Warning: This post is going to get all philosophical and wonky. However, if the handful of faithful will follow along for a bit I’ll try to explain why I believe the Financialist fervor of the Monied and the Consumerist enthusiasm of the Leveraged are at odds. We can call our system “free market capitalism,” “Capitalism,” or “a Mixed Economy,” or whatever appellation sounds sufficiently patriotic in the moment — but an essential point remains: We have within the system two conflicting forces not easily synchronous.
At one end we have the Financialists, financialism being the form of capitalism in which the primary economic activity consists of creating and manipulating financial instruments. These instruments can be equities, loans, bonds, mortgages, or anything else linked to the transference of wealth and the acceptance of monetary risk. For the last four decades our financial sector has transformed from one in which the primary revenue streams came from channeling investment from areas of surplus to areas of shortage, to one in which the significant revenue streams come from the sale, re-sale, and hedging of those financial products. From one in which the assets were the primary focus, to one in which the asset based securities are the center of attention. [Seeking Alpha]
The creation and manipulation of financial instruments creates wealth. There’s no question about this. However, the wealth created by the financialists tends to stay among the financialists.
The Census Bureau chart indicates a divergence in income distribution beginning in the early 1970s and broadening as we approached the early part of the 21st century in the United States.
When we look at the chart for 2002 to 2007 the divergence is even more dramatic.
The share of income (wealth) increases going to the top 1% vastly outpaces the share of income increases headed toward the other 99%, and this is the point at which the rubber meets a very bumpy road.
Consumerism requires buyers. Among some advocates of more simple lifestyles, the term has acquired a negative connotation — we are using up more physical resources than other nations, we are becoming robotic acquisition machines programmed by advertising to spend what we don’t have for that which we don’t need, and so on. But, for all of the approbation heaped upon it — the fact remains that unless people go to the showrooms automobiles don’t sell.
One contrarian view is that we really don’t have a consumer economy because the statistics on consumption include government purchases, the expenditures of non-profit organizations, and a host of other transactions that narrowly defined don’t constitute “consumer consumption.” This view postulates that what we need are more “producers.” The problem unaddressed by this line of argument is that production for its own sake doesn’t work — except to build up inventory. One of the last things any enterprise ever wants to see is a backlog of surplus inventory — of anything. Unless goods and services can be sold they ought not be produced. The only thing an enterprise gets from Uber-Production is overstaffed offices and/or overstuffed warehouses.
We can buy things for cash or on credit. One of the more intriguing arguments set forth by ultra-conservative writers is that Americans should become more financially responsible, and restrain themselves such that they can live beneath their means, save for retirement and emergencies, and avoid over-leveraging themselves. There’s a catch in this for the Financialists.
Consumer credit, student loans, automobile contracts, mortgages, home equity loans, and other forms of credit are fodder for the Financialists. These are the very financial instruments which can be manipulated, repackaged, and resold (and then bet on) by the financial markets. Unless there are home mortgages, there cannot be mortgage based securities. Unless there are student loans, these cannot be repackaged in bond forms. Unless here are credit card accounts receivable, there cannot be financial instrument created and manipulated to add to the financial market revenue streams.
And now we get to the potholes.
If the consumers are leveraged to the garage ceiling, the financialists are doing well. However, when consumers pull back there are fewer financial instruments available from which to create more financial products. A quick home-made chart of what happened to revolving credit in the last five years is illustrative:
How about non-revolving credit?
What the two simplified charts indicate is that from 2007 to 2009 consumers were “de-leveraging” (paying off revolving and non-revolving loans). Since it took a year longer for the revolving credit to start heading north, we can easily assume that consumers were slower to get out the plastic cards for consumer goods and services.
In a real world, if consumers stopped purchasing goods and services on credit — be it in terms of mortgages, car loans, etc. — then we’d expect to see banks not doing so well be cause the basic fodder for financial products was constricting. However, financialism doesn’t always operate in the real world.
The FDIC released this report on May 24, 2011:
Commercial banks and savings institutions insured by the Federal Deposit Insurance Corporation (FDIC) reported an aggregate profit of $29 billion in the first quarter of 2011, an $11.6 billion improvement (66.5 percent) from the $17.4 billion in net income the industry reported in the first quarter of 2010. This is the seventh consecutive quarter that earnings registered a year-over-year increase. For the sixth consecutive quarter, reduced provisions for loan losses drove the improvement in earnings.
“The industry shows continuing signs of improvement,” said FDIC Chairman Sheila C. Bair. She added, “though there is a limit to how far reductions in loan-loss provisions can boost industry earnings.”
OK, commercial banking operations were recouping after The Big Bust. The investment banking sector hasn’t been so fortunate.
“Across a sample of a dozen large banks, underlying revenues over the four quarters to the end of March have fallen by just over 15% compared with a year earlier, while pre-tax profits have halved, according to my analysis. Pre-tax return on equity across the industry is running at just 9.6% over the past four quarters, or little more than half banks’ cost of capital.
The main factor in the bleak forecast is that most banks have been unable to cut their costs fast enough. Over the past year, costs have fallen by just 4% as many banks have tinkered at the fringes in the hope that the showers will pass or that the bad weather would force some of their rivals to give up. As a result, the average cost-income ratio across the industry is an unsustainable 79%. An indication of the scale of the problem is that in order to get to an average pre-tax return on equity of 17% (which translates roughly into a 12% net return) investment banks would have to cut their expenses by a further 20%. That’s nearly $30bn of cuts in annual costs.” [FinNews] (June 26, 2012)
Two points to take away from this — (1) the investment banking sector hasn’t been able to cut costs fast enough and (2) hoping that one’s competitors will take a nose dive doesn’t sound like a viable strategy. There may be a third point as well, hubris and investment banking are not a good mix.
Market volatility can certainly make for profitable trades, but some caution must be taken that the volatility won’t come back around. “Economic uncertainty” seems to be a catch-all phrase to describe why investment banking, the heartland of the financialists, are having a bad time of it. The problem is that some of the “uncertainty” was created by the financialists themselves. Witness the activities of Goldman Sachs in Greece, and the recent exposé of Barclays machination with the LIBOR. Tighter regulation or oversight means that such joys as Goldman Sachs’ infamous ABACUS synthetic CDOs aren’t on the menu, or holding such an exalted place in the revenue stream.
The moral of this story is that however much the financialists may wish to push “austerity” on their customers in the interest of being paid back, there must be a foundation for the financial products they want to create. There have to be home mortgages, car loans, and lines of consumer credit before there can be CDOs crafted based on these instruments.
IF consumer confidence, or indeed consumer capacity, diminishes then so do the opportunities for creating secondary markets for those financial products. A nation with stagnating wages and declining wealth in a predominant part of its population is less likely to use credit which can be transformed into secondary financial markets. If manufacturing concerns don’t feel any need to expand because there is insufficient demand for their products then they would obviously not seek to issue corporate bonds. It’s been pointed out before, one man’s asset is another’s liability — but if there is no appetite to take on further liabilities (loans, bonds, etc.) then there is a constriction in the capacity to create credit based assets.
Financialists could probably trade amongst each other for days on various synthetic creations of their own devising, but eventually there must be a solid something related to the real world upon which the creations are based. This is probably a good reason why austerity programs in the U.K. have not yielded positive results. Beating the drum yet again, there are TWO sides to the classic economic equation — and therefore trying to function in the dream world wherein only the supply side matters is delusional.