What exactly is the function of the financial sector in our society? Simply this: Its sole function is supplying capital efficiently to aid the real economy. The financial sector is a tool to help those that make real tools, not an end in itself. But five fatal flaws in the financial sector’s current structure have created a monster that drains the real economy, promotes fraud and corruption, threatens democracy, and causes recurrent, intensifying crises.

~ Bill Black

Today I’d like to review an article on the financial sector that I came across via The Big Picture. It’s by Bill Black, author of The Best Way to Rob a Bank Is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He is also “a white-collar criminologist who has spent years working on regulatory policy and fraud prevention.”

The debate over whether and how much to regulate the financial industry often devolves into a left vs. right political battle about issues that are actually irrelevant to the core problems in the financial industry and the economic system. Critics who lean left say that the “fat cat” bankers earn way too much money and the industry should be regulated with salary caps and other measures. Those on the political right say that if capitalism allows those financial firms to prosper to the point that executives can reap billion dollar paydays, so be it. (I’ve argued that bailouts mean we can no longer call our system capitalism but that’s a debate for another day.)

How the Servant Became a Predator: Finance’s Five Fatal Flaws

In this article, Bill Black spells out some of the ways in which the financial sector has gradually become too big and too powerful to be of any economic utility. Here are his 5 Fatal Flaws:

1. The Financial Sector Harms the Real Economy

Black sees a number of ways in which the financial services industry, which is just supposed to act as a middleman to the real economy, not only fails to contribute to economic growth, but actually detracts from it:

• It’s Too Big: Forty years ago the financial sector received about 2% of the total profits and the economy did just fine. Now, it takes a 40% of those profits. When you read that statistic, Black’s characterization of the sector as “bloated” and “grossly over-compensated” seems a lot less hyperbolic.
• From Parasite to Predator: Black cites a book by James Galbraith, called The Predator Statein which he shows that “[i]n addition to siphoning off capital for its own benefit, the finance sector misallocates the remaining capital in ways that harm the real economy in order to reward already-rich financial elites harming the nation.”
• Capital Markets Have Decapitalized the Real Economy: This decade, corporate stock buybacks and grants to officers have exceeded new capital raised by the U.S. capital markets.
• Skimming the Brain Trust: While the U.S. economy suffers a critical shortage of educated mathematicians, engineers, and scientists, many of the graduates from these areas choose to enter the financial sector instead because of the exponentially lucrative pay scales.
• Recurrent Financial Bubbles: Black asserts that the financial sector has become expert at creating and implementing what he calls “accounting control frauds”, which are entities that seem legitimate but ultimately allow their creators to enrich themselves at the expense of the real economy. They maximize short-term profits and somehow evade losses and prosecution once the bubbles burst. The ongoing mortgage fraud crisis is just one example of this.
• Capital Misallocation: Capital is denied to the entrepreneurs who could use it to grow the real economy, but require a longer-term view in order to realize the benefits of their investments.
• Government Complicity: Many of these huge financial firms carry great sway in the halls of government by virtue of their generous campaign contributions and massive lobbying efforts – all of which is funded using the piles of capital they have skimmed from the real economy.

2. The Financial Sector Produces Recurrent, Intensifying Economic Crises Here and Abroad

I’ll let Mr. Black speak for himself here:

“The current crisis is only the latest in a long list of economic crises caused by the financial sector. When it is not regulated and policed effectively, the financial sector produces and hyper-inflates bubbles that cause severe economic crises. The current crisis, absent massive, global governmental bailouts, would have caused the catastrophic failure of the global economy. The financial sector has become far more unstable since this crisis began and its members used their lobbying power to convince Congress to gimmick the accounting rules to hide their massive losses.”

3. Extraordinary Predation

The financial sector drives the upper one percent of U.S. income distribution and is responsible for the dramatic increase in “grotesque income inequality.”

4. Cheaters Always Prosper

The financial sector’s leading role in committing, aiding and abetting accounting control fraud has the following consequences:

• Corrupt financial elites
• Rise in Social Darwinism and Gresham’s Dynamic, where “bad money drives out good” and “honest professionals are pushed out” so that the charade can continue. If you read Matt Taibbi’s latest indictment of the corruption in the financial sector and its incestuous relationship with government, you’ll understand that this stuff is really happening. If you haven’t read it, please do, but be prepared to be more than a little angry by the time you finish it: Why Isn’t Wall Street in Jail?

5. Concentration of Power Puts Economy and Democracy at Risk

The CEOs of the largest financial firms wield so much power that it has put the financial, economic and democratic systems in peril:

“This excessive power was a major contributor to the ongoing crisis. Effective financial and securities regulation was anathema to the CEOs’ ideology (and the greatest danger to their frauds, wealth, and power) and they successfully set out to destroy it. That produced what criminologists refer to as a “criminogenic environment” (an atmosphere that breeds criminal activity) that prompted the epidemic of accounting control fraud that hyper-inflated the housing bubble.”

Why Does It Continue?

The one question that occurs to me every time I read articles about the corruption that has become rampant in our financial system is “Why does it continue?” Why do we endure this type of criminal behaviour and stand by silently as it goes unprosecuted? A few ideas occur to me:

• The average citizen is too busy worrying about their day to day concerns to learn about it, much less take a stand.
• The details of many of these financial Frankenstein products are pretty complex and most of us have neither the time nor the desire to acquaint ourselves with them.
• Many of us feel powerless to do anything about the corruption, even if we recognize it and understand its implications.
• With the exception of the odd opinion piece, and a few reporters like Matt Taibbi and Jonathan Weil of Bloomberg, the financial and mass media have been grossly negligent in investigating and reporting on these issues.
• The masses will remain apathetic until one or more of these factors directly and meaningfully interrupts their lives. Besides, the markets are on a tear. That means everything is peachy, right?
• Anyone who brings up the truth of these matters is very quickly, and usually successfully, labeled a conspiracy theorist and written off as a wingnut, the veracity of their reporting notwithstanding.

Recent weeks have proven that even the most well-entrenched despots have an expiration date. The words “plutocracy” and “oligarchy” are popping in more articles. I wonder what the tipping point will be for the financial sector. How long can the Federal Reserve’s shut-up money keep the peace? Will QE3 do the trick?

How do you view the financial sector? Has our society become a plutocracy?

(Image Credit: Barry Barnes)