By David Apgar, the Director of ApgarPartners LLC, a new business that applies assumption-based metrics to the performance evaluation problems of development organizations, individual corporate executives, and emerging-markets investors, and author of Risk Intelligence (Harvard Business School Press 2006) and Relevance: Hitting Your Goals by Knowing What Matters (Jossey-Bass 2008). He blogs at WhatMatters.
The TARP Subcommittee of the House Committee on Oversight and Government Reform spent two hours on Wednesday asking whether the Dodd-Frank bill has ended the scourge of banks that are too big to fail. The real question is whether anyone has tried to end the scourge of bankers who are too rich for the government to fail them.
The Buttonwood column in this week’s Economist asks the key question why living standards have declined – and well it should, as this is the central economic and political question in the rich world today. The column dismisses several alternative economic explanations and concludes by asking whether international banks are running the financial equivalent of a protection racket right out of The Godfather to keep their bonuses high. It suggests they’re threatening to move offshore if central bankers stop subsidizing them with low, destabilizing interest rates.
The Economist is right about the racket but wrong about the reason, in my view. And if we don’t understand the reason for stagnation and decline in median living standards and the closely related growth in inequality, we won’t be able to do anything about it.
Buttonwood starts off with a heaping helping of appalling statistics. Since the recovery began US wages are up $ 168B while profits are up by more than three times that amount — $ 528B. Nor is the trend limited to the financial crisis – productivity rose 83% from 1983 to 2007 while median male wages rose just 5%. (Women did better but were in the midst of a huge change in workforce participation.) Some of Ed Wolff’s statistics on inequality can round out the picture – the share of US income of the top 1% has risen by two thirds in one generation from 12.8% in 1982 to 21.3% in 2006.
The column rules out the explanation of British central banker Mervyn King that this is all really a return to a world of stable and balanced economies as rich countries cut back consumption to match production and eliminate their current account deficits. The trouble is that similar trends in living standards and inequality appear in countries like Germany that have long consumed less than they produced. And China – the world champion in over-production and under-consumption – has watched personal income drop from 69.3% to 57.5% while profits rose from 21.2% to 31.3% of GDP between 1996 and 2007. What is happening to the average guy’s and gal’s wage has little to do with global rebalancing.
Maybe it has to do with globalization, though. Many economists have argued that China’s massive success in mobilizing its workforce has created a world labor surplus. Wages will stop stagnating in Cleveland, runs the idea, once workers settle down in Guangdong. Yet these millions of newly mobilized Chinese workers did not suddenly materialize out of a Ming Dynasty cloud. What’s new is a fantastic increase in their productivity. Labor productivity should raise labor’s share of income around the world, however – not lower it. Greater Chinese labor productivity can’t explain lower US standards of living.
Another popular culprit is technology. And yet technology-driven productivity increases were greater in the 1990s than in the decades coming before and after – exactly the opposite of the fast-slow-fast pattern in wage stagnation and accelerating inequality in the US.
Buttonwood wonders whether the decline of unions is to blame. It’s true that unionization has dropped to a paltry 11.9% of the labor force. But it stood at just 20.1% in 1983.
All of which leads the column to point to rich-world central bankers’ stubborn subsidization of banks through low interest rates. Might the subsidy explain both persistently high banker compensation and the financial sector’s disproportionate profits?
Those profits certainly are high – 29% of total US profits in 2010 Q4 even though the Wall Street Journal estimates that the sector produces only 10% of the economy’s value-added. Much of that profit – and by far the highest compensation rates – come from investment banks, however, not commercial banks. Yet low interest rates don’t directly drive investment bank profits. They affect the economy by keeping commercial bank deposit rates low compared to loan rates. Low interest rates are a problem but they look more like a fall-guy than the Godfather behind the decline in western living standards.
For a better explanation go back to an old piece of folk wisdom so well established that economics graduate students get little credit for building regressions for it. Bankers charge a percentage of the value they transfer – be it the value of an acquisition target, a bond offering, or an investment account. The rest of the economy charges for the value they create (lawyers’ contingency fees excluded). And the more value that the economy transfers as a percent of what it creates, the higher the percent of earnings that goes to banks. The financial sector operates quite literally outside the capitalist economy.
How can the financial sector sustain such high rents? Investment banks get investors to pay high brokerage fees by threatening to cut them out of the best investment opportunities. And they gouge issuers by threatening to cut off their access to the best investors. Big commercial banks get companies to pay through the nose for bond offerings by threatening to cut back on their lines of credit.
But no government has the stomach to block financial mergers or even fight the exploitation of hard-to-supervise conflicts of interest that arise from combining investment and commercial banking services. Better consumer protection might seem like a good idea but was politically out of the question during seven years of progressively deteriorating mortgage suitability standards.
So there’s some truth to the Godfather analogy. You’d be right to look for a horse’s head under the sheets. If you find one, though, it’s not a warning to your central banker. It’s a warning to governments that might interfere in any way – through antitrust enforcement, consumer protection, a full return to Glass-Steagall, or compensation caps – with the tremendous luxury of charging for the transfer rather than the creation of value.