Notes On How the Financial Sector Really Works


7-17-09, 10:15 am

  I would categorize the financial sector as unproductive. In one sense this seems pretty obvious since they do not physically produce anything. But, apologists for the banks might say, this Smithian distinction is misleading. For the real criterion of whether the banks are productive or not is to be found in their balance sheets. It was, they would say, an archaic Calvinist prejudice on Adam Smith's part to tie productiveness to physical production. This criticism of Smith is made both by conservatives like Rothbard and by some marxist writers. The latter argue that the crucial question is not whether the banks produce anything physical, but whether they produce surplus value.   Do they produce surplus value?   Well they undoubtedly show a profit most years, so if one is content to look only at the form of things, then they would appear to be productive. But if we look in more detail at the national accounts we find the picture is not so simple. The banks do a variety of things, some of which can be portrayed as simple services, sold as a commodity, others are harder to portray in this way. In their accounts they show an entry for income from the provision of services. An example of this would be charging for clearing checks or for making payments into other accounts. However, what one sees when one looks at the UK banking sector is that such charges for banking services are insufficient even to meet the wage bills of the banks. For the general public, this is the main use of banks, but it is not their main source of revenue. That comes instead from profits on financial contracts. The first and oldest source of such profits is the charging of interest on their own capital which they lend out, and, the money of their depositors that they lend out. Over time the banks and other financial institutions have come to make a part of their revenue by trading in financial contracts of ever greater complexity and abstraction. Can any of this be regarded as productive?   Whether they are productive or not, how are we to explain the much greater prominence in economic life of the financial sector?   Unproductiveness of modern lending   Suppose we have a public company, let us call it Redmond Autos, which is initially 100 percent owned by shareholders. The revenue from the cars it produces will then be split three ways: some to its suppliers, some to its employees, and the residual value to the shareholders. If this is now bought by a private equity company Rising Phoenix Holdings who finance their purchase with bank loans leaving the firm with large debts. A large fraction of what previously went as dividends to shareholders is now transferred to the banks as interest. It is clear that no additional value is created by such a change, and that in consequence the interest payments are just another contractual form that can be assumed by profit revenue.   Suppose instead that a company is expanding and finances its expansion by credit from the bank. Here, arguably, the bank is playing an indirect productive role. It does not produce anything itself, but by channeling idle deposits to industrial investors, it allows the latter to expand production. A net growth in deposits by members of the public corresponds to income that has been earned but not spent, if the bank channels these to productive investors it allows that portion of the national income to be materialized in new capital equipment.   But productive lending is now a relatively small fraction of what the great financial centers like London and New York do. Look at Figure 1, you see that the non-financial corporations are net lenders, not net borrowers from the banks. The net lending and borrowing in the system must balance so the banking system actually works mainly to channel profit from industry, and from overseas companies into the two sectors that are net borrowers: the state and private households. Some of the expenditure by the state will be on productive publicly owned assets – new highways, schools etc, but the larger part will go on current costs or unproductive items like new fighters and submarines. The money lent to the personal sector, will again partly finance new fixed assets: new houses, but again a large part will go on consumer credit.   On balance therefore, the financial system is acting to fund unproductive activities.   Unproductiveness of dealing in contracts   The financial system trades in a huge variety of other contracts: shares, bonds, futures contracts etc. At first sight, trading in such contracts would appear to be a zero sum game. The as traders buy and sell shares between one another, one person's loss will be another person's gain and vice versa. But this is no longer the case in a bull market. If the general price of financial assets rises over a period of years, then in paper terms at least, all traders can show a monetary profit. What then creates prolonged bull markets?   Look at figure 2. In an ideal capitalist world the state would run a balanced budget, the nation would not depend on foreign borrowing and the financial system to channel savings from households to industry. But in reality the industrial rate of profit is too low, the number of new shares being issued to finance industrial investment is not sufficient to absorb savings. This imbalance becomes even worse since the industrial sector ceases to be a net investor and becomes a net saver as shown in figure 2. This shortage of new issues causes the price of existing shares to be bid up to absorb the funds.   But here is a paradox, a rise in the price of financial assets can not of itself absorb net savings. If fund manager A uses incoming funds to buy shares from fund manager B, then A can balance its accounts: its new deposits are now matched by new assets. But B now has the money for the shares. What does it do?   It tries to purchase other shares, bidding the price of all shares up in the process. The money stays in the financial system. This inflationary process would seem to go on indefinitely unless there were some balancing outflow of funds. It is here that the bonuses and profits of the banks play a role. Because asset prices are appreciating all round, financial firms show big trading profits which they distribute as dividends and bonuses to their traders. [footnote:As I write this Goldman Sachs has announced that it is paying out $4 billion in bonuses to its traders for the last quarter alone, averaging about half a million dollars per individual.]   During the bull market the financial system as a whole acts as a vast ponzi scheme. Any excess of deposits by savers over and above the current needs of industry and the state are translated into profits and bonuses. Savings are converted into current consumption revenues of the banking community.   The bull market sustained the illusion that saving is possible even though real capital accumulation was barely more than replacement levels. As time passed the illusion grew more and more unstable. The banks, having distributed so much dividends and bonuses in the good days, became under capitalized. When the crunch came they failed and the taxpayer had to take over their liabilities.   Their failure emphasizes that the exponential growth of real capital values can only occur when backed by an exponential growth of something real – ultimately an exponential growth of the source of value: labor. When population stabilizes, a real exponential growth of real capital becomes impossible. Investment then becomes a matter of just replacing old capital stock with more up to date equipment, with no net growth in value.   The financial system now takes on the role of the feudal aristocracy and priesthood. They spend the nation's surplus product in conspicuous consumption. Instead of papal indulgences promising a better hereafter, they sell modern promissory notes supposedly guaranteeing a happy retirement. The promises are almost as egregious as those Luther protested against. Today's savings have gone on bankers bonuses, air force jets and soldiers wages. The truth is that the real consumption of the retired must always be supplied the the labor of their younger contemporaries. The enormous, expensive and unproductive financial system consumes savings today whilst being unable to conjure up new labor to support future retirees. It would be better by far, if the money currently frittered away by the financial system were channeled through the tax system directly to today's pensioners.