Tuesday, August 31, 2010


This piece is about something that I think people have sort of talked about, and around, but not really homed-in on adequately and placed in the proper economic historic framework. It is about another significant “innovation” that occurred over the past 30 years that has run the course of boom to bust and how people didn’t see this innovation in the proper historic boom to bust frame. As you know, I have previously framed much of the deterioration in the economy to the huge historic economic arch of a paradigm shifting innovation, that leads to a ramping-up in overall economic growth, which then ends in a mature “product” that has little room for enough growth to keep the economy growing. (See Below ***) Additionally because the creation of the product becomes more “efficient” this leads to higher productivity and, consequently, jobs are shed in the end-term process. The end result is either a severe recession or a depression. We have seen this time and time again beginning with manifest destiny (our country’s growth west) and also includes electricity, the transistor, the post-war baby boom and computers. The one that seems to have been left out of the discussion to date, at least in the context of the historic arch in which I have expressed interest, is the one I wish to write about: a paradigm shifting innovation in banking.

Through most of the twentieth century banking was local and, therefore, relatively small on a company-to-company level. State and federal regulations created this structure. However, starting in the late 70's, these regulations were lifted. As a result, banks became larger, crossed state lines, and, arguably, more efficient (See: The Real Effects of U.S. Banking Deregulation, http://research.stlouisfed.org/publications/review/03/07/Strahan.pdf). The author of this article, publishing in 2003, lays out the history of this deregulation and how it has seemingly lead to a significant amount of overall growth in the economy. He saw this is being “all good” but he didn’t see the dark side and he didn’t see the historic boom to bust frame I have referred to previously. In fact, all he saw was good times ahead. Of course, he was wrong.

One of the reasons he was wrong was he failed to consider the general historic boom to bust frame, more on this shortly. But another reason he, and others, were wrong, was that he/they didn’t see the inherent problems of taking small, largely privately held, banks away and leaving large, stockholder-owned, banks in their place. I believe this to be a significant mistake. As Paul Krugman summarized in a 2009 article in the NY Time Magazine:

By 1970 or so, however, the study of financial markets seemed to have been taken over by Voltaire’s Dr. Pangloss, who insisted that we live in the best of all possible worlds. Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the “efficient-market hypothesis,” promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information. (The price of a company’s stock, for example, always accurately reflects the company’s value given the information available on the company’s earnings, its business prospects and so on.) And by the 1980s, finance economists, notably Michael Jensen of the Harvard Business School, were arguing that because financial markets always get prices right, the best thing corporate chieftains can do, not just for themselves but for the sake of the economy, is to maximize their stock prices. In other words, finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a “casino.” How Did Economists Get It So Wrong? http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1&scp=3&sq=krugman&st=cse (Emphasis added)

Now here’s the problem created by this “irrational exuberance” Krugman writes about. When there is an innovative “product”, “service”, “paradigm”, that begins its inevitable transition from maturity to petering-out, a company is caught between a rock and a hard place because growth declines as the innovative “product”, “service”, etc., matures. Declining growth means declining profits and declining profits mean declining stock prices. Yet, if one accepts the “efficient-market hypothesis” the solution for any company becomes the creation of “the appearance of growth” at any cost because, if you don’t, your company tanks in the stock market. Although it is a minor example, I see evidence of this “profit at any cost,” and the petering-out of the banking innovation, in the recent report that some financial institutions are looking into the possibility of purchasing grandpa’s and grandma’s insurance policies for needed cash (needed because of the market crash) and then packaging them into bonds as they did with the mortgages. http://www.nytimes.com/2009/09/06/business/06insurance.html?scp=8&sq=insurance&st=cse To me, this is evidence of how desperate these companies are for profit-making services and, if they have to stoop to this level, how bad the situation really is.

While it is not my area, I think that if someone looks at the development of these financial derivatives, loose mortgage and other lending practices (that were necessary to insure continued profits to satisfy the “efficient-market hypothesis” beast), you might just see they started around the same time as the banking expansion that started in the early 80's was losing some of its velocity. These large banking institutions needed these new revenue sources to prop-up their profit sheets (Rule “efficient-market hypothesis,” rule) and no one bothered to ask the question whether this was sound because the “efficient-market hypothesis” ipso facto conferred soundness on these practices.

So where does that leave us. Well, if I am right about this, and the other innovation I wrote about previously (computers), here’s what I see. First, I now see two, not one, innovations that have reached their post-economic growth creation phase: a) the banking innovation and b) the computer innovation (and remember how much a part of our economic growth these two “innovations’ have been in the past 20-30 years). Second, while I see the banking innovation running the usual course, as I wrote previously, the computer innovation will continue to cause problems because, unlike any previous innovation, the computer innovation will continue to make companies more efficient, and they will have to become more efficient in this economic climate, therefore jobs will continue to be lost. Third, as tax revenues continue to decline, particularly on the state and local levels, the one area that has seen genuine job growth over the past ten years, government jobs, will see both lay-offs and an increase in furlough days and the like. The effect on consumer spending of this is obvious. Fourth, we still have the commercial real estate and consumer debt bubbles to come. More or less, I believe this will remain the situation until: a) our economy flattens out vis a vis the rest of the world; and/or 2) we come up with that random paradigm shifting innovation to jump-start sustained, accelerated, growth sufficient to recapture the millions of jobs lost up to the point of the appearance of this new innovation.

*** 2/21/09

I am still caught in this thought pattern where I can't really see a way out even in five years, and remember the FED said this is predicated on nothing else really going wrong. In the column earlier this week, Krugman observes the CBO has projected there will be a $2.9 trillion difference over the next three years between what industry can produce and what can be consumed. When I went back to my text book on the economy, I saw that sort of discrepancy, between productivity and consumption, seems to be a factor in bringing about a depression. On the plus side, this is why we must, at any cost, create jobs. But, long term, I see this as possibly being very different because what has brought about increased productivity, computers, etc., will continue ad infinitum, meaning some sort of continued downturn in jobs. In fact, as business continues to worsen, existing businesses will be forced to become more efficient/productive and those changes will not go away upon recovery. Right now, I see this as possibly being some sort of reverse Malthus thing where there may never be enough consumers for full production, and jobs continue to decline until the next huge thing (like electricity, the combustible engine, etc.) that will result in the creation of a large number of jobs directly or indirectly. This sort of thing cannot be planned. It is like a mutation, it just happens. The other thing that worries me is during the Great Depression, it was the commercial banks, largely, that purchased the debt that drove the New Deal and then the War. As such, as my text book put it, our debt was largely contained within our borders. Not so this time around. So when the time comes to pay the debt back, instead of the debt being in our economy, it will be in some other country's economy. Thus, ultimately, we will lose this potential multiplier.

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