Grantham: Finance Goes Rogue

I made some comments earlier this week on Jeremy Grantham’s quarterly letter to investors regarding deflation. Let’s move to another topic Grantham wades into that is near and dear to my heart: the financial sector. Grantham argues that a disproportionate share of the US economy is devoted to financial services. He says:

My previous argument in the Economist debate was that the 3% of GDP that was made up of financial services in 1965 was clearly sufficient to the task, the proof being that the decade was a strong candidate for the greatest economic decade of the 20th century. We should be suspicious, therefore, of the benefits derived from the extra 4.5% of the pie that went to pay for financial services by 2007, as the financial services share of GDP expanded to a remarkable 7.5%. This extra 4.5% would seem to be without material value except to the recipients. Yet it is a form of tax on the remaining real economy and should reduce by 4.5% a year its ability to save and invest, both of which did slow down. This, in turn, should eventually reduce the growth rate of the non-financial sector, which it indeed did: from 3.5% a year before 1965, this growth rate slowed to 2.4% between 1980 and 2007, even before the crisis.

You should recognize this paragraph as a suggestion that the excess share of GDP devoted to financial services is malinvestment. This is the argument I have been making for some time, namely that the industrial organization of the US does not lead to longer-term growth. The growth rates of the past decades were an illusion created by large increases in leverage in the household and financial services sectors (see "A brief look at the Asset-Based Economy at economic turns"). Of course, I fully support the financial services sector as vital to capitalism as does Grantham; he works in it, after all.

However, financial services are the plumbing of an economy, the grease that reduces friction. Its value comes from how it distributes capital into the rest of the economy. The financial services sector is not the source of innovation and productivity growth upon which a nation can grow over the longer-term; the companies it supplies capital to are. Collateralized debt obligations, interest-rate swaps, mortgage-backed securities and inflation-indexed securities may sound cool; but are they really the things that sustain an economy’s longer-term growth path? Do we need more CDOs and MBS paper to compete internationally? No. In fact, an over-reliance on financial services where profit is made through debt financing i.e. gearing or leverage creates instability.

Grantham puts it this way:

This bloated financial system was also increasingly deregulated and run with increasing regard for profit and bonus payments at all cost. Thirty years ago, Hyman Minsky could have told you that this would guarantee a major financial bubble sooner or later and at periodic intervals into the indefinite future. This unnecessary explosion in the size of the financial world has been a clear example of the potential for dysfunctionality in the capitalist free market system. I have not been a great fan of the theory of rational expectations – the belief in cold, rational, calculating homo sapiens; indeed, I believe it to be the greatest-ever failure of economic theory, which goes a long way toward explaining how completely useless economists were at warning us of the approaching crisis (with a half handful of honorable exceptions). But it would be a better world if their false assumptions were actually accurate ones: if only information flowed freely, were processed efficiently, and were available equally on both sides of every transaction, we would indeed live in a more efficient and probably better world. The problem that information is asymmetrical in the financial business is a serious one. One side of the transaction, say an institutional pension fund, is often at the mercy of the other, say the prop desk of a talented and mercilessly profit-oriented investment bank.

Notice the derision Grantham has for rational expectations and similar theories. I share his condemnation of both how these theories were used to increase risk and leverage and what it says about how the economics profession aided and abetted the economic collapse. Read "James Galbraith: Why the ‘Experts’ Failed to See How Financial Fraud Collapsed the Economy" from last month and you will see Galbraith making similar remarks.

But what about fraud? We don’t hear people talking about fraud a lot. I think misrepresentation and asymmetric information are at the heart of this economic crisis. The Goldman fraud case is one of the few that have been brought since the crisis began where regulators were able to extract a significant amount of cash. Grantham talks about how insiders dupe outsiders using information asymmetries. He sees this as a core element of the crisis. Moreover, as banks have gotten into proprietary businesses, their market-maker role shows an increasing number of conflicts of interest. Welcome to The Age of The Trader.

The problem of asymmetrical information is compounded by the confusion between the roles of agent and counterparty. I grew up in a world where stocks and other financial instruments were traded by the client with a high degree of trust in the agent. Millions of dollars traded on a word, without a tape recording. Somewhere along the way, without any formal announcement of the change, the “client” in a trade mutated into a “counterparty” who could be exploited. Steadily along the way, the agents’ behavior became more concerned with the return on their own trading capital than with the well-being of their clients. One of my nastiest shocks in 45 years was the realization one day in 1985 that we had been ripped off by our then favorite broker on one of the early program trades we were doing. We had supposed we had developed a trusting relationship. We had certainly done many incentive trades that were successful from our point of view. Perhaps, with hindsight, our strong incentives might have merely motivated them to rip off some other client.

Is the Age of the Trader coming to an end? I have my doubts, but let’s hope so. Grantham, for one, sees the Volcker rule as a huge plus in that effort.

There is a lot more to this Grantham newsletter on this and other topics. Expect to see more highlights in future posts. The link to the registration page for the full piece is below.

Source: Summer Essays (registration required) – GMO Quarterly Letter, July 2010, Jeremy Grantham

  1. TK says

    The real financial problem is the way currency is created. Basically, by having an unlimited money supply (fiat currency), backed by consumer debt, the money supply only grows with an ever increasing supply of new loans. Without this, the money supply shrinks and you have a bust. If there was a natural limit on the money supply, there would be market forces that would keep everything in check and as a consequence, there would be very little, if any, distortions in the money supply, nor would there be so much money to exploit. And people would retain real purchasing power.

  2. Mgkurilla says

    The financial industry is an extractive industry that carves out a peice for itself. When the industry was small and boring, it was tolerable, but as the overall industry grew and took the sharpest knives in the drawer, it slowly morph from a classical “middleman” taking their cut for a neccessary service to grow into a destructive industry that destoryed wealth in order to extract a small bit for itself. After 2000 (with TARP, TALF, Fannie, Freddie, etc), the industry began in earnest to destroy the future.

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