Does the Financial Industry Subtract Value from the Economy?
Published on - January 26th, 2008 (by J.D. Roth) Vintek pointed me to a Bill Moyers interview with John Bogle, founder of The Vanguard Group and patron saint of index funds. (He’s also one of my financial heroes.) Mostly, the conversation revolves around the problems with the modern U.S. economy:
BILL MOYERS: What is the job of capitalism?
JOHN BOGLE: Well, ultimately, the job of capitalism is to serve the consumer. Serve the citizenry. You’re allowed to make a profit for that. But, you’ve got to provide good products and services at fair prices. And that’s the long term, that’s what businesses do in the long term. The businesses that have endured in America have done that and done that successfully.
But, in the short term, there’s all these financial machinations in which people can get very rich in a very short period of time by creating highly complex financial instruments, providing services that can be cut back easily [...] not measuring up to basically their duty.
We all know that in professions, the idea has been service to the client before service to self. That’s what a profession is. That’s what medicine was. That’s what accountancy was. That’s what attorneys used to be. That’s what trusteeship used to be inside the mutual fund industry. But, we’ve moved from that to a big capital accumulation — self interest — creating wealth for the providers of these services when the providers of these services are in fact subtracting value from society. So, it doesn’t work.
I’m struck by the notion that the financial industry is “subtracting value from society”. Bogle — as the foremost proponent of index funds — has long maintained that this is the case. Is it true? I don’t know. That sort of claim is beyond my ability to evaluate.
But the idea reminds me of James B. Stewart’s book, Den of Thieves, which explores the stock market scandals of the 1980s. When I read it last spring, I wasn’t just shocked by the crimes of Michael Milken, Ivan Boesky, Martin Siegel, and Dennis Levine; I was amazed by the billions of dollars the financial services industry drained from the market as a matter of everyday business. It must drain some money in order to operate, but the salaries and perks these people earned seemed extravagant.
JOHN BOGLE: Banks, money managers, insurance companies, certainly annuity providers. They’re all subtracting value from the economy. They have to subtract. To be clear on this now — I don’t want to overstate it. To be clear on this, they have to subtract some value. But, the question is —
BILL MOYERS: What do you mean they subtract some value?
JOHN BOGLE: In other words, — you’ve go to pay somebody something to provide a service. It’s just gotten totally out of hand. My estimate is that the financial sector takes $560 billion a year out of society. Five hundred and sixty billion.
BILL MOYERS: Where does it go?
JOHN BOGLE: It goes into the pockets of hedge fund managers, mutual fund managers, bankers, insurance companies.
Finally, here’s a warning from Bogle about the dangers of deficit spending:
JOHN BOGLE: People are spending at a higher rate than they’re earning, and we’re starting to pay a price for that now, particularly in the mortgage side. But eventually, that could easily spread and people won’t be able to do that anymore. You can’t keep spending money you don’t have…
It wasn’t that many years ago — maybe a couple of generations ago — that if you wanted something, you saved for it. And when you completed saving for it, you bought it. Imagine that. And that wasn’t so bad.
But now that we know that we can have the instant gratification and pay for it with interest payments, of course, over time — which is not an unfair way to do it — we’re going to pay a big price for the excessive debt we’ve accumulated in this society, both in the public side and the private side.
This is fascinating stuff, even though it’s outside my area of expertise. Get Rich Slowly is not a blog about economics (and I don’t expect to post again on the subject any time soon). Yet economic forces do play a role in shaping our personal finances. If you have the time and the inclination, watch the video or read the transcript. As for myself, this interview strengthens my resolve to invest in index funds.
Postscript: Last month, Bill Moyers interviewed Dr. Benjamin R. Barber about “how the global economy produces too many goods we don’t need, too few of those we do need, and, to keep the racket going, targets children as consumers in a market where shopping is a twenty-four hour business.” I haven’t watched this interview yet, but it sounds interesting.
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I understand Dr. Barber’s and John Bogle’s criticism, but how do you determine what the goods are that we need and don’t need. I’m sure everyone has different ideas about what those are.
For instance, I would expect “food” to be a good brought up. However, it’s not the market failing to provide it; rather, its distortions in the market caused by Western food subsidies that prevent poorer countries from developing their own food industry..its just far cheaper to import.
Barber is more concerned with conspicuous consumption. (Link: http://en.wikipedia.org/wiki/Conspicuous_consumption)
This consumption is of goods whose value mainly comes from displaying wealth…aka “Keeping up with the Joneses.”
This topic comes up quite a bit in economics conversations I have. How do you change what people value?
Kudos to Bogle, who practiced what he preached…and has one happy consumer in me.
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Wow, that’s deep.
From an economic standpoint though, the financial industry’s compensation for providing services will always trend towards the equilibrium brought about by supply and demand. If educated consumers thought that the fees were too high, they would select other investment vehicles. The fees may be too high but if the net returns are better than the net returns of lower fee funds, investors will favor the higher fee funds.
Notice that I said “educated” investors. That’s where things change and where I believe government intervention is good. The financial industry must have recognized standards so that investors aren’t tricked out of their monies.
Where those financial institutions make most of their money, though, is in sheer volume. If you personally received one ten-thousandth of one cent for every financial transaction in the USA, you would probably be able to retire in less than a day and no one would even miss it. Financial institutions know this. They also know just how far to push that button before someone, individuals or governments, will react.
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I have not always agreed with John Bogle, but I have always enjoyed hearing what he had to say. I remember when he was ushered out of Vanguard he was quite outspoken on several issues.
Best Wishes,
D4L
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I don’t doubt that financial services are too expensive. That’s particularly noticeable in the UK where the majority of financial products are extremely competitive if you know what you’re doing, but the majority of actively managed unit trusts (mutual funds) have commission charges of 1.8%. Not that they average there, but they more or less cluster there. It’s not uncommon to have index trackers that charge at 1% – you have to ask what they are doing for the money.
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Need: Innovations in battery technology, solar panels that are advanced and mass produced, electric cars that are safe, reasonably priced, and built to last (have you seen the weather stripping on the GEM car doors?), durable goods that don’t break and require replacements (gutter cleaner, better socks).
Don’t need: plastic goods like junky toys, McDonald toys, toys from the dentist, toy reinforcers from school, household decorations, home expresso machines that break, microwave ovens with poorly designed handles that break, cars with parts that are designed to break.
The insurance industry is a honking scam. Have you seen the stats on how much they take in vs. their payout?
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I don’t see how $560Bn gets “taken out of the economy” just because it ends up in hedge fund managers’ or bankers’ pockets. These people don’t stash the money under their mattresses. They spend it on things like food, computers, luxury boats (thus injecting money back into the economy). They save it in the bank, thus participating in the process of money creation through reserve lending (thus injecting money back into the economy). They invest it in the market, either funding companies’ capital needs by buying into IPOs or putting money back into the hands of those who sold them the securities they buy (thus injecting money back into the economy).
Maybe they’re paid too much for doing too little, but you can say that about any number of CEOs of companies in other (non-financial) industries. Heck, you can say that for people on unemployment, who get paid without working.
I’m not sure about insurance companies and firms that market and sell annuities, but the majority of the profits for hedge funds and investment banks don’t come from Average Joe overpaying fees or commissions. They come from companies who need the banks’ expertise in raising capital or restructuring balance sheets. They come from pension funds, endowments, and other investors with billions of dollars to deploy and return targets to meet, who can’t just stick all their money in index funds. Very little of that $560Bn come from normal folk, so it’s not exactly like Blackstone or Goldman Sachs is hurting the average person.
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The financial markets in many ways seem to meet the criteria of a lemon market: http://en.wikipedia.org/wiki/The_Market_for_Lemons
I think that explains a lot of things in modern markets, such as healthcare.
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“It wasn’t that many years ago — maybe a couple of generations ago — that if you wanted something, you saved for it. And when you completed saving for it, you bought it. Imagine that. And that wasn’t so bad.”
WOW, I can hear my Dad saying these same exact words. Our friends and family think we are insane going back to a cash only existence, but to tell you the truth, we can’t wait until we get there.
Darrell
–
http://angrydebtor.com
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Americans had become consumers instead of citizens. Now when we see the bottom come out of the home market and pause to think of how much consumption was fueled by home equity, with the personal debt still left to the consumer…and toss in the dollars tossed to Iraq..the billions leaving every year for international pharmeceutical companies while we have no universal healthcare…I think the future will be defaulted loans all around and hopefully the growth of community cooperatives. Corporations, governments, investments–how can they be trusted? If I am in a hopeful mode, I think Americans may stop thinking of themselves as consumers and start remembering that they are first and foremost citizens and neighbors.
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Bogle is – directly or indirectly – referring to the role of value, and the role of caretaking that value. He’s momentarily stepped away from the strictly monetary idea of value to reflect on the purpose of finance and economic activity generally. He is in effect saying that an economy is the thing that helps a society survive, but that economy is in service to society, and that the social role of finance, banking, etc, is to keep other things ticking over. When those activities become ends in themselves, a dereliction of duty is committed, a fiduciary dereliction. He speaks of it as subtracting value from society.
Put another way, he is asking about accountibility: who are these people and corporations accountable to? What kinds of structures should exist to ensure that economic activities are serving the interests of society?
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One thing to note: It isn’t just the consumer out there trying to get Instant Gratification. Everyday businesses are “buying forward” customer demand to hit arbitrary Wall Street Target.
It quickly turns into a ponzi sceme that hasto break down when you run out of credit
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Certainly, an example of a company manufacturing needs and not goods that fill needs is the pharma companies inventing conditions out of whole cloth, and then marketing them via ads and the bribery of doctors.
Take a look at this bit of bamboozlement:
http://mentalhealth.about.com/cs/psychopharmacology/a/prozacpms.htm
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No, really. For my job, I sit around all day writing about hedge fund managers and how much money they are stashing, losing, stealing, squandering, etc. A lot of these dudes are “activists investors” and will basically just run a company into the ground for their own gain. Yeah, there are some that re-invest into startups and help new businesses, but there are equally as many or more that consolidate and eliminate – making the rich richer.
Plus there are these cataclysmic “oopsies” that happen every now and then when rogue traders and investors lose billions of dollars. Recently, the Jerome Kerviel guy.
http://en.wikipedia.org/wiki/List_of_trading_losses
In my opinion, “financial services,” and “money managers” are generally rotten. They’re in the business of making money, that’s it. I can’t think of much value that provides to society, other than further stratifying distribution of wealth.
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What Mr. Bogle seems to forget is that all of those hedge fund managers have to do something with their money. As Milton Friedman said “What do they do with their dollars? Eat them?” He forgets that those fantastically rich men buy houses, hire maids, buy services and put most of their money back into the market be it directly through spending, or by investing in VC, helping small businesses become successful.
To Jflashantonio,
It seems that you have no idea how a free market works. It might be “your job”, but you should be fired. You talk about the “dudes” who are activist investors, and then make it seem like they have something to gain by the company doing poorly. If someone owns the company through stock, they wouldn’t want it to fail. Duh.
If someone buys a company and then “consolidates and eliminates” they have made a deal that the owner of the company wanted. They didn’t nab it in the night, blindsiding the owner and leaving the employees penniless.
If the rich get richer, so what? Does someone else, providing a service people want and pay for, being more successful make your life worse? Did you notice that Bill Gates and Warren Buffett, the second and third richest men in the world are giving their fortunes to… charity? The only reason you can be angry with the rich is because you aren’t successful enough.
What are these cataclysmic “oopsies” you are talking about? You are angry when hedge fund managers do well, yet angry when “rouge traders” do poorly. What?
Also, just because you don’t want financial services doesn’t mean that no one does. It seems almost EVERYONE in America uses a bank, money manager or other “rotten” service.
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The argument that “hedge fund managers have to do something with their money” ignores opportunity costs. What could someone else have done with that same money. Afterall, even thieves spend the money they steal.
If, as Bogle says, “the financial sector takes $560 billion a year out of society” that money would have otherwise been invested in increasing our society’s productive capacity. And the was Bogle’s genius. He recognized the enormous cost to investors of paying people to manage their investments. The low fees of Vanguard and other index funds allow more of the money people invest to be productive.
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Ross hit it on the head. An economy works best when capital and labor are utilized in the most efficient manner. Financial products do just the opposite.
The top 25 hedge fund managers made more than the average CEO of a corporation last year. That is ludicrous. They do not add that much value. People who invest in hedge funds are buying the sizzle, not the steak.
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Read some of Warren Buffet’s shareholder letters for the past few years. He does a great job of explaining this concept.
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Lily: I think it is important not to focus on what managers do with their money (i.e. you note that they spend it and it goes back into the economy). After all, the people they have taken it from would have spent it or invested it and likewise sent it back into the economy. Money is a fluid and it will flow one way or the other. It terms of “circulating through the economy” it is a dead heat.
I think the thing to focus on is that money is not wealth. Wealth is the “stuff” that makes us happy. A lot of times it is actually stuff, but sometimes it is services (like a massage) or whatever. Money happens to be what we most commonly exchange for wealth.
Bogle makes the very compelling argument that financial services people on average underperform the market as a whole and get paid handsomely for it. They have subtracted value (i.e. dollars) that could have been exchanged for the things that make us happy and they got paid for this little service. A magician/illusionist also gets paid for making things disappear, but the difference is that that is fun and entertaining (entertainment equals wealth because it makes us happier). Normally, someone who gets paid to make your wealth disappear would be considered a con artist.
If people paid a small fee for other people to manage their money so they wouldn’t have to think about it, Bogle would consider that good (because peace of mind is wealth). His issue is that financial services professionals charge more than small fees on the premise that they can help you “beat the market.” That obviously isn’t true in aggregate. On the whole people are paying out, but they aren’t receiving any corresponding wealth in return. In that respect, financial services is charlatanism.
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The insurance industry is a honking scam. Have you seen the stats on how much they take in vs. their payout?
No, insurance isn’t a “scam”. Not that the insurance companies aren’t making a healthy profit, but they are providing an important service by spreading risk. They may overcharge for that service, but that is not a scam. And there is a marketplace that provides some accountability.
After all, the people they have taken it from would have spent it or invested it and likewise sent it back into the economy.
In the case of the investment industry, I think it is important to remember they are taking investment capital out of the economy. We hear a lot about how Americans don’t save enough, but we don’t hear about how much of the money they set aside for savings and retirement ends up buying fancy cars for Wall Street financiers.
Put another way, he is asking about accountibility: who are these people and corporations accountable to? What kinds of structures should exist to ensure that economic activities are serving the interests of society?
We have a whole set of structures that insulate corporations from accountability. The financial services is one of those.
Very few of the theoretical “owners” of companies have any say at all in their governance. There are usually several layers of organization – mutual funds, hedge funds, banks, insurance companies, corporate boards – between the owner/investor and corporate management.
Instead corporate “owners” are passive investors whose only real role is to buy and sell stock. While the market for stock provides some accountability, stock prices are very weak signals about management given all the other factors that determine them.
The fees may be too high but if the net returns are better than the net returns of lower fee funds, investors will favor the higher fee funds.
Financial managers, on average, are going to do less well than the market as a whole. And investors have almost no way to actually measure the likelihood that a particular fund manager will do better or worse, other than past performance. Which will get them nowhere, since past returns are largely a matter of luck.
Fortunately, the balance of that luck is on the good side. Stocks go up more than they go down. So almost everyone walks away a winner.
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# Jflashantonio Says:
January 26th, 2008 at 1:46 pm
In my opinion, “financial services,” and “money managers” are generally rotten. They’re in the business of making money, that’s it. I can’t think of much value that provides to society, other than further stratifying distribution of wealth. #
You’ve got to be very careful not to lump everyone in an industry into this “rotten” category.
Capitalism is about making money. While some money managers and hedge funds charge egregious fees, some don’t. To look at an industry and cite a few examples of bad decisions and greed, and then lump the whole industry into that group is really doing a disservice to the industry.
I am sure if you looked into any industry you would find people who are out to “make money.” Some do it ethically while some don’t, that is just the facts of life.
Perhaps I am writing this because I am in the money management field, but ask yourself this; is it wrong to take other people’s money and make more for them? Shouldn’t money managers be able to take a nice share of the profits for doing something the investor couldn’t do themselves? We manage trusts that are going to live out in perpetuity and give back to many communities and sustain many generations through difficult times. If you want to look at what I think is a more equitable way for hedge funds to do things, look at hurdle rates and high watermarks. With those provisions in place, and not following the typical 2% of assets and 20% of profits that a hedge fund charges, you can find some pretty smart/ethical people in the business.
Perhaps I am ranting… Please forgive me.
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Don, I have a problem with the fact that Bogle (at least in the passages quoted above) group everyone in the financial services industry together and say they’re all taking value out of the economy. I don’t think all financial services firms universally subtract value from the economy. In particular, I think investment banks add value.
At a very rudimentary level, banks connect entities that need capital with entities that can provide capital (through equities or bond issuances). They also help companies grow through mergers and acquisitions. There’s no “outperforming the market” here; just one industry providing services to companies willing to pay for them.
The alternative to having investment banks act as “middlemen” in market-making or in advisory is to have each company develop their own financing arm. They’d have to hire people to structure offerings, hire other people to market them to investors, hire even more people to make sure everything is kosher from a regulatory perspective. This is far more inefficient than having a single industry provide this service.
The same thing could be said of commercial banks, which match up depositors’ funds with borrowers. You can argue that eventually all savings and lending will be done socially (a la Prosper), but for now the safest, easiest way for savers to earn interest is to put their money in an account (including CDs) at a bank. The safest, easiest way for borrowers to get money is to find a bank willing to lend it to them.
This doesn’t take away from the fact that mutual fund managers may be overpaid. The insurance industry may be evil. Hedge funds may be rogue. But while Bogle may be right from a normative view (how things should be), the fact is that these people are highly compensated because their clients are willing to pay them that much. Whether they deserve the money is a value judgment; supply-and-demand economics doesn’t care if these are good people doing good things for the economy.
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Without getting too specific in this debate, I would agree that many in financial services are over-valued. That price will only fall in line with their actual value with an open and competitive market (which we mostly have) and savvy consumers (which we mostly do not). It is only through education of the consumer and scrutiny of these disciplines that we can realign value and price.
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Thank you J.D.! The Benjamin Barber interview with Bill Moyers is absolutely brilliant! Perhaps the best short interview that I have ever seen. If everyone could hear it, our country (and world) would be so much better.
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