Finance: A cuckoo in the economy’s nest

Much of my September 1999 book In Praise of Hard Industries was quickly vindicated when America’s New Economy boom collapsed in 2000. But until recently my baleful analysis of the growth in financial services — “the economics of the cancer cell,” I called it — remained controversial. Not anymore. My analysis can be read online via Amazon’s Look Inside feature but, for convenience sake, here it is verbatim and in its entirety.

[Chapter 3 of Eamonn Fingleton’s 1999 book In Praise of Hard Industries: Why Manufacturing, Not the Information Economy, Is the Key to Future Prosperity.]

As we noted in chapter 1, the financial services industry ranks second only to computer software in the extent to which it is extolled by postindustrialists. And true enough, at first sight, the postindustrialists’ enthusiasm for financial services seems to make sense. After all, pay levels in financial services are generally well above average. Moreover, many kinds of financial services have shown extraordinarily rapid growth in recent decades, not least in the two leading postindustrial economies, the United States and the United Kingdom.

But on closer examination, such apparent strengths turn out to be distinctly double-edged. Take the industry’s high salaries and bonuses. These are simply a reflection of the fact that, like computer software, the financial services industry hires disproportionately from the cream of the intellectual crop. Given that many top financial professionals clearly possess superb entrepreneurial skills, it is not hard to imagine them enjoying similarly large rewards running high-growth companies in exciting new fields of advanced manufacturing. Their attraction instead to a career in finance deprives the manufacturing sector of vital leadership and thus undoubtedly contributes directly to the serious deterioration in manufacturing competitiveness that the United States has suffered in recent decades. In this respect, the United States is merely following in the footsteps of the United Kingdom, whose deindustrialization in the early part of the twentieth century was driven in part by a similar trend: the cream of the intellectual crop preferred careers in finance and other high-prestige service industries over manufacturing careers.

Now for the financial sector’s growth. Clearly seen in terms of its increasingly significant role in depriving the manufacturing sector of leadership, such growth is far from the unmitigated blessing the post industrialists imagine. Worse, many of the financial sector’s fastest-growing activities turn out to be utterly unproductive and even pos itively destructive from the point of view of the general public good. As we will now see, much of what the financial sector has been doing in recent years has been feathering its own nest at the expense of the great investing public. Growth of this sort is the economics of the cancer cell, and in praising it, the postindustrialists have made their biggest mistake of all.

First, some faint praise

Let’s be clear at the outset: much — perhaps most — of what the financial services industry does even these days is of considerable value to society. Banks, for instance, make a vital contribution not only in facilitating the transmission of money (via checks and bank wires) but in providing a store of value (via savings accounts) and in financing business expansion. Insurance companies enable individuals and businesses to minimize their risk of loss from accidents and other instances of bad luck. Foreign exchange dealers facilitate trade between nations. Even the securities industry, whose many excesses we discuss in detail later, makes a vital and important contribution to prosperity to the extent that it facilitates long-term investment in stocks and other risk assets.

Yet for all the talk of the supposedly beneficial effect of financial innovation in recent years, the financial sector’s economically productive services are almost all old, established ones that had already reached a high degree of maturity more than a century ago in both the United States and the United Kingdom. In fact, there really have been few truly useful major innovations in financial services since then.

It is chastening, therefore, for today’s financial professionals to look back to that time. For it is an amazing fact that the financial sector preempted vastly less labor then than it does now. Even the London financial services industry got through the day with a total of no more than 30,000 clerks, scriveners, and messenger boys — less than half the workforce of a typical major Wall Street firm today. Yet London was then by far the world’s largest financial center, functioning as it did as the clearinghouse not only for the United Kingdom’s internal finances but for most of the world’s international transactions. Today, by comparison, the London financial services industry needs more than 500,000 people to conduct a much smaller share of the world’s financial transactions.

A question arises. Why do financial services preempt so much more labor today than in former times? A large part of the answer is, of course, that fundamental demand for financial services has soared in step not only with expanding world trade but with increasing personal wealth, and rising populations. Meanwhile, various minor but highly useful new services, such as credit cards and travelers’ checks, have also contributed to the growth.

But there is something else going on here beyond an increase in demand for useful services — something that is best called financialism. The term refers to the increasing tendency for the financial sector to invent gratuitous work for itself that does nothing to address society’s real needs but simply creates lucrative jobs for financial professionals. The financial sector can get away with this because the people ultimately paying the bill usually don’t know they are doing so. The beneficiaries of big pension funds, for instance, rarely have any knowledge of, let alone control over, how their money is invested. Financialism has probably always been with us, but it has grown rapidly in recent decades, in step with the progressive deregulation of financial markets. In painting a euphoric picture of further fast growth in financial services, the postindustrialists are in the main merely projecting forward into the future the continuing proliferation of wasteful financialism.

The essence of financialism: trading for trading’s sake

Probably the greatest factor driving the financial sector’s growth in recent years has been an explosion in financial trading. It has also been probably the most undesirable; as such, it is the very essence of corrosive financialism.

It is difficult to exaggerate the scale of the trading explosion. In aggregate, financial trading in the United States grew more than thirtyfold in real terms between the early 1970s and the mid-1990s. And in some specialist areas, the growth has been even more spectacular. Take trading in foreign securities. As reported by Nicholas D. Kristof of the New York Times, such trading has grown one hundred times faster than the American economy as a whole in the last quarter of a century.

The major driver of all this growth has clearly been deregulation, which, in turn, has been driven by the widespread belief among conventional economists that the freer a financial market is, the more “efficient” it is — that is, the more accurate it is in valuing financial assets. Such accuracy is important to the general health of the economy in that it serves to ensure that capital is channeled to those uses that are most likely to result in high economic growth.

The problem is that there is no evidence that deregulated financial markets do in fact value assets more accurately than regulated ones. Rather, the reverse may be true: the evidence is that as deregulation has proceeded, markets have become increasingly volatile and are therefore valuing assets more and more irrationally.

The all-time classic example of how deregulation has served to increase market volatility was the New York stock market’s infamous “Black Monday” plunge of 22.6 percent on October 19, 1987. If share prices are supposed to reflect a rational consensus on the future prospects for corporations, this move was utterly inexplicable. There was no significant development in the real economy that day that presaged serious trouble ahead for American business. In fact, as the Yale economist Robert J. Shiller has pointed out, the only significant economic news on Black Monday was the news of the crash itself. Based on a survey of nearly 1,000 investors soon after Black Monday, Shiller concluded that the collapse was an utterly irrational outbreak of crowd psychology in which 40 percent of institutional investors experienced “a contagion of fear from other investors.” This conclusion was handsomely vindicated in the following year, when not only did the American economy boom, but New York stocks bounced back spectacularly to recover all their losses and more.

The important point for our purposes here is that the Black Monday crash — the biggest one-day fall ever — took place in what free-market theorists considered the most “efficient” market in financial history. Thanks in large measure to deregulation, countless new financial instruments had been introduced in the previous decade that had dramatically increased trading volume — and thus were supposed to forestall precisely the kind of monumental irrationality so apparent on Black Monday.

Among these financial instruments, perhaps the most devastatingly counterproductive was so-called portfolio insurance. Portfolio insurance is a system of program trading in which an investment fund automatically sells more and more of its holdings as share prices drop. In principle, it closely resembles the “stop-loss” orders favored by many unsophisticated small-time stock speculators. Stop-loss orders are widely considered by intelligent investors to be a loser’s strategy, and for good reason: they run directly counter to the basic logic of sensible long-term investment, which is, of course, to buy low and sell high. According to the Brady Report, an official inquiry into the incident, between $60 billion and $90 billion of equities were subject to portfolio insurance in mid-1987 and were thus poised to be dumped as the market fell. The result was what Robert Kuttner has aptly described as “mindless freefall.”

The tendency for increased trading to breed ever more irrational volatility has also been notably apparent in currency markets, where trading volume has been soaring at a compound rate of 20 percent annually in recent years. The irrationality has been particularly apparent in the case of the tempestuous relationship between the Japanese yen and the American dollar. By the standards of conventional economics, the yen-dollar market should be one of the world’s most efficient and, by extension, one of the most stable. After all, the fundamental determinant of exchange rates is each nation’s relative competitiveness in tradable goods. Given that divergences between different nations’ levels of competitiveness change only very slowly over the years, the yen and the dollar should probably move within a band of no more than a few percentage points against one another in any one year.

In practice, however, the yen-dollar exchange rate has become ever more irrationally volatile since the mid-1980s. In that time the yen has doubled in dollar terms on two separate occasions — first in the mid-1980s, and again in the first half of the 1990s. Then, in the second half of the 1990s, it was the dollar’s turn to soar: between the spring of 1995 and the summer of 1998 it jumped more than 80 percent against the yen. To cap it all, the market then immediately reversed itself, with the yen soaring more than 30 percent in less than two months, one of the fastest recoveries in currency market history.

There might have been a modicum of method in all this madness if each currency had risen or fallen as its home economy’s fortunes waxed or waned. But if anything, the pattern of the last fifteen years has demonstrated the opposite principle. Several times when the American economy has done badly, the dollar has soared on currency markets — most notably in 1980, 1982, 1990, and 1991. Similarly, in several years when the Japanese economy has done badly, the yen has soared — most notably in 1986, but also between 1992 and 1995. Conversely in 1996, a year when Japan recorded the best growth of any major nation, the yen lost more than 9 percent of its value.

It is hard to see any purpose in all this financial churning — other than, of course, to create lots of jobs for currency traders. The consequences are doubly negative for society at large: not only are such traders’ talents wasted on a useless activity, but the volatility created by the trading explosion generates dangerously misleading signals for business executives trying to plan ahead. In the early 1980s, when the dollar was wildly overvalued, American business executives made major decisions to move production offshore — only to find that with the subsequent fall in the dollar these decisions looked distinctly questionable. Perhaps the most farcical example was a decision by IBM in the early 1980s to initiate a major expansion of its production operations in Japan to take advantage of the then-low exchange rate for the yen. In pursuit of that strategy, IBM moved hundreds of key American and European executives into Tokyo in 1984 and 1985. Most of these executives had families who had to be transplanted to Japan at vast expense in terms of moving costs, real estate commissions, and initial charges for joining exclusive Tokyo clubs. Yet no sooner had the expenses been incurred than the yen suddenly rocketed on foreign exchange markets, thereby pulling the rug out from under the entire plan. Within three years the yen had doubled — and an embarrassed IBM was forced to sound an ignominious retreat, in the process incurring additional large expenses extricating the bemused families from Tokyo!

If the irrational volatility of financial markets were the only evidence we had to indict the trading explosion, our case would be damning enough. But there is much more. Take, for instance, the contribution of the ever growing army of well-paid analysts and other “experts” whose views drive so much trading these days. When Wall Street analysts turn positive on a stock, institutional investors rush to buy. Then a few months later, when the analysts inevitably turn cool, the institutions dump the stock by the million.

For Wall Street securities firms, this is a wonderfully profitable merry-go-round — which is, of course, the whole point. But for society at large, the vast amount of intellectual energy expended on all this churning is almost entirely wasted. For the fact is that Wall Street securities analysts are notoriously unreliable. In a study in 1997, David Dreman and Eric Lufkin found that Wall Street analysts’ forecasts of corporate earnings were “written in sand.” In the first seven years of the 1990s, a typical analyst’s forecast of corporate earnings was off by a shocking 48.7 percent — an even worse performance than was revealed in similar surveys carried out in the 1970s and 1980s. Writing in Forbes magazine, Dreman issued this resounding condemnation: “The inaccuracy of these forecasts shows how dangerous it is to buy or hold stocks on the basis of what analysts predict for earnings. In a dynamic, competitive worldwide economy there are just too many unknowables for such pretended precision.”

So much for the securities industry’s efforts to predict corporate earnings. Some of its other efforts to provide investment advice are even less intellectually respectable. Take, for instance, the activities of Wall Street’s “chartists.” These are analysts who ignore corporate fundamentals such as earnings trends and instead try to predict future stock price movements based merely on studying a stock’s past trading patterns. Yet for all the millions of man-hours the chartists expend on analyzing stock charts, it is a well-known fact, proven in careful academic studies, that chart-reading simply does not work. The ultimate indictment of the chartists has come from the economist Burton Malkiel, who in a famous study many years ago asked students to construct bogus stock charts based on flipping coins. He then presented these charts to several chartists. Sure enough, the chartists professed to read into the random zigzags significant patterns that they believed would help them make money on future price movements of the “stocks” concerned.

Given advisers like these, it is clear that most fund managers are adrift in a sea of make-believe and self-delusion. And the proof is in the pudding. All the evidence is that fund managers in aggregate consistently fail to match the performance of the market averages. In fact, the shocking truth is that American portfolio managers, aided as they are by an army of advisers, a globe-girdling network of computers, and a cornucopia of new financial instruments, are likely to underperform the random choices of a chimpanzee throwing darts at the stock pages.

As reported by Edward Wyatt of the New York Times, barely 10 percent of all diversified mutual funds outperformed the Standard & Poor’s 500-share index in the five years to 1998. Nor was this an un- representative period. As far back as 1968, Michael C. Jensen showed that mutual fund managers failed to outperform relevant market indexes. According to a survey in 1992 by Ravi Shukla and Charles Trczinka, no less than 200 subsequent studies generally supported Jensen’s conclusions.

A detailed analysis by John C. Bogle, chairman of the Vanguard group of mutual funds, has shown that in the ten years to 1995 the annual return on diversified funds lagged the index by fully 1.8 percent a year. Yet to produce this disappointing result, the mutual fund industry had employed a veritable army of highly paid portfolio managers in identifying and buying stocks believed to enjoy better-than-average prospects. As a result, the funds incurred expenses totaling about 1.7 percent of total assets each year.

The conclusion is that portfolio managers are engaged in what is at best a zero-sum game; to the extent that they incur any significant expenses, it becomes a negative-sum game. Not surprisingly, therefore, most first-rate independent advisers tell savers to steer clear of the standard heavily advertised mutual funds and invest instead in so-called index funds, whose portfolios mirror the makeup of a relevant market index and therefore guarantee a performance close to that of the index. As index funds require virtually no ongoing trading or stock-picking, they can therefore promise to keep expenses to as little as 0.2 percent of total assets under management.

Of course, this is not to deny that some investors can beat the market. But all experience shows that such people are rare, and not unnaturally they prefer to apply their talents to managing their own money — or at least to managing investment vehicles in which they themselves are major investors. In essence, the typical run-of-the-mill investment manager who runs mutual funds and other widely marketed investment vehicles is wasting his time. One is reminded of the old adage, “Those who can, do; those who can’t, teach.” In the matter of picking winning stocks, those who can, make profits for themselves; those who can’t, lose money for other people.

Perhaps the ultimate irony is that some of the world’s most successful investors are outspokenly scornful of both the recent explosion in financial trading and the deregulation that has spawned it. Take, for instance, the speculator-turned-philanthropist George Soros. Having built a fortune of several billion dollars by taking advantage of the irrationality of other investors, he can probably claim to understand better than almost anyone how inefficiently today’s deregulated markets value financial assets. In recent years he has become a vociferous advocate of a move back to greater regulation of financial markets as a way to “stop the market destroying the economy.”

Perhaps even more devastating for the postindustrialists is the testimony of Warren Buffett, the Omaha-based stock investor who is ranked by Forbes as second only to Microsoft founder Bill Gates among the world’s richest individuals. Buffett never tires of mocking the proliferation of new financial services. His message is that those Wall Street gurus and advisers who come up with new techniques for evaluating shares and other financial assets are — not to put too fine a point on it — snake oil salesmen.
As for new financial instruments, he flatly rejects Wall Street’s self-serving view that these do the work of Adam Smith’s “invisible hand.” Rather, in Buffett’s view, such instruments are “an invisible foot kicking society in the shins.” He sees traded stock options as gimmicks that do nothing to create real wealth but merely ensnare financial professionals in playing futile zero-sum games with one another. He has been particularly scornful of portfolio insurance, labeling it an “Alice-in-Wonderland practice,” and he has been perhaps the single most influ ential voice in blaming it for the Black Monday crash of 1987.

The ultimate tragedy is that all the money to keep this charade on the road comes from millions of ordinary American savers. They pay high fees for the management of their pension and mutual fund assets, and less visibly, they pay the stockbrokers’ commissions and other costs incurred in the ever quickening pace of financial trading.

A key to understanding why this charade continues unchecked is marketing. Mutual funds and other investment products are sold, not bought. The more an investment company spends on marketing, the more business it can expect to garner. Various techniques have been honed over the years to take advantage of savers’ emotions — and particularly their gullibility and greed. The time-honored method of catching unsophisticated savers, for instance, is persistent foot-in-the-door salesmanship. At a higher level, the formula that works is more subtle: mahogany-paneled offices, Persian rugs, British hunting prints, and an army of well-tailored sales executives drawn mainly from the upper ranks of society. But either way, what wins business is the right marketing strategy, not the best investment record. This is abundantly apparent in, for instance, the fact that, as recorded by the investment columnist James K. Glassman, those fund management houses that charge the highest fees actually produce by far the worst investment performance. The simple truth is that such houses don’t have to perform well so long as they can continue to charge the hefty fees that fund their vast ongoing marketing efforts.

The end result of all this excessive marketing and trading is that the American investment management business is costing the United States probably at least $50 billion a year more than it should. This represents enormous waste by any standards. Yet in large part because the workings of the modern financial services industry have been so enthusiastically endorsed by the postindustrialists, it has never been subjected to any serious reality checking.

American financial exports: myth versus reality

American savers are, of course, not the only potential customers for the American financial services industry. There is a whole world of foreign savers out there, many of whom have huge amounts of money to invest. This point has encouraged the postindustrialists to imagine that the United States can make a fine business exporting its financial services to “less financially sophisticated” nations around the world.

At first sight, this seems to be one of the postindustrialists’ stronger cards. After all, to the casual observer it would appear that American financial companies are already huge exporters. In fact, in their public relations activities, American financial organizations never tire of boasting about their “global reach.” As any American who travels on business can testify, American financial organizations seem to have long ago appropriated much of the prime office space in such important foreign financial capitals as London, Hong Kong, and Tokyo.

But how globalized are American financial organizations really? The truth is profoundly disappointing for the postindustrialists.

Take a look, for instance, at the operations of a typical “globalized” financial firm such as Merrill Lynch. To judge by its self-evaluation, Merrill Lynch is the sun around which the world’s financial system revolves. Rarely has this message been more powerfully conveyed than in the firm’s 1996 annual report. As one leafs through the pages, the clichés of financial globalism fairly tumble out. The report opens with a parade of picture-postcard views that would do justice to a travel agent’s brochure: a camel seated in front of an Egyptian pyramid, a fleet of Neapolitan gondolas, a little Japanese girl in a traditional kimono, a turbaned Indian boy, a troupe of African dancers. Later pages are decorated with a snowstorm of exotic foreign banknotes, plus enough national flags to outfit a Miss World contest.

The report makes much of various awards the firm’s international operations received in the year under review: “Best Debt House in Asia,” “No. 1 Latin American Research House,” and five other similar mouthfuls that in their grandiloquent territorial claims would do justice to Ozymandias himself.

In view of the apparently vast scope of Merrill Lynch’s foreign activities, one would have been forgiven for assuming that the firm was a major contributor to America’s invisible exports. A look at the fine print, however, shows that its contribution was actually negligible. In fact, for all the globalism of the firm’s annual report, fully 76 percent of its revenues in 1996 were generated within the plain old United States of America. Moreover, little of the 24 percent of revenues generated abroad constituted American exports. Remember that for a service to count as a U.S. export, it must not only be paid for by foreign customers but be performed within the United States. Most of Merrill Lynch’s foreign revenues, however, arose from services performed offshore by foreign personnel working in foreign offices. After deductions for foreign salaries and other foreign expenses, there was little left to be remitted to the United States. Take, for instance, a typical service provided by the firm’s Tokyo branch — a purchase order from a Japanese client for stock in a Japanese company. Typically such a trade is handled by a Japanese employee working in a Japanese office. The employee’s salary, the office rent, the telephone bill, and countless other expenses are paid in yen and represent value added that accrues entirely to the Japanese economy. In fact, the American economy’s balance of payments is likely to benefit only to the extent that the Tokyo branch makes a profit on the trade.

In reality, the aggregate amount of profit remitted to the United States by Merrill Lynch’s overseas subsidiaries is tiny and probably represents less than 3 percent of the firm’s total revenues in a typical year.

Similar analysis shows that other supposedly globe-girdling American financial services companies make equally disappointing contributions to the U.S. balance of payments. Take American Express. In many ways, it is better equipped than any other important financial services company to compete in foreign markets. After all, having introduced the traveler’s check in 1891, it was a highly globalized company before World War I, and with the subsequent development of the American Express card it went on to establish a network of offices in more than 160 countries. Thus, American Express enjoys probably a greater global reach than any other financial services company, and it certainly boasts one of the strongest brand names in the global financial services industry.

That said, American Express’s contribution to the U.S. balance of payments is quite disappointing. Of the company’s total revenues of $16.2 billion in 1996, fully $12.0 billion came from within the United States. Thus, little more than one-quarter of the company’s business was done abroad. Yet fully 40 percent of its workforce — a disproportionately large share of the total — was employed outside the United States, and many of the company’s other foreign expenses were also correspondingly large. When the company’s various foreign expenses were deducted, the company’s net contribution to the American balance of payments was probably less than $500 million — or about 3 percent of the company’s total revenues.

Clearly, from the point of view of the American balance of payments, a fundamental problem with financial services is precisely that they are services and thus for the most part must be performed close to the customer. But this is far from the only reason financial services tend to make a poor contribution to a nation’s export prowess. Another key reason is that almost all the world’s financial markets are tightly regulated in a way that inevitably limits opportunities for great American financial institutions.

This is particularly true in East Asia, which happens to be precisely where the great bulk of the world’s savings surpluses arise these days. The financial markets of most continental European countries also offer disappointingly few export prospects for American banks. Take Germany. As the world’s third-largest economy after the United States and Japan, Germany could be a lucrative market for American banks. In reality, the vast German banking market remains a secure fiefdom of Germany’s Big Three banks, Deutsche Bank, Dresdner Bank, and Commerzbank. In particular, Germany’s great industrial corporations generally entrust the Big Three with most of their banking business. This is not an accident: much of the stock in major German industrial corporations is owned or controlled by the Big Three.

Opportunities for American banks are similarly curtailed in most other parts of the developed world. In truth, banking is considered almost universally by government officials to be a “strategic” industry that wields potentially enormous power to shape a nation’s economy. Thus, nations naturally prefer that their bank industry stay under the control of their own nationals.

But even in areas of the financial services industry where politics is less likely to be a major concern than in banking, American players are still firmly blocked in their hopes of expansion abroad. Take the American discount brokerage industry. In theory at least, its services ought to be of great interest to countless investors around the world. After all, as the Tokyo-based economist Kenneth Courtis has argued, the low commission rates they charge make them highly competitive compared to brokers in other parts of the world. Take a typical example, a purchase order for one hundred shares of Microsoft. As Courtis has pointed out, this would cost a Japanese investor around $500 in brokerage and other transaction costs if it were carried out in Tokyo, but as little as $3 if carried out over the Internet by an American discount broker.

Yet Japanese investors do virtually no business through American Internet brokers. The reason, of course, is that there are many barriers blocking the expansion of American Internet brokers around the world. One obvious obstacle is the requirement that American brokers obtain local regulatory permission to advertise their services in foreign markets. As John Tagliabue of the New York Times has pointed out, such permission is generally withheld when a brokerage firm provides its services from a location beyond the reach of the financial regulators of the nation concerned. The inability to advertise may seem like no more than a minor hindrance, but in practice it is a major barrier because investors tend to prefer to deal with organizations whose names are well known to them.

Even English-speaking nations known for their strong support for the theory of globalization are notably inhospitable to the American discount brokerage industry. Take Canada. Before it allowed E*trade, a California-based online broker, to do business within its jurisdiction, it insisted that the firm set up a branch on Canadian soil. Australia and New Zealand also set similar conditions. As The Economist pointed out, such conditions largely negate the basic advantage of online trading, which is that it obviates the need to maintain the costly physical infrastructure necessary in pre-cyberspace days.

Perhaps even more startlingly, the United Kingdom has given U.S.-based Internet brokers a chilly reception. Again, E*trade’s experience has been instructive. When E*trade first applied to do business in the United Kingdom, British regulators insisted that, among other things, it locate its computers on British soil. In the end, E*trade finessed the problem by announcing plans to provide its services through a British partner — but this arrangement, of course, meant that the service would be performed largely or totally by workers in the United Kingdom, not by U.S. workers. The contribution to the U.S. balance of payments is therefore likely to be negligible.

The most significant aspect of the United Kingdom’s attitude is that it is likely to provide cover for other nations that have consistently dragged their feet about opening their financial markets. If even the enthusiastically globalist United Kingdom is not prepared to exempt American online brokers from local regulatory oversight, few other major nations are likely to roll out the red carpet for them. And in fact, as of the summer of 1998, most European governments were adamantly refusing to allow the American discount brokerage industry to advertise for business within their territories.

To apologists for postindustrialism, the fact that so far most foreign financial markets are largely closed to American financial organizations represents no more than a temporary problem. In their view, other countries have merely been a little slower than the United States to recognize the supposed win-win advantages of deregulation and globalization. Thus, the apologists confidently look forward to the day when other nations will deregulate and therefore open themselves to the American financial services industry. This expectation, however, overlooks the strategic view that other nations take of their financial systems. For a start, most other nations see tight financial regulation in part as a vital tool in deterring their wealthier citizens from hiding hot money in foreign bank and brokerage accounts. Moreover, governments tend to regard their nations’ savings as a national resource that should be applied in the first instance to boosting their own industries and jobs. Even the supposedly open financial capital of Singapore insists that its citizens put much of their long-term savings money in the government-controlled Central Provident Fund. Needless to say, this fund favors Singaporean jobs in its investment policies. A similar, if much more subtly expressed, concern that national savings be mobilized for the benefit of local job creation can also be discerned in several rich European countries, most notably Germany and Switzerland.

U.S. aspirations to sell financial services abroad are further frustrated by a fundamental weakness of the modern American economy — a low savings rate. In the space of a single generation, the United States has gone from being the world’s biggest exporter of capital to the world’s biggest importer. Since capital is the scarce raw material of financial services, the hidden leverage that the United States once enjoyed over world financial markets has long since disappeared. The unfortunate truth is that the United States no longer sets the rules of world finance.

A question of ethics: finance as rotten apple

If the expansion of financial services in recent years resulted merely in the frittering away of the talents of many top Americans on a negative-sum game, it would be bad enough. But another lamentable dimension to the financial services explosion cries out for attention: the deterioration it has fostered in the nation’s ethical standards.

As turbo-charged new investment vehicles such as derivatives have proliferated, illicit opportunities for financial criminals to enrich themselves at the expense of the general public have increased dramatically. Perhaps even more important, the risk of detection is decreasing all the time. It has become vastly more difficult to police financial markets in these days of radical deregulation in which miscreants have ready access to the secrecy of foreign bank accounts and can dress up their finagling in a dense thicket of complexity.
At issue here are not the cruder forms of financial crime, such as selling worthless penny stocks to elderly widows and other vulnerable members of society. Today, as in the past, heartless villainy of this sort is practiced by only a tiny minority. At issue instead are much more subtle practices that are likely to prove tempting to a much broader range of financial professionals, most of whom would never stoop to the bare-faced blackguardism of the penny-stock promoters.

One such practice is insider trading, which, if the Securities and Exchange Commission’s caseload is any guide, has grown dramatically in recent years. As reported by Paul A. Gigot of the Wall Street Journal, the SEC at the end of 1997 was investigating more than twice as many cases as it had been a decade earlier. Moreover, given that financial scams are now more difficult to detect than ever before, the SEC’s caseload is probably no more than the tip of the iceberg.

One of the fastest-growing financial crimes is a maneuver known as “front running,” which involves buying a stock ahead of a major buying program by a big fund management house. A few days later, after the buying program has sent the stock price soaring, the front runner can hope to cash out at a handsome and almost risk-free profit. Another form of insider trading that has probably burgeoned in recent years is illicit buying by influential stock analysts for their own accounts before they issue a bullish view on a stock.

Other financial crimes can be a lot more subtle. Take, for instance, a technique known as selective allocation. The key to this is that many portfolio managers act for several different portfolios in their stock-purchasing activities. They often allocate their purchases to their various portfolios only at the end of each day — by which time many trades may already be showing significant profits while others will be showing losses. By selectively allocating the profitable trades to some portfolios and loss-making ones to others, they can greatly favor some beneficiaries at the expense of the rest.

As Steven D. Kaye has documented in U.S. News & World Report, favoritism in allocating winning trades can pay dividends for fund managers in many circumstances. In one blatant case uncovered by the SEC a few years ago, Kemper Financial Services (a firm now renamed Zurich Kemper Investments) allocated winning trades to an in-house account, while allocating less profitable trades to two Kemper mutual funds that managed money on behalf of the ordinary investing public.

In a less blatant version of the technique, fund management houses may allocate winning trades to portfolios run for large corporations and other sophisticated clients. Such clients are generally much more demanding than small investors in expecting good performance and are much faster to vote with their feet when the performance is sub-par. Thus, a fund management house has a strong interest in keeping such clients happy, even if this means penalizing the mutual funds and other portfolios run for the benefit of small investors. Many variations are possible. In one example of alleged impropriety reported by the SEC, a California-based money manager was accused of allocating profitable trades to certain accounts that paid high management fees based on performance, while allocating less profitable trades to other accounts that paid no special reward for good performance.

The development of increasingly complex derivatives in recent years has been a particular boon to financial criminals. In a typical pattern, securities firms deliberately concoct instruments that are so complex that most institutional investors cannot fully understand them. Moreover, the market in any particular type of instrument is typically extremely thin, and thus prices can be readily manipulated by the securities industry. Devastating accounts of Wall Street’s profits from the derivatives game have been written by, among others, the former Salomon Brothers executive Michael Lewis and the former Morgan Stanley executive Frank Partnoy. Partnoy in particular has been coruscating in his criticisms of the securities industry’s practices. After alleging in his book F.I.A.S.C.O.: Blood in the Water on Wall Street that Wall Street makes huge profits by “trickery and deceit,” he adds for good measure: “Everyone I knew who had been an investment banker for a few years, including me, was an asshole.” Referring to his time as a derivatives salesman, Partnoy commented: “The way you earned money on derivatives was by trying to blow up your client.”

Of course, the securities industry has never been famous for its high ethical standards. But the problem today is not only that the scale of the finagling is larger than before, but that thanks in no small measure to the postindustrialists, the industry enjoys much more prestige than formerly and its ethical standards have thus proved contagious. Prominent Americans in other walks of life see how money is made in a highly regarded industry and reckon that similarly opportunistic, if not illegal, tactics are acceptable in their own less exalted fields.

The contagious effect of Wall Street’s low ethical standards is particularly apparent in, for instance, the increasingly manipulative way that industrial executives now use executive stock options to line their own pockets — often by engaging in short-term financial maneuvering that they know is damaging to their companies’ long-term prospects. As early as 1989 the MIT Commission on Industrial Productivity reported that there was “no shortage” of executive incentive plans geared to a company’s profit performance over just one year or even a mere six months. As the commission pointed out, a chief executive whose compensation is geared to such short-term measures is likely to take an even more shortsighted view than the stock market. The worst part of it is that short-term executive incentive programs tend to encourage outright gambling by corporate executives in their frantic efforts to manipulate their companies’ profits. Such gambling is in fact a no-lose proposition for the executives themselves. On the one hand, if a gamble pays off, they can obviously cash out quickly at huge profits. Less obviously but even more controversially, if the gamble fails, they always have another chance to play the game. And this time, because the stock price has undoubtedly fallen in the meantime thanks to the previous year’s losing gamble, executives can reset the buying price for their options at a much lower level, thus putting themselves in line to benefit hugely from even the most modest recovery in their companies’ profits.

All in all, it is clear that the financial services industry has played the role of pied piper in leading American society toward a general lowering of standards in the last thirty years. The consequences are hard to measure but are clearly significant for economic efficiency, not to mention for the general spiritual health of the nation.

Yet as we have seen, the apotheosis of American finance in recent years is based on an utterly wrongheaded reading of the role that finance should play in an economy. Forgetting that services should serve people, the financial services industry has come to regard itself as somehow superior to society — an attitude that the postindustrialists have clearly done nothing to discourage.

Our conclusion, therefore, is that finance is an essential service without which the economy could not function. But it should not be raised on a pedestal above the rest of the economy. Still less should it be considered a driving force of the economy’s future prosperity.

Stripped of rhetoric, most of the new financial activities the postindustrialists extol feed parasitically on the rest of the economy. What we have is not a goose that lays golden eggs but a different feathered vertebrate entirely: a cuckoo in the economy’s nest.

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