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The Black Hole of Financialization

I came across a thoughtful article from Automatic Earth recently. Although the article might appear a little off-beat, referencing “black holes” and whatnot, it’s actually right on the mark.

The comparison between the concept of “time dilation” in Einsteinian relativity and finance is very apt. Countries with more sophisticated financial structures provide businesses and individuals with greater options for “time-shifting” consumption via the financial system. Citizens in the US suffer less than citizens in Tunisia (for example) because we can use our  financial system (on the government and individual level) to get more of what we need now (even though we really can’t pay for it in the long run). A Tunisian, on the other hand, has to focus on finding food and water today. Tunisians live closer to the “real” (physical, tangible) economy, whereas Americans live further away from issues directly pertaining to food and water, thanks to our access to credit and government giveaways (financed by borrowing on the government level).

It becomes increasingly difficult for citizens to distinguish the “real” economy from the “financial” economy the longer they live in the latter and are separated from the former. The Adam Smith tenets of capitalism pertain to the real economy, but in the US and other “sophisticated” nations, we’ve gradually substituted “financialization” for real economic activity to the point that virtually everyone confuses the two.

Consider the simple notion of net present value (NPV), the bottom-line of Adam Smith-style capitalism. A business or individual gathers real resources (the financial system only provides capital for this, it’s a supporting activity) and recombines these resources so that they are worth more than the sum of their parts (taking the time value of money into account). When this is done successfully, what we call “the economy” expands, and the aggregate general welfare of mankind improves (although some individuals may be worse off).

The main point of this short article is that we (and especially the Bernank) have deeply confused the beneficial kind of Adam Smith capitalist wealth creation with the illusory wealth created by the financial system. The financial system is beneficial only in its supporting role to the real economy. But the profits earned via trading activities from the Goldman Sachs and JP Morgans of the world are not Adam Smith-style profits — the ones that grow the overall economy and improve the general welfare. These type of profits are instead “zero-sum” profits. When Goldman wins on a trade, someone else loses the same amount. Moreover, the economic system is actually poorer because these zero-sum profits involve transaction costs, which means that all the Goldman/JP Morgan-type activities are actually negative NPV in the aggregate.

A key point from the Automatic Earth article is that “sophisticated” economies have increasingly moved towards these types of financialized business activities (thanks to the incredible political clout of the financial lobby) and moved away from Adam Smith-style real economy business activities. But, thanks to the ability to “time-shift” our consumption via the financial system, “first-world” citizens enjoy a delayed reaction to the true cost of this shift. It’s out there, and we’ve got to face it eventually, but we instead keep choosing short-term fixes, the proverbial “kicking the can down the road,” which just makes the price we’ll have to pay even higher in the long run.

The bottom line: we can’t “financialize” our way out of anything. The financial sector may earn profits for themselves, but only the profits they earn via making productive business and consumer loans and investments truly grow the economy. Virtually all of their trading and M&A activities just reshuffle the deck, like a card sharp, so that at the end of the day the financial sector holds more face cards while the rest of us hold more twos and threes (and jokers!).

It’s therefore not enough to just grow the economy, but we also need to shrink the unproductive trading-based part of the financial sector so that in the long run real economic activity grows faster than zero-sum financial type activity. Until we get that point and act on it, we’re just spinning our wheels and sinking deeper into the mud of financialization.

Categories: Market Commentary
  1. September 2, 2011 at 12:17 am

    So nice to stumble upon your piece by means of search.yahoo.com. I was an active reader of http://www.calculatedriskblog.com/ during the lead-up to 2009 bust and de-leveraging cycle. I do not recall reading such a crisp description tying Adam Smith’s macroeconomic theories as being rooted in the ‘real economy’ at calculatedrisk or similar sites. An interesting point indeed.

    Certainly, we’ve grown used to throwing public borrowing & exotic financing at any hint of ‘real economy contraction’ during the great run of 1982 : 2008 . And the piper must eventually be paid

    Now to the stir the pot.. Aren’t Finance professors actually training and equiping bright young finance students and therefore swelling the ranks of the non-productive sector of the economy ?

  2. September 2, 2011 at 7:51 am

    Chris — thanks for your comment. I am confident that quite a few of my former students have gone on to economically unproductive careers, engaging in activities like short-term trading, underwriting 125% LTV mortgages, etc. However, it is also the case that many others work in the more economically productive aspects of finance, like practicing sound loan underwriting and personal financial planning. Thanks for reading.

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