The economics discipline has for the most part managed to ignore the 800 pound gorilla in the room: that of the role that the financial services industry has come to play. Astonishingly, even though the reengineering of the world economy along the lines preferred by mainstream economists resulted in a prosperity-wrecking global financial crisis and a soft coup by financiers, the discipline carries on methodologically as if nothing much had happened. And one of its huge blind spots is its refusal to acknowledge the role of banking and finance in modern commerce. Interest rates are simply an input into the preferred form of macro models, DSGE (dynamic stochastic equilibrium models). Economies are assumed to be self correcting, and to automagically “correct” to full employment. All shocks to the system are exogenous. In other words, boom-bust credit cycles are simply omitted because they are ideologically inconvenient and instability is too hard to model.
Various heterodox economists (as well as some empirically oriented economists that come out of the mainstream, most notably Andrew Haldane of the Bank of England and Claudio Borio and Piti Disyatat of the Bank of International Settlements) are making a concerted effort to represent the role of the finance in modern economies. A new paper by Michael Hudson (University of Missouri at Kansas City) and Dirk Bezemer (University of Groningen, Netherlands) makes an important contribution by looking at financial services from a Classical economics perspective. Classical economists took a decidedly dim view of what they saw as unproductive rent-seeking, with “rent” seen as the dead hand of the feudal aristocracy weighing on current production:
Rentiers are those who benefit from control over assets that the economy needs to function, and who, therefore, grow disproportionately rich as the economy develops. These proceeds are rents – revenues from ownership “without working, risking, or economizing”, as John Stuart Mill (1848) wrote of the landlords of his day, explaining that “they grow richer, as it were in their sleep”. Classical economics from Adam Smith onwards analysed rents, its effects, and policies towards rents, but the very concept is lost on today’s economics.
Just as landlords were the archetypal rentiers of their agricultural societies, so investors, financiers and bankers are in the largest rentier sector of today’s financialized economies: finance controls the economy’s engine of growth, which is credit in all its forms. Economies obviously need banking services, insurance services, and real estate development and so, of course, not all of finance is “without working, risking, or economizing”. The problem today remains what it was in the 13th century: how to isolate what is socially necessary for ‘retail’ banking – processing payments by checks and credit cards, deciding how to relend savings and new credit under normal (non-speculative) conditions – from extortionate charges such as 29% interest on credit cards, penalty fees and other charges in excess of what is socially necessary cost-value.
Hudson and Bezemer argue that the failure to distinguish between productive activity versus rent seeking distorts and overstates the accounting for national output:
Creating a more realistic model of today’s financialized economies to trace this phenomenon requires a breakdown of the national income and product accounts (NIPA) to see the economy as a set of distinct sectors interacting with each other. These accounts juxtapose the private and public sectors as far as current spending, saving and taxation is concerned. But the implication is that government budget deficits inflate the private-sector economy as a whole. However, a budget deficit that takes the form of transfer payments to banks, as in the case of the post-September 2008 bank bailout, the Federal Reserve’s $2 trillion in cash-for-trash financial swaps and the $700 billion QE2 credit creation by the Federal Reserve to lend to banks at 0.25% interest in 2011, has a different effect from deficits that reflect social spending programs, Social Security and Medicare, public infrastructure investment or the purchase of other goods and services. The effect of transfer payments to the financial sector – as well as the $5.3 trillion increase in US Treasury debt from taking Fannie Mae and Freddie Mac onto the public balance sheet – is to support asset prices (above all those of the banking system), not inflate commodity prices and wages. Similarly, the 2009 ‘quantitative easing’ policy in Britain confused loans used in the real economy (which were stagnating or falling throughout the experiment) with boosting bank balances with the Bank of England which quadrupled over 2009 (Graph 3). Bezemer and Gardiner (2010) show that neither bank loans nor spending nor GDP increased noticeably
during or after the exercise, but there was a curious stock market rally during 2009.
The authors describe how much the financial sector has grown relative to the productive economy. Financial sector total financial assets (as in the asset side of bank balance sheets and off balance sheet vehicles) was one times US GDP in the early 1950s and is roughly 4.5 times GDP now. Financial sector earnings were 10% of total corporate profits in the 1950s and 1950s and rose to 40% in the early 2000s. Yet despite the sorry record, in terms of falling growth rates, stagnant average worker wages, and increasingly frequent and severe financial crises, orthodox economists look favorably upon financial “deepening,” meaning the proliferation of financial products and services (aka “innovation”). To put it more simply, the rentiers have the firm backing of mainstream economists, despite the evidenced of its destructiveness:
Just as debt deflation diverts income to pay interest and other financial charges – often at the cost of paying so much corporate cash flow that assets must be sold off to pay creditors – so the phenomenon leads to stripping the natural environment. The so-called ‘debt-resource-hypothesis’ suggests that high indebtedness leads to increased natural resource exploitation as well as more unsustainable patterns of resource use (Neumayer 2012, pp. 127-141)…
Demographically, the effect of debt deflation is emigration and other negative effects. For example, after Latvian property prices soared as Swedish bank branches fueled the real estate bubble, living standards plunged. Families had to take on a lifetime of debt in order to gain the housing that was bequeathed to the country debt-free when the Soviet Union broke up in 1991. When Latvia’s government imposed neoliberal austerity policies in 2009-10, wage levels plunged by 30 percent in the public sector, and private-sector wages followed the decline (Sommers et al 2010). Emigration and capital flight accelerated: the Economist (2010) reported that an estimated 30,000 Latvians were leaving every year, on a 2.2m population. In debt-strapped Iceland, the census reported in 2011 that 8% of the population had emigrated (mainly to Norway).
The irony of Hudson’s and Bezemer’s need to look back to the early days of economics is that a view that was widely shared then was the importance of usury ceilings. Why? If bankers were free to seek out the highest yielding loans, they would. And the people who would pay the most would not be businessmen but rich gamblers. So the fact that unconstrained banking would wind up promoting speculation rather than investment was seen as obvious centuries ago, yet supposedly more sophisticated modern economists seem to prefer to truck with Dr. Pangloss and tell us that the system they’ve helped create is both inevitable and virtuous, when neither is true.