Study: Financial industry's value overestimated

Financial Industry's 'Value Added' Significantly Overestimated, Report Contends

November 30, 2011 | Reuters

Banks' contribution to the economy may be hugely overstated, underscoring anger about the scale of taxpayer rescues and resultant government cutbacks, but a sharp retreat of banking worldwide looks painful for all and needs calibrating.

As sovereign debts and austerity bite across the West, spurring popular protest over rising inequality and malfunctioning capitalism, governments have been under pressure to act tough on the outsized and risky banking that was deemed too big to fail.

With everyone now on the hook for shoring up those banks and severe economic hardship being felt across the North Atlantic countries, the debate about "socially useless" aspects of banking has been intense.

Since 2007, the regulatory backlash has included forcing banks to build higher capital buffers; separating retail banking from global investment finance; curbing excessive pay; and taxing transactions and speculative activity.

But one eye-catching angle on the reassessment came from Bank of England economists this month.

In a paper for the VoxEU think tank, the Bank's executive director for Financial Stability, Andrew Haldane, and economist Vasileios Madouros claimed British and U.S. national accounts have significantly overestimated the "value added" provided by financial services firms before and since the crisis began.

The essence of their argument is that in calculating gross domestic product, government statisticians give far too much weight to banking activity that merely involves creating and bearing risk in lending and asset holdings.

Under the current system, the paper points out that the value added ascribed to U.S. financial intermediaries was as much as $1.2 trillion last year -- some 8 percent of GDP and a fourfold increase in its share of GDP since World War Two. In Britain the equivalent in 2009 was even higher at 10 percent.

To justify those huge gains, the economists argue that the productivity of bank capital and staff would need to have soared too -- in part justifying the huge rises in pay and bonuses. But the precipitous collapse of many of these banks in 2007 and 2008 questions whether the scale of those efficiency gains was anything more but smoke and mirrors.

"High pre-crisis returns to banking had a much more mundane explanation. They reflected simply increased risk-taking across the sector," Haldane and Madouros wrote, insisting that risk taking such as credit expansion to complex products leveraged by short-term borrowings does not amount to value added.

But national accounts blur the distinction between this unproductive "risk bearing" and productive "risk management," where banks provide valuable services of broking, credit screening or intermediation that helps firms and households grow, save and invest.

As a result, the gigantic balance sheet expansion of global banks in the decade prior the credit crisis was wrongly accounted for as increased value added. Households investing in a bond or taking out a mortgage, for example, also bear credit and liquidity risk but this is not seen as value added in GDP.

"If risk-making were a value-adding activity, Russian roulette players would contribute disproportionately to global welfare," Haldane and Madoura concluded.

The paper cites studies that showed adjusting accounts for this error would reduce the estimated economic output of euro zone banks by up to 40 percent. And applying that to UK banks would have cut their 2009 contribution to GDP from 10 percent to as low as six percent -- or an error of some 55 billion pounds.

A bigger distortion is that the hundreds of billions of dollars of public subsidies or bailouts to ailing banks meant many of these firms didn't even have to bear the very risks incorrectly flattering their output, productivity and pay.

"Instead it has been borne by society. That is why GDP today lies below its pre-crisis level. And it is why government balance sheets, relative to GDP, are set to double as a result of the crisis in many countries," Haldane and Madouros said.

ROLLING BACK BANKS

The calculations go some way to quantifying how far out of kilter banking was from the real economy. But it also shows that resolving the "too big to fail" dilemma that forced the bailouts will also involve some reversal of the balance sheet explosion.

The problem right now is that banking retreat is unleashing a double-whammy on an already austerity-squeezed global economy.

Uncertainty about the future shape of banking and another world downturn mean new capital for banks is scarce, forcing them to cut lending to meet more stringent capital ratios, such as the 9 percent base required of euro zone banks by mid-2012.

European banks alone are expected to ditch up to 3 trillion euros of loans next year to meet new capital rules.

U.S. investment banking giants too are cutting back assets and activities and openly talking about a secular downsizing of the industry [ID:nN1E7AE1WW]. And the world's ten largest banks involved in capital markets are estimated to have have lost about $250 billion of market capitalization since March.

Though wary of being deflected by banking lobbies into abandoning reforms, policymakers are recognizing that too much, too soon could dangerous.

Bank of England governor Mervyn King said on Monday euro bank deleveraging was already showing signs of a credit crunch.

"These are enormous challenges and it will not be easy to get through this," he said. "There will I think need to be a significant amount of rationalization of debts and credits in the world before we are finally to emerge from the end of this."

Finding a way to let the air out of the balloon slowly may be the big challenge of 2012 and beyond.

'We are the 1 percent': 147 firms own 40% of global wealth

Gee, I'm relieved to hear that 1 percent of transnational corporations (TNCs) control the world not thanks to a global conspiracy, but thanks to nature.

And it's comforting to hear that the top 25 TNCs includes many global financial institutions, such as Barclays, Bank of America, Credit Suisse, Deutsche Bank, JPMorgan Chase, Meryll Lynch, Morgan Stanley, UBS, Societe Generale, and Goldman Sachs, which are all officially Too Big Too Fail -- and all recipients of the $16 trillion Fed bailout (see page 131).

Run wild and free, TNCs, like you were born to do! OWS, stop opposing nature!

Seriously though, the problem here is not necessarily industry concentration, but rather interconnectedness that, in a case like the 2007-08 financial crisis, could lead to a systemic collapse. As Nassim Taleb notes, nature loves "robustness," meaning, through evolution, biological systems favor backups & redundancies which don't necessarily lend themselves to optimal efficiency, but are quite effective at preventing system failure.

In our new global economy the establishment of transnational anti-monopoly rules is a timely idea, but we must figure out how to implement them in practice.

Revealed – the capitalist network that runs the world

By Andy Coghlan and Debora MacKenzie

October 24, 2011 | New Scientist

AS PROTESTS against financial power sweep the world this week, science may have confirmed the protesters' worst fears. An analysis of the relationships between 43,000 transnational corporations has identified a relatively small group of companies, mainly banks, with disproportionate power over the global economy.

The study's assumptions have attracted some criticism, but complex systems analysts contacted by New Scientist say it is a unique effort to untangle control in the global economy. Pushing the analysis further, they say, could help to identify ways of making global capitalism more stable.

The idea that a few bankers control a large chunk of the global economy might not seem like news to New York's Occupy Wall Street movement and protesters elsewhere (see photo). But the study, by a trio of complex systems theorists at the Swiss Federal Institute of Technology in Zurich, is the first to go beyond ideology to empirically identify such a network of power. It combines the mathematics long used to model natural systems with comprehensive corporate data to map ownership among the world's transnational corporations (TNCs).

"Reality is so complex, we must move away from dogma, whether it's conspiracy theories or free-market," says James Glattfelder. "Our analysis is reality-based."

Previous studies have found that a few TNCs own large chunks of the world's economy, but they included only a limited number of companies and omitted indirect ownerships, so could not say how this affected the global economy - whether it made it more or less stable, for instance.

The Zurich team can. From Orbis 2007, a database listing 37 million companies and investors worldwide, they pulled out all 43,060 TNCs and the share ownerships linking them. Then they constructed a model of which companies controlled others through shareholding networks, coupled with each company's operating revenues, to map the structure of economic power.

The work, to be published in PLoS One, revealed a core of 1318 companies with interlocking ownerships (see image). Each of the 1318 had ties to two or more other companies, and on average they were connected to 20. What's more, although they represented 20 per cent of global operating revenues, the 1318 appeared to collectively own through their shares the majority of the world's large blue chip and manufacturing firms - the "real" economy - representing a further 60 per cent of global revenues.

When the team further untangled the web of ownership, it found much of it tracked back to a "super-entity" of 147 even more tightly knit companies - all of their ownership was held by other members of the super-entity - that controlled 40 per cent of the total wealth in the network. "In effect, less than 1 per cent of the companies were able to control 40 per cent of the entire network," says Glattfelder. Most were financial institutions. The top 20 included Barclays Bank, JPMorgan Chase & Co, and The Goldman Sachs Group.

John Driffill of the University of London, a macroeconomics expert, says the value of the analysis is not just to see if a small number of people controls the global economy, but rather its insights into economic stability.

Concentration of power is not good or bad in itself, says the Zurich team, but the core's tight interconnections could be. As the world learned in 2008, such networks are unstable. "If one [company] suffers distress," says Glattfelder, "this propagates."

"It's disconcerting to see how connected things really are," agrees George Sugihara of the Scripps Institution of Oceanography in La Jolla, California, a complex systems expert who has advised Deutsche Bank.

Yaneer Bar-Yam, head of the New England Complex Systems Institute (NECSI), warns that the analysis assumes ownership equates to control, which is not always true. Most company shares are held by fund managers who may or may not control what the companies they part-own actually do. The impact of this on the system's behaviour, he says, requires more analysis.

Crucially, by identifying the architecture of global economic power, the analysis could help make it more stable. By finding the vulnerable aspects of the system, economists can suggest measures to prevent future collapses spreading through the entire economy. Glattfelder says we may need global anti-trust rules, which now exist only at national level, to limit over-connection among TNCs. Sugihara says the analysis suggests one possible solution: firms should be taxed for excess interconnectivity to discourage this risk.

One thing won't chime with some of the protesters' claims: the super-entity is unlikely to be the intentional result of a conspiracy to rule the world. "Such structures are common in nature," says Sugihara.

Newcomers to any network connect preferentially to highly connected members. TNCs buy shares in each other for business reasons, not for world domination. If connectedness clusters, so does wealth, says Dan Braha of NECSI: in similar models, money flows towards the most highly connected members. The Zurich study, says Sugihara, "is strong evidence that simple rules governing TNCs give rise spontaneously to highly connected groups". Or as Braha puts it: "The Occupy Wall Street claim that 1 per cent of people have most of the wealth reflects a logical phase of the self-organising economy."

So, the super-entity may not result from conspiracy. The real question, says the Zurich team, is whether it can exert concerted political power. Driffill feels 147 is too many to sustain collusion. Braha suspects they will compete in the market but act together on common interests. Resisting changes to the network structure may be one such common interest.

Stiglitz: Spend, spend, spend

Spend, Spend, Spend

There is only one way out of the global recession, and government must lead the way.

By Joseph E. Stiglitz

October 3, 2011 | Slate

As the economic slump that began in 2007 continues, the question persists: Why? Unless we have a better understanding of the causes of the crisis, we can't implement an effective recovery strategy. So far, we have neither.

We were told that this was a financial crisis, so governments on both sides of the Atlantic focused on the banks. Stimulus programs were sold as being a temporary palliative, needed to bridge the gap until the financial sector recovered and private lending resumed. But, while bank profitability and bonuses have returned, lending has not recovered, despite record-low long- and short-term interest rates.

The banks claim that lending remains constrained by a shortage of creditworthy borrowers. And key data indicate that they are at least partly right. After all, large enterprises are sitting on a few trillion dollars in cash, so money is not what is holding them back from investing and hiring. Some (perhaps many) small businesses are, however, in a very different position: Strapped for funds, they can't grow, and many are being forced to contract.

Still, overall, business investment—excluding construction—has returned to 10 percent of GDP (from 10.6 percent before the crisis). With so much excess capacity in real estate, confidence will not recover to its pre-crisis levels anytime soon, regardless of what is done to the banking sector. The financial sector's inexcusable recklessness, given free rein by mindless deregulation, was the obvious precipitating factor of the crisis. The legacy of excess real-estate capacity and over-leveraged households makes recovery all the more difficult.

But the economy was very sick before the crisis; the housing bubble merely papered over its weaknesses. Without bubble-supported consumption, there would have been a massive shortfall in aggregate demand. Instead, the personal savings rate plunged to 1 percent, and the bottom 80 percent of Americans were spending, every year, roughly 110 percent of their income. Even if the financial sector were fully repaired, and even if these profligate Americans hadn't learned a lesson about the importance of saving, their consumption would be limited to 100 percent of their income. So anyone who talks about the consumer "coming back"—even after deleveraging—is living in a fantasy world.

Fixing the financial sector was necessary, but far from sufficient, for economic recovery. To understand what needs to be done, we have to understand the economy's problems before the crisis hit.

First, America and the world were victims of their own success. Rapid productivity increases in manufacturing had outpaced growth in demand, which meant that manufacturing employment decreased. Labor had to shift to services. The problems are not dissimilar to those of the early 20^th century, when rapid productivity growth in agriculture forced labor to move from rural areas to urban manufacturing centers. With a decline in farm income in excess of 50 percent from 1929 to 1932, one might have anticipated massive migration. But workers were "trapped" in the rural sector: They didn't have the resources to move, and their declining incomes so weakened aggregate demand that urban/manufacturing unemployment soared.

For America and Europe, the need for labor to move out of manufacturing is compounded by shifting comparative advantage: Not only is the total number of manufacturing jobs limited globally, but a smaller share of those jobs will be local.

Globalization has been one, but only one, of the factors contributing to the second key problem: growing inequality. Shifting income from those who would spend it to those who won't lowers aggregate demand. By the same token, soaring energy prices shifted purchasing power from the United States and Europe to oil exporters, who, recognizing the volatility of energy prices, rightly saved much of this income.

The final problem contributing to weakness in global aggregate demand was emerging markets' massive buildup of foreign-exchange reserves—partly motivated by the mismanagement of the 1997-98 East Asia crisis by the International Monetary Fund and the U.S. Treasury. Countries recognized that without reserves, they risked losing their economic sovereignty. Many said, "Never again." But, while the buildup of reserves—currently around $7.6 trillion in emerging and developing economies—protected them, money going into reserves was money not spent.

Where are we today in addressing these underlying problems? To take the last one first, those countries that built up large reserves were able to weather the economic crisis better, so the incentive to accumulate reserves is even stronger.

Similarly, while bankers have regained their bonuses, workers are seeing their wages eroded and their hours diminished, further widening the income gap. Moreover, the United States has not shaken off its dependence on oil. With oil prices back above $100 a barrel this summer (and still high), money is once again being transferred to the oil-exporting countries. And the structural transformation of the advanced economies, implied by the need to move labor out of traditional manufacturing branches, is occurring very slowly.

Government plays a central role in financing the services that people want, such as education and health care. And government-financed education and training, in particular, will be critical in restoring competitiveness in Europe and the United States. But both have chosen fiscal austerity, all but ensuring that their economies' transitions will be slow.

The prescription for what ails the global economy follows directly from the diagnosis: strong government expenditures, aimed at facilitating restructuring, promoting energy conservation, and reducing inequality, and a reform of the global financial system that creates an alternative to the buildup of reserves. Eventually, the world's leaders, and the voters who elect them, will come to recognize this. As growth prospects continue to weaken, they will have no choice. But how much pain will we have to bear in the meantime?

This article is also available at Project Syndicate.