The Financial Industry

Hey guys, just wanted to do a quick response to Dennis’s blog entry about the economy and stuff. Toward the end, he mentions “savings” and the desire for President Elect Obama to “PLEASE promote higher savings rate.” Naturally, this led me to opine about a few items below.

Question: how do we define savings when it comes to financials? Doesn’t that include the high-risk instruments that got us in trouble in the first place? Usually when people talk about savings they really mean investments. Case in point, if I were sitting on a big pile of money, and not putting it to work in any sort of portfolio, most educated people would call me a fool (whether or not they are right is another story). But is buying stocks the best way to save money? What about derivatives, the complicated financial instruments Warren Buffet referred to as “financial weapons of mass destruction”? Imploring people to save money is great, but please ask them to do it wisely!

To me, the most important aspect of any economy is production. The financial companies play an important role by investing in firms that will produce valuable goods, thus facilitating more production. Of course, you can go one step further and invest in a financial company that will then invest that money in a good production firm. And then of course, you can go infinite steps further to the point that the financial institutions are continually passing money back and forth.

But without the production of quality goods that started it all, what are we really investing in? I argue that the Financial Industry is extremely bloated, and needs to be downsized significantly before people can begin to invest their money with confidence.

800px-nyugdpfinancialshare

(It turns out that someone had already written about this in the wikipedia-entry for “Financialization” so check that out as well.)

Prior to recent times, the trend was that more and more aspiring executives and MBAs students wanted to work in Finance; I’m sure that is still the case to a slightly lesser extent today. The result is an increasingly diluted talent pool of skilled management for the companies that actually produce things. So perhaps we shouldn’t be surprised at the number of bad decisions being made by American car companies; it’s not as if Harvard MBAs were lining up outside their offices, desperate to add Ford or GM to their résumés. 

career_builder_hero

Of course this begs the question: why were so many bad decisions made in the finance industry itself? The short answer is that they really weren’t bad decisions from a greedy, short-term perspective.

profits_finance_vs_manufacturing1

(My apologies that this graph conveniently stops at 2006, I’m assuming the red line went down after that …)

Similar to Real Estate, Financials caught a “bubble” in the 2000s (or the “oughts” or “00’s” if you prefer). This was caused by a lot of things, but one can even trace it back to the massive financial deregulation that occurred in the 1970s. Now as we saw with the dot-com bubble in the late 1990s, extremely successful industries tend to behave like that drunk guy at the craps table–the more money they’ve won, the more money they’ll gamble on the next roll. Not only is this human nature, but it seems hard not to act in such a way when the government also encourages it.

It’s always a good idea to keep things in perspective by thinking about what money really is (of course I am highly simplifying things here): Money exists in order to be spent, at some point in the future. Investment return rates are really incentives for consumers to save money rather than spending it right away. For most of the decade, returns were higher for most financial instruments then the market should have dictated. The resulting increase in investment volume only made the financial collapse more severe than it otherwise would have been.

From a consumer’s standpoint, saving money is important because it allows people to avoid debt. On the other hand, poor investments can be counterproductive in that respect. The recent trend has been that the money we invest increasingly ends up in the pockets of financial middle-men, rather than the leaders of manufacturing or service industries. For the long-term health of our economy, I think it is critical that this trend be reversed.

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