The Dominance of the Financial Sector has Become a Mortal Danger to the U.S. Economic Security

Over the last several decades, the U.S. financial sector has grown relentlessly. It has doubled in size over the last 14 years. During the period 1973 to 1985 the financial sector never earned more than 16% of domestic profits. This decade, it has averaged 41% of all the profits earned by businesses in the U.S. In 1947 the financial sector represented only 2.5% of our gross domestic product. In 2006 it had risen to 8%. In other words, of every 12.5 dollars earned in the United States, one goes to the financial sector, much of which, let us recall, produces nothing.

Most of that growth has not been among community or regional banks -- or credit unions. I'm talking about Wall Street.

Wall Street's growth is one big reason that most of America's economic growth during the last decade has flowed into the hands of investment bankers, stock traders and partners in firms like Goldman Sachs. The Center on Budget and Policy Priorities reports that fully two-thirds of all income gains during the last economic expansion (2002 to 2007) flowed to the top 1% of the population. And that, in turn, is one of the chief reasons why the median income for ordinary
Americans actually dropped by $2,197 per year since 2000.

No surprise then that disproportionate numbers of the "best and brightest" graduates of our finest universities headed off to Wall Street. After all, that's where if you are very clever you can make tens of millions of dollars before you are thirty - mostly producing nothing.

By 2007 the top 50 hedge and private equity fund managers averaged $588 million in annual compensation each - more than 19,000 times as much as the average U.S. worker. And by the way, the hedge fund managers paid a tax rate on their incomes of only 15% -- far lower than the rates paid by their secretaries.

This huge wealth transfer from the "real" economy to the world of finance has also created a vicious cycle of increased credit dependency. If your family's real income isn't going up, but costs are, you try to borrow to stay afloat. That is one reason why private debt now equals 350% of the Gross Domestic Product - the highest ever. The more debt that consumers owe to the shrinking number of big financial institutions, the greater the share of their shrinking or stagnant incomes that is siphoned off to the finance sector - and the cycle just gets worse. And when the disposable income of ordinary Americans shrinks, they don't have the money to buy the new products and services that will fuel long term economic growth in the real economy.

Something is very wrong in this picture.

In fact, as last year's financial collapse make ever so clear, the increasing dominance of the financial sector - and its deregulation -- has become a mortal danger to our economic security.

The financial sector - including the big insurance companies - has morphed into a cancer growing on our economy - a cancer that could easily strangle our prospects for our long-term economic security.

Later this week, Congress begins consideration of a package of measures that would serve as a first step in re-regulating and hopefully shrinking the American financial industry. This battle has not attracted as much attention as the critical fight over health care, but it is just as important for the well-being of everyday Americans.

The "best and brightest" from Wall Street would like to make the issues involved in this debate look complex and technical - beyond the understanding of ordinary mortals. But there are a couple of clear principles to remember as the debate unfolds:

1). History has shown that financial markets cannot accomplish their ostensible goal of allocating risk and directing capital to their highest and best uses unless they function within the context of very strict rules. That is so because speculators have a natural tendency to create products and systems that allow them to engage in reckless excesses that cause the entire system to lurch from bubble to bubble, collapse to collapse. This is not a theoretical argument. History proves the case beyond a reasonable doubt.

In 1792 the newly-minted United States suffered its first credit crisis. Another credit crisis followed about once every fifteen years until 1932. Then, the mother of all credit crises caused the Great Depression that in turn spawned the Securities and Exchange Commission (SEC) to regulate the stock market, the Federal Deposit Insurance Corporation (FDIC) to guarantee deposits in banks, and the Glass-Steagall Act that prevented banks from engaging in other forms of more risky financial activity.

For the next 50 years, those regulations--coupled with a wise use of Keynesian economic policies -- prevented another financial crisis. That is one of the reasons why America's experienced an unprecedented era of economic growth for every sector of the population - and a massive reduction in the inequality of income distribution.

But in the 1980's the Reagan "revolution" worked its de-regulatory magic on the Savings and Loan industry. It didn't take long for many of these once-stable institutions to collapse and cause the first credit crisis in a half-century. That should have given the country fair warning, but a few years later Wall Street convinced Congress to repeal the Glass-Steagall Act, and it prevented the regulation of newly-exploding "financial products" like "derivatives" that were basically bets on the movement of underlying investments like stock and bonds. Wouldn't want to "discourage financial innovation," they said. The growing predominance of private equity financing also took more and more financial transactions from the light of transparent regulated public markets into the de-regulated shadows.

Then there was the securitization of debt. Banks and other lenders bundled mortgages and other loans into packages and then chopped the packages into units that could be sold on secondary financial markets. These new markets made a lot more money available for loans, but there was no provision made for the inherent dangers. For years previous, bankers made loans with the realization that they were on the hook if they went bad. The new secondary markets allowed them to make the loans, and sell off the risk to a diffuse "market" that left them free of any risk.

All the while, the size of the financial sector was fed by the growing use of credit cards that could legally siphon off huge streams of revenue from ordinary Americans into the hands of bankers. And the elimination of usury laws encouraged the development of the "payday loan" industry that allowed someone to borrow $500 and pay $2,000 of interest on the loan over the next two years.

The result of all of these trends has been massive consolidation of power by a few major financial institutions that have ranged far afield from banking into highly speculative activities of all sorts. Brokerage firms like Goldman Sachs and banks like CitiBank have become indistinguishable. Massive portions of the credit market now exist outside of the oversight of any regulator.

Today, 45% of the banking market in the U.S. is dominated by Bank of America and CitiBank.

Finally, of course, huge remuneration packages were paid to clever Ivy League graduates who could make billions in speculative profit, even if they did so by taking Godzilla-sized risks. Remuneration systems paid them on the basis of short-term gain and they suffered no financial penalty for long-term pain. So they were "off to the races."

2). Much of the financial sector does not produce anything. The principal missions of the financial sector are to take on risk and allocate capital effectively. Some of the industry - especially community and regional banks - do just that. But in the last year the financial sector as a whole didn't "take on risk," it shifted risk to ordinary Americans through gigantic taxpayer bailouts. And often the Wall Streeters themselves escaped the recent economic debacle, having salted away hundreds of billions of dollars.

Fundamentally the financial sector is made up of middlemen, who spend their time creating schemes that allow them to funnel society's money through their bank accounts so they can take a sliver of every dollar off of the top.

Right now, the private health insurance industry is busy trying to defend its turf against a public health insurance option. It wants to maintain its "right" to take that tribute off the top of as many health care dollars as possible. Remember, the private health insurance industry doesn't deliver any actual health care.

The same is true of most of the financial sector. It is the farmers, manufacturing firms, the health care providers, the transportation companies, the guys who sweep up buildings, the cops and firefighters, the people who teach our kids - those are the people who produce the goods and services that we consume in our economy.

Most "innovative financial products" like derivatives are nothing more than schemes that allow speculators to build up paper wealth that will fuel the next credit bubble. Creating mechanisms to allow speculators to bet on the direction of stock prices or other actual investments doesn't do any more for the underlying economy than allowing the same people to bet on horse races.

Most Wall Street speculators don't contribute any more to our common well being than professional gamblers - which is pretty much what they are. Gaming in Las Vegas has fine entertainment value, but providing a gigantic worldwide casino for the rich is not an economically vital core function for the world's financial markets.

I'm not arguing against using financial markets to allocate capital and risk. Banks, stock markets and other financial institutions can be and have historically been - important and efficient means of accomplishing these goals. But not when the tail begins to wag the dog. Not when the financial sector, which can be useful at serving the needs of the productive sectors of the economy, comes to dominate the economy.

After all, if so much wealth flows from the productive sectors of the economy into the fundamentally unproductive financial sector, ordinary people don't have enough money to buy the products that drive economic growth in the real economy.

3). Left to their own devices, financial speculators often kill off productive enterprises through leveraged buyouts and private equity plays. A case in point was highlighted last week by the New York Times. Simmons Bedding has been in business producing high quality mattresses for almost 133 years. Now it's about to file for bankruptcy protection - but not because it isn't a viable successful business. Simmons has been milked dry by a succession of buyers and Wall Street investment banks that have made millions through leveraged buyouts that made good financial sense for Wall Street, but left the manufacturing firm deeper and deeper in debt. The Times reports that "the financiers borrowed more and more money to pay ever-higher prices for the company, enabling each previous owner to cash out profitably."Simmons now owes $1.3 billion compared with $164 million in 1991. According to the Times, "In many ways, what private equity firms did at Simmons , and scores of other companies like it, mimicked the sub-prime mortgage boom. Fueled by easy money… these private investors were able to buy companies like Simmons with borrowed money and put down relatively little of their own cash. Then not long after, they often borrowed even more money, using the company's assets as collateral.""The result: THL (the private equity firm) was guaranteed a profit regardless of how Simmons performed. It did not matter that the company was left owing far more than it was worth." Too bad for Noble Rodgers, an employee of 22 years, who along with 1,000 others have been laid off. Too bad for the American manufacturing base. The investment bankers got theirs.

4). The bigger the financial sector gets, the more power it has to hold the entire economy ransom for huge bailouts when their speculative bubbles collapse. Firms that are allowed to grow as large as AIG, CitiBank and Bank of America create "systemic" risk that threatens the world financial system. The bottom line is that if a financial institution is too big to fail, it's just too big, period. The new regulatory proposals now pending before Congress are critical first steps in reining in the power of the financial sector. The proposed Consumer Financial Protection Agency is especially important. It would end the anything-goes "Dodge City" mentality that allows consumers to have their pockets picked by financial "products like teaser-rate mortgages with prepayment penalties that guarantee the consumer pays more than meets the eye. It will require tight regulation of credit card interest rates and fees.But equally critical are tough new regulations of the entire financial sector - including the "derivatives" and "credit-default-swap" markets - and private equity, as well as regulations to eliminate remuneration systems that incentivize recklessness, and requirements that mortgage originators maintain a stake in the loans they sell. The "resolution" authority proposed by the Obama Administration is also an important step to assure that there is an orderly way to close even the largest of financial institutions.

Serious regulation will inevitably cut back on the flow of income from normal people to the financial sector as a whole. But over time, our goal needs to be to restore dominance of the economy to the productive sectors of economic endeavor, and to break up the financial and insurance cartels that have a stranglehold on our future.That will not happen without a monumental struggle. The Obama Administration's proposals for financial re-regulation are the first offensive on this critical front in the war for our long-term economic security.