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Finance's Five Fatal Flaws

The finance sector's sole function is supplying capital efficiently to aid the real economy. It is a tool to help those that make real tools, not an end in itself.

William K. Black, an Associate Professor of Economics and Law at the University of Missouri-Kansas City, was a federal regulator during the Savings and Loan crisis and appears in Michael Moore's 'Capitalism: A Love Story.'

By William Black

1.    The financial sector harms the real economy.

The financial sector, even when it is not in crisis, harms the real economy.  First, it is vastly too large.  The finance sector is an intermediary (a “middleman”) and like all middlemen it should be as small as possible while still being capable of accomplishing its mission.  If it larger than that minimum size it is inherently parasitical.  Unfortunately, it is vastly larger than necessary.  The finance sector dwarves the real economy that it is supposed to serve.  Forty-years ago, our real economy grew better with a financial sector that received one-twentieth as large a percentage of total profits (2%) than does the current financial sector (40%).  The minimum measure of how much damage the bloated, grossly over-compensated finance sector causes to the real economy is this massive increase in the share of total national income wasted through the finance sector’s parasitism.

Second, the finance sector is worse than parasitic.  James Galbraith’s recent book, The Predator State, aptly names the problem.  The finance sector functions as the sharp canines that the predator state uses to rend the nation.   In 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.  

• Corporate stock repurchases and grants of stock to officers have exceeded new capital raised by the U.S. capital markets this decade.  That means that the capital markets decapitalize the real economy.  Too often, they do so in order to enrich corrupt corporate insiders through accounting fraud or backdated stock options.

• The U.S. real economy suffers from critical shortages of employees with strong mathematical, engineering, and scientific backgrounds.  Graduates in these three fields all too frequently choose careers in finance rather than the real economy because the financial sector provides far greater executive compensation.  Individuals with these quantitative backgrounds work overwhelmingly in devising the financial models that were important contributors to the financial crisis.  We take individuals that could be conducting the research & development work essential to the success of our real economy (including its success in becoming sustainable) and put them instead in financial sector activities where, because of that sector’s perverse incentives, they further damage the financial sector and the real economy.  Michael Moore makes this point in Capitalism:  A Love Story.  

• The financial sector’s fixation on accounting earnings leads it to pressure U.S manufacturing and service firms to export jobs abroad, to deny capital to firms that are unionized, and to encourage firms to use foreign tax havens to evade paying U.S. taxes.

• It misallocates capital by creating recurrent financial bubbles.  Capital flows not to where it will be most useful to the real economy, but rather to the investments that create the greatest fraudulent accounting gains.  The finance sector is particularly prone to providing exceptional amounts of funds to the worst accounting “control frauds.”  (A control fraud is a seemingly legitimate entity used by the person that controls it as a fraud “weapon.”  Financial control frauds’ “weapon of choice” is accounting fraud.)  Accounting control frauds are so attractive to lenders and investors because they produce record, guaranteed short-term accounting “profits.”  They optimize by growing rapidly like other Ponzi schemes, making loans to borrowers unlikely to be able to repay them (once the bubble bursts), and engaging in extreme leverage.  Unless there is effective regulation and prosecutions this misallocation creates an epidemic of accounting control fraud that hyper inflates financial bubbles.  The FBI began warning of an “epidemic” of mortgage fraud in its congressional testimony in September 2004.  It also reports that 80% of mortgage fraud losses come when lender personnel are involved in the fraud.  (The other 20% of the fraud would have been impossible had these fraudulent lenders not suborned their underwriting systems and their internal and external controls in order to maximize their growth of bad loans.)

• Because the financial sector cares almost exclusively about high accounting yields and “profits” it misallocates capital away from firms and entrepreneurs that could best improve the real economy (e.g., by reducing short-term profits through funding the expensive research & development that can produce innovative goods and superior sustainability) and could best reduce poverty and inequality (e.g., through microcredit finance that would put the “Payday lenders” and predatory mortgage lenders out of business).

• It misallocates capital by securing enormous governmental subsidies for financial firms, particularly those that have the greatest political power and would otherwise fail due to incompetence and fraud.  

2.    The financial sector produces recurrent, intensifying economic crises here and abroad.

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 instable since this crisis began as they used their lobbying power to convince Congress to gimmick the accounting rules to hide their massive losses and Secretary Geithner has declared that the largest financial institutions are exempt from receivership regardless of their insolvency.   These factors greatly increase the likelihood that these systemically dangerous institutions (SDIs) will cause a global financial crisis.

3.    The financial sector’s parasitism is so extraordinary that the finance sector now drives the upper one percent of our nation’s income distribution and has driven much of the increase in our grotesque income inequality.   

4.    The financial sector’s parasitism and its leading role in committing and aiding and abetting accounting control fraud combine to:

• Corrupt financial elites and professionals, and

• Spur a rise in Social Darwinism in an attempt to justify the elites’ power and wealth.      

Accounting control frauds suborn accountants, attorneys, and appraisers and create a “Gresham’s dynamic” that drives honest professionals out – cheaters’ prosper.  Executive compensation has become so massive, so divorced from performance, and so perverse that it too creates a Gresham’s dynamic that encourages widespread accounting fraud by both financial firms and firms in the real economy.  

As financial sector elites became obscenely wealthy through parasitism and fraud their psychological incentives to embrace Social Darwinism surged.  While they were by any objective measure the worst elements of the public, their sycophants in the media and the recipients of their political and charitable contributions worshiped them as heroic.  Finance CEOs adopted and spread this myth – they were smarter, harder working, and innovative.  They rose to the top entirely through their own brilliance and willingness to embrace risk.  All of their employees weren’t simply above average – they were exceptional.  They hated collectivism and adored Ayn Rand.  

5.    The CEO’s of the largest financial firms are so powerful that they pose a critical risk to the financial sector, the real economy, and our democracy.

The CEOs can directly, through the firm, and by “bundling” contributions of its officers and employees, easily make enormous political contributions and use their PR firms and lobbyists to manipulate the media and public officials.  The ability of the financial sector to block meaningful reform after bringing the world to the brink of a second great depression proves how exceptional its powers are to corrupt nearly every critical sector of American public and economic life. The five largest U.S. banks control roughly half of all bank assets.  The largest banks use their political and financial power to provide them with competitive advantages that allow them to dominate smaller banks.

This excessive power was a major contributor to the ongoing crisis.  Effective financial and securities regulation was anathema to their CEO’s ideology (and the greatest danger to their frauds, wealth, and power) and they successfully set out to destroy it.  That produced a “criminogenic environment” that prompted the epidemic of accounting control fraud that hyper inflated the housing bubble.

The financial industry’s power and progressive corruption combined to produce the perfect white-collar crimes.  They successfully lobbied politicians to legalize the obscenity of “dead peasants’ insurance” that Michael Moore exposes in chilling detail.  State legislatures changed the law to allow a pure tax scam to subsidize large corporations at the expense of their taxpayers.  

Caution:  Never Forget the Need to Fix the Real Economy

Economic reform efforts are focused almost entirely on fixing finance because the finance sector is so badly broken that it produces recurrent, intensifying crises.  The latest crisis brought us to the point of global catastrophe, so the focus on finance is obviously rational.  The focus on finance carries a grave risk.  The sole purpose of finance is to aid the real economy.  The real economy is what creates the goods and services, our jobs, and our incomes.  Our ultimate focus needs to be on the real economy.  The real economy came off the rails at least three decades ago for the great majority of Americans.  We need to commit to fixing the real economy by guaranteeing that everyone willing to work can work and making the real economy sustainable rather than recurrently causing global environmental crises.  We must not spend virtually all of our reform efforts on the finance sector and assume that if we solve its defects we will have solved the other fundamental reasons why the real economy has remained so dysfunctional for decades.  We need to be work simultaneously to fix finance and the real economy. 

William K. Black is an Associate Professor of Economics and Law at the University of Missouri-Kansas City.  He is a white-collar criminologist and was a senior financial regulator.  He is the author of 'The Best Way to Rob a Bank is to Own One.'