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     Jan 28, 2009
THE BEAR'S LAIR
Financial services rust belts
By Martin Hutchinson

Those who have visited Michigan recently or the Mahoning Valley of Ohio in the 1980s can recognize the symptoms of a rust belt. A hitherto prosperous industry, paying high wages to its employees, has been overtaken by market changes and is forced into harsh downsizing or even bankruptcy. As a result, the lives of many inhabitants degenerate into alcoholism, home foreclosures and welfare.

This time around, the decaying industry is finance, and the rust belt cities are London and New York.

The parallels with the US automobile industry are closer than they look. In the early years of the auto industry, it included both large

 

companies and small specialty manufacturers, the latter being remembered now as producers of "vintage" cars of very high quality. Then the Great Depression wiped out most of the specialty producers, which could not compete with the mass producers' costs. For the next several decades, the business was dominated by a heavily capitalized oligopoly with extremely highly paid employees, quite high profitability but deteriorating product quality. Finally, it became clear that the oligopoly was uncompetitive and the industry began to shed workers and close plants.

In finance, the early specialty producers were the London merchant banks; for Duisenberg, Packard and Stutz you can substitute Hambros, Warburgs and Hill Samuel. They, too, had superb product quality and are remembered with great fondness by their former customers. They were driven out of the business by heavily capitalized competitors, in this case running behemoth high-risk trading desks rather than mass-production assembly-line factories. The employees of the well-capitalized behemoths were even better paid than the unionionized, UAW car workforce in the 1950s. Then gradually product quality began to deteriorate, and bad practices such as "liar loan" securitized mortgages, accounting "mark-ups" of assets that had not been sold and self-deluding risk management crept in.

The main difference between the two cases is that the collapse of the finance sector has taken the form of a sudden Gotterdammerung rather than the steady but inexorable decline characteristic of the US automobile industry. The bottom line is the same: Detroit needs to downsize radically, but so does Wall Street.

As I have written previously, in and after the 1980s the central activity of the financial sector became not service but rent-seeking. Finance doubled its share of gross domestic product (GDP) in the 30 years to 2006, but very little of the addition represented products and services that provided true value to the economy as a whole.

Securitization was mostly a complex and expensive means of getting assets off banks' balance sheets. Derivatives helped manage risks, but only a tiny percentage of the multi-trillion dollar outstandings in the derivatives markets represented risk amelioration; the rest was just trading noise or outright speculation. Hedge funds and private equity funds were mostly a means of multiplying excessively the fees charged for investment management; they almost drove out of business the true venture capital funds, which had a genuine economic value.

Principal trading, the most exciting activity of all in the glory years for greedy investment bank partners, was simply a means of using large amounts of outside shareholders' capital to trade on insider information about the market's deal flow. All of these activities were legal; none of them added value to anybody but their immediate practitioners, while they represented additional costs and lower returns for everybody else. In other words, they fulfilled the dictionary definition of rent seeking.

Given the aggression, greed and high intelligence of the average investment banker, rent seeking can never be eliminated completely. Nevertheless, the conditions that made it flourish have already changed, and good policy will ensure that they do not recur in the future. In particular:
  • Financial complexity is mostly an additional source of risk, and provides little or no added value to the economy as a whole. A Bernard Madoff-style Ponzi scheme could grow to the monstrous size it did only in an environment in which even institutional investors were ignorant and incurious about the way in which their investment returns were derived.
  • More than a decade of easy money after 1995 increased asset prices, thereby providing returns to those who bought assets on a leveraged basis, while making leverage itself very easy to obtain.
  • The move from thinly capitalized "Duisenberg" investment/merchant banks, providing advice to companies and arranging their financing, to behemoth "General Motors" financial conglomerates that took principal positions in the securities of companies they advised produced an immense interconnecting web of conflicts of interest and insider trading opportunities.
  • Risk management methodologies, which achieved acceptance so great that under the Basel II regulations "sophisticated" banks were allowed to select their own, were fundamentally flawed. They rested on an academic theory of efficient markets that in practice is easily disprovable and represents a very poor approximation to reality. The prolonged period of easy money and bullish markets appeared to validate them; we now know better.
  • Remuneration practices in the industry became far more generous than their historical norms, more also than that necessary to attract staff of the right intellectual caliber and other qualities. This was a product of the almost uninterrupted bull market in bonds and stocks from 1982 to 2007, a large part of the returns from which was scooped off by financial sector employees who added far less value than they extracted.

    If rent seeking is to a large extent eliminated, it is likely that the financial services sector will approximately halve in size, returning to around its 1970s share of GDP. Its usage of capital will decline only modestly, since the excessive leverage built up in the last decade will need to be corrected.

    Conversely, the sector's human resource usage needs to decline by much more than half - after all, we have a multitude of tools today that allow the relatively simple functions of traditional finance to be performed much more efficiently, and with less human input. In addition, with modern telecommunications technology, many of the routine tasks of finance (including almost all the non-mechanizable parts of the back office, but also much research and document preparation) can be performed by well-educated but lower-paid employees in India or elsewhere. Thus, while the sector's overall value-added will halve, the portion of value-added attributable to capital will significantly increase; that attributable to labor will decline.

    For the financial practitioners of New York and London, the future is thus bleak. Rewards will be greatly reduced, as the market operates ferociously both on the income side and the employee costs side of their employers. Headcount will also be greatly reduced, as functions are eliminated, work is outsourced to the Third World and the weaker entities go bankrupt or are merged into competitors. The decline in practitioners' incomes might be as much as 80%, even after a modest market recovery, though the number of practitioners should reduce by only 50% to 60%.

    That also promises a weak future for the local beneficiaries from financial services incomes in New York or London. Such losers would include local housing markets and those of the smarter resorts, together with the army of real-estate agents, decorators, construction companies and lawyers that have benefited so egregiously during the bubble. It would also include local restaurants, clothing retailers, jewelers and other high-end products and services.

    The tourism business will find far fewer takers for the kind of "short break" luxury sybaritic packages in which it has recently specialized. Thus the short-term knock-on effect on the overall economy of poorer bankers will be severe, even though the long-term economic benefits of eliminating the dead-weight costs of the bloated banking community will be even greater.

    The two centers most adversely affected by these changes will be London and New York. Asian financial centers will continue to benefit from the faster regional rates of overall economic growth, while as in the 1980s, the problems of Dubai will spread far beyond finance.

    In New York, the "rust belt" effect will be severe but not overwhelming - it will be 1970s Cleveland rather than 1980s Youngstown. Many of the skyscrapers of the financial district and the luxury residential areas will become ghost buildings, as their predecessor buildings did in the 1930s, but they are unlikely to descend to the chain-round-the facility guarded-by-a-Rottweiler-and-a-tattooed-thug state symptomatic of the worst industrial blight.

    However, the resemblance to 1970s Cleveland (which defaulted in 1978) will probably be increased by a municipal bankruptcy. Mayor Michael Bloomberg has pursued the policy of former New York mayor (1965-73) John Lindsay. He has increased municipal spending by 52% over six years while prices rose 20%, and has relied on hefty increases in property taxes to fund the increase. Those funding sources have disappeared, but we are still only at the stage of cosmetic cuts and financing gimmicks.

    As the downturn continues, New York's fiscal state will become rapidly worse, and default is inevitable in a year or two. Bloomberg has altered the rules to allow himself to run for mayor again this November; he would be mad to do so, since the fiscal deterioration would make his third term a very unpleasant experience.

    London will be the Youngstown of this downturn, an excellent market for Rottweilers, wire mesh and tattooed thugs. The city's Docklands area in particular will revert to its 1970s squalor, albeit with some very expensive buildings scattered around. Few of the financial institutions that have prospered so lavishly in the London of the past couple of decades are British owned, and those that are were excessively involved in the British mortgage market - an even bigger disaster than the US market because home values were even more outrageous at the peak.

    Given that the financial sector will be downsizing anyway, will top management in Frankfurt, New York or Tokyo want to keep its stable of expensive London whiz-kids in order to continue participating in a market that was never central to their overall strategy and is now unprofitable? I doubt it.

    Even the Russian mafia may leave, though probably to Cyprus rather than Moscow. Whereas New York's downturn may produce municipal bankruptcy, London's downturn has a fair chance of producing national bankruptcy. Going forward, British youth will have to find a new way to make a living - single-malt Scotch and tourism cannot support a nation of 60 million people.

    Inhabitants of London and New York have spent the last couple of decades sneering at their provincial cousins, particularly those involved in the grubby world of manufacturing. Now the Rust Belt has reached them also.

    Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found at www.greatconservatives.com.

    (Republished with permission from PrudentBear.com. Copyright 2005-09 David W Tice & Associates.)

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