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Wall Street recovery going swimmingly

So, for a long time, financial industry profits made up a huge share of the nation's total profits. Then the financial sector blew up the economy and its share of total profits dropped, as you might expect. And now? As this graph from Paul Krugman shows, it's all back to normal, or even worse than normal.

finprofit.png

"We got into this mess because we had an over-financialized economy, with finance making a share of profits out of all proportion to its actual economic contribution," comments Krugman. "And now it’s baaaack."

I'd add one other point: In textbook economics, high, sustained profits signal a market inefficiency, as open and vigorous competition would generally drive the cost of something down to something very near the cost of production. We generally get around this by restricting competition. Patents, for instance, grant companies temporary monopolies over their ideas. To see what happens without these induced inefficiencies, look at the stock market, which is now open to competition from everyone with a computer and a E-Trade account and has lost its centrality to the financial models of big banks.

In the financial sector, the opacity and complexity of the market keeps other entrants out, and the extremely cheap federal money that these banks now have access to is helping them accelerate their business. But this isn't a good thing. In fact, aside from signaling that the financial sector isn't as competitive as one would hope, it's showing that there are still extraordinary, outsize profits to be made by inventing and selling complex, opaque financial instruments -- which is the same dynamic that got us into this mess.

By Ezra Klein  |  April 14, 2010; 2:50 PM ET
Categories:  Financial Crisis  
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Comments

I wonder how useful that graph would be to predict downturns in the future? If that data exists for the last, say, 100 years, it would be interesting to see if it could have been reliably used in this manner.

Posted by: Lomillialor | April 14, 2010 3:15 PM | Report abuse

Indeed, it's supposed to be the role of speculators to close that persistent excess profitability, right? But who will speculate on the speculators!

Posted by: bdballard | April 14, 2010 3:19 PM | Report abuse

What I am dying to learn is *who* is holding or *where* is all that option-ARM paper?

Much larger than subprime default wave, there is a *tidal wave* of option-ARMs that are due to reset in the next two years.

In other words banks might be making great profits now (and expensing 40% of their revenues as employee compensation) via the government's "gift" of an interest spread (Richard Koo's workout prescription), but to me that 40% should have been reserved for the impending option-ARM default tsunami (plus now we also know that banks are window dressing their leverage between report, making the Fed's "stress tests" suspect).

Posted by: msa_intp | April 14, 2010 3:33 PM | Report abuse

Lomillialor, I think you could piece together a series back into the 50s from data available from the Dept of Commerce Bureau of Economic Analysis (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp4q09_3rd.pdf) and data published in Table B-91 of the Economic Report of the President ( http://www.gpoaccess.gov/eop/tables09.html ).

By my quick calculation, the percentage didn't go over 20% until 1990

Posted by: bdballard | April 14, 2010 3:38 PM | Report abuse

"...the stock market, which is now open to competition ... and has lost its centrality to the financial models of big banks."

You mean business model.

Posted by: rglvr | April 14, 2010 3:50 PM | Report abuse

While I can see issues with being over-dependent on a single sector of the economy, is it really such a bad thing that the Financial Sector is so huge?

There has been a massive expansion in global trade and the global economy over the past three decades, and that means that in order to make it work, we needed and got a significantly larger financial sector. Since businesses tend to congregate where they can take advantage of the factors they need to succeed (in this case, access to a large pool of talent plus interaction with existing centers of finance), why not the US?

Somebody has to be one of the hubs of global finance, and I'm thankful one of them is New York City (the others are London and Tokyo).

Posted by: guardsmanbass | April 14, 2010 3:54 PM | Report abuse

"The opacity and complexity of the market keeps other entrants out"... Of commercial banking? Of M&A advisory? of starting a hedge fund?

Posted by: cdosquared5 | April 14, 2010 4:27 PM | Report abuse

guardsmanbass, for the vast majority of cases, how is financially facilitating international trade qualitatively more complex than my local bank clearing my check or ATM transaction at the grocery store? And if the modern finance sector's growth is so closely linked to rising global trade, why doesn't this link come up more often in the myriad stories that appear about the US finance sector?

Posted by: bdballard | April 14, 2010 4:47 PM | Report abuse

First of all, I wonder who really believes anything Krugman has to say. But that is beside the point. If we want competition, we first have to decide if we want this activity. If we do, it may be something to spread into more markets. I suspect that we need a more regulated environment with performance "bonds" to keep people honest.

Posted by: GaryEMasters | April 14, 2010 4:56 PM | Report abuse

I'm not quite sure that its a "large pool of talent" that attracts international financial traders to the US; instead, the attraction seems to be a large pool of inactive (or incompetent) regulators.

I'm omitting the classic example of the "talented" trader who modified software to perform algebraic operations in the incorrect order, thereby raising his profits -- a modification which no regulator caught until the money had been spent, leaving a turnip from which no blood could be recovered. That claimed profits can now be fully spent before their sources can be verified is problematic... and not an indication of talent.

Posted by: rmgregory | April 14, 2010 5:04 PM | Report abuse

"Much larger than subprime default wave, there is a *tidal wave* of option-ARMs that are due to reset in the next two years."

Unless we keep interest rates at zero in an attempt to replicate Japan's stupid approach. Many ARMs are resetting downward.

Of course, ZIRP is also the reason the financial sector is so rich. The Treasury borrows money at a range of rates- about 4.7% for the thirty year note. The Fed lends it to banks for nothing. The banks can then buy Treasuries with it. Genius plan.

Money launderers of the world have nothing on our corrupt government.

Posted by: staticvars | April 14, 2010 5:04 PM | Report abuse

@staticvars: "Unless we keep interest rates at zero...."

Yup. But it would great if Ezra did some investigative reporting of who/where is all this paper (including CMO tranches), and what would happen if the Fed couldn't control long-term rates (remember that the Fed just ended its MBS-buying program, and China might float the yuan).

Posted by: msa_intp | April 14, 2010 5:22 PM | Report abuse

This chartdoesn't show the absoloute amonut of profits in any particular year. Finance's share could be rising in part because profits in other sectors are falling. I.e., if the denominator is getting smaller.

Posted by: tomtildrum | April 14, 2010 5:23 PM | Report abuse

"I'd add one other point: In textbook economics, high, sustained profits signal a market inefficiency, as open and vigorous competition would generally drive the cost of something down to something very near the cost of production."

Well, this is true in perfectly competitive markets, like agricultural products. If the profits of corn growers is persistently high, something is probably messing with the market.

Monopolistically competitive markets (don't let the term fool you, this still means fierce competition) this isn't necessarily true. There could be features of an industry which suggest high profits. In finance, high profits almost certainly occur because the difference between best and almost best execution for non-financial firms is huge. Let's say your company needs a $3 billion 7 year term loan. Goldman Sachs says it will do it for $30mm, or 1% of the total. Seeing this large profit, a group of MBA grads found 'XYZ Investment Bank' and offer to do it for $5mm or 0.17% of the total, saving the company $25mm. However, Goldman thinks that the loan can get by at L+250 (~2.75%/yr now), whereas XYZ is only able to place it at L+275 (~3.00%/yr). Assuming a 35% marginal tax rate, the extra interest cost is $34.2mm, and still more than $25mm on a present value basis. Conversely, XYZ might underbid Goldman, but be unable to sell the loan to other banks and be unable to fund it and go bust (and that's just want the non-financial company wants in its history when it goes back to the capital markets - its deal failing and the underwriter going bust). So to Ezra's point, it's hard for new entrants to come in - but at the same time, financial firms can generate tremendous value for their customers by precisely fine-tuning their products. However, there is a lot of competition in finance. If you want someone to manage your syndicated bank loan, say, you could go to Goldman, Morgan, JP Morgan, BofA, Citi, Wells, Sun Trust, PNC, BB&T, BofNY/Mellon, RBS, UBS, Credit Suisse just to name the largest banks I can personally think of. Yes, there are barriers to entry to startups, but also keep in mind there are lots of medium sized banks that will grow over time and have the ability to get into the business and fight for thos profits.

So it's not that the market isn't efficient, it's just that those who can get winning bids do so by creating a lot of incremental value for non-financial firms. The market for NBA players is efficient, even if pretty much none of us could compete for the profits earned by Kobe or LeBron, because we don't have the ability to create value on their level.

Posted by: justin84 | April 14, 2010 6:02 PM | Report abuse

Looking at that graph, it really was
a long, slow roll downhill and off the cliff during the Bush administration, wasn't it.

Posted by: dcunning1 | April 14, 2010 10:57 PM | Report abuse

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