financial crisis, and Sanders’ understanding of the policy tools available to deal with them. Krugman’s claims about these issues are misleading, almost certainly wrong, and, in my view, call into question the credibility of his New York Times column as a source of economic information and analysis.

Krugman starts here:

“Bernie is becoming a Bernie Bro.” I’ll leave it to others to dissect this one. Moving on:

“Let me illustrate the point … by talking about bank reform.

“The easy slogan here is ‘Break up the big banks.’ It’s obvious why this slogan is appealing from a political point of view: Wall Street supplies an excellent cast of villains. But were big banks really at the heart of the financial crisis, and would breaking them up protect us from future crises? Many analysts concluded years ago that the answers to both questions were no.”

As you can see by following Krugman’s link here, this is not, what Krugman suggests it is: it is not a link to an article quoting multiple analysts presenting strong arguments with evidence that large banks were not responsible for the crisis. It is a link to an opinion piece by Paul Krugman himself. Period.

And, moreover, in this linked piece, Krugman is far more circumspect and uncertain of the answers than if implied in his statement “that many analysts concluded years ago.” So, who are these “many analysts”? On what basis did they reach their conclusions?

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Lessons from Iceland’s Financial Crisis

Nina Eichacker

Nina Eichacker is a lecturer in economics at Bentley University. This blog post summarizes her recent Political Economy Research Institute (PERI) working paper “Too Good to Be True: What the Icelandic Crisis Revealed about Global Finance.”

Iceland’s 2008 financial crisis should have been foreseen. By 2006, banking and economic data described an overheating financial sector and aggregate economy, and analyses by private and public researchers had reports describing those trends and their likely consequences. However, many were still surprised by the onset of Iceland’s large financial crisis. These events point to the dominance of neoliberal theories about the necessity of financial liberalization, and an assumption that a northern European country would have the institutional sophistication to avoid financial crises like those observed in developing countries that rapidly liberalize their financial sectors. A wider adherence to Keynesian and Minskyian theories of financial crisis would have helped predict Iceland’s crisis, and future such episodes.

One factor that contributed to the Icelandic financial crisis was the lack of financial market transparency. Organizations that could have reported on the conditions of the Icelandic financial marketplace and the state of the Icelandic economy did not. Despite positive reports by Frederic Mishkin and others citing Icelandic institutions’ integrity, (Mishkin and Herbertsson, 2006), the Icelandic state threatened to defund public Icelandic institutions and agencies that published reports contradicting the narrative of a robust financial infrastructure and growth. Iceland’s Chamber of Commerce paid economists like Mishkin hundreds of thousands of dollars to write favorable reports about Iceland’s financial sector and overall economic growth prospects. (Wade and Sigurgeirsdottir, 2010) The Icelandic news media consistently underpublished reports critical of the Icelandic financial sector, while publishing many stories that praised Iceland’s big three banks (Andersen, 2011). Sigurjonsson (2011) identified the root cause of this disparity as the cross-ownership of media company shares by Icelandic financial actors and institutions and financial corporation shares by Icelandic media institutions. The interconnectedness of these industries created conflicts of interest for all involved. The under production of criticism, and the over production of praise for Iceland’s banks skewed public understanding of the nature of Icelandic banks’ activity.

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Turbulence and Stability in Financial Markets: China in Recent Times

Sunanda Sen, Guest Blogger

Sunanda Sen is a former Professor of Economics at Jawaharlal Nehru University, New Delhi.

Liberalisation of financial markets, as observed in different parts of the world economy, has never contributed to stability—avoiding unforeseen and unbridled movements in prices and quantities—in those markets. Discontinuation of state-level restraints, in deregulated markets, always generates an atmosphere of uncertainty, which itself has been instrumental in generating turbulence, and then leading to crises. Crises in different financial markets across the world are usually preceded by booms, fed by destabilising financial activities in opened-up markets.

The current downslide in China’s stock markets has followed this familiar pattern, with the crash that took place between June and July 2015 foreshowed by an unprecedented boom which came with the fast pace of liberalisation in the financial sector.

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From “Boring” Banking to “Roaring” Banking, Part 3

Gerald Epstein

This is the final installment 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 why there have not been more significant reforms since the financial crash and Great Recession, and on a reform agenda for today. Parts 1 and 2 are available here and here.

Dollars & Sense: Of course, bubbles burst and exacerbate the severity of downturns. One of the amazing things about the aftermath of the recent crisis has been the apparent imperviousness of the financial sector to serious reform—especially in contrast to the Great Crash of 1929 and the Great Depression. How do you make sense of that?

Gerald Epstein: You have to use a political economy approach to understand the sources of political support for finance. I call these multilayered sources of support the “bankers’ club.”

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From “Boring” Banking to “Roaring” Banking, Part 2

Gerald Epstein

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.

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From “Boring” Banking to “Roaring” Banking, Part 1

How the Financial Sector Grew Out of Control, and How We Can Change It

Gerald Epstein

Gerald Epstein is a professor of economics and a founding co-director of the Political Economy Research Institute (PERI) at the University of Massachusetts-Amherst. In April, he sat down with Dollars & Sense co-editor Alejandro Reuss to discuss major themes in his current research. This first part (in a three part series) focuses on the dramatic growth in the financial sector and the transformation from regulated “boring” banking to deregulated “roaring” banking.

Dollars & Sense: What should we be looking at as indicators that the financial sector has grown much larger in this most recent era, compared to what it used to be?

Gerald Epstein: There are a number of different indicators and dimensions to this. The size of the financial sector itself is one dimension. If you look at the profit share of banks and other financial institutions, you’ll see that in the early post-war period, up until the early 1980s, they took down about 15% of all corporate profits in the United States. Just before the crisis, in 2006, they took down 40% of all profits, which is pretty astonishing.

Another measure of size is total financial assets as a percentage of gross domestic product. If you look at the postwar period, it’s pretty constant from 1945 to 1981, with the ratio of financial assets to the size of the economy—of GDP—at about 4 to 1. But starting in 1981, it started climbing. By 2007, total financial assets were ten times the size of GDP. If you look at almost any metric about the overall size of the financial sector—credit-to-GDP ratios, debt-to-GDP ratios, etc.—you see this massive increase starting around 1981, going up to a peak just before the financial crisis, in 2006.

Two more, related, dimensions are the sizes of the biggest financial firms and the concentration of the industry. For example, the share of total securities-industry assets held by the top five investment banks was 65% in 2007. The share of the total deposits held by the top seven commercial banks went from roughly 20% in the early postwar period to over 50%. If you look at derivatives trading, you find that the top five investment banks control about 97% of that. So there’s a massive concentration in the financial system, and that hasn’t declined—in some ways, it’s gotten worse—since the financial crisis.

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