Fixing Market Madness

“The focus by elites on making money out of money rather than making real goods and services has led to wealth for the few, and overall national economic decline. In a financialized economy, the financial tail is wagging the economic dog.” Steve Denning, (Forbes magazine, May 31, 2015)

America used to make things, but now we make financial deals. Leveraged buy-outs, mergers, hostile takeovers, and similar stock manipulation games don’t actually grow the real economy. None of this increases sales or production. None of it improves the financial security of the majority of us. But it makes money for the deal makers and it accumulates wealth at the top. The big investment banks, stock brokerage companies, hedge fund managers, and “vulture” capitalists do well but everyone else, including the actual companies involved, pay the price.

Many economists and business experts say this excessive “financialization” is bad. The increasing size of the financial services industry and the rise of too-big-to-fail investment banks is destabilizing. Here are a few examples:

 “We’ve witnessed what happens when “owners” of businesses have no accountability for outcomes in the real world. Financiers are rewarded for generating short-term profit, even when the investments turn out to be phony or to cause harm.”

Stephanie McMillan (YES Magazine July 7, 2009.)

“…many observers believe that this expansion of the financial sector comes at a high cost. Scholars and politicians alike point to the “financialization” of the economy — and an increased reliance on the financial sector to create growth — as the root cause of many of our economic problems.” Christopher Witko (Washington Post, March 29, 2016)

“So we’re looking at a sector that serves vital functions (no modern economy can exist without banks) but that, when it grows too large, tends to slow economic growth, increase inequality, and experience crashes that exact a huge toll on society.” Gautam Mukunda (“The Price of Wall Street Power, Harvard Business Review, June 2014. I would recommend reading this entire article.)

We have suffered many bank panics, market crashes and depressions throughout our history. There have been attempts to regulate banking and investment activities. The Glass-Steagall Act (1933) separated commercial banks (which accept deposits and make loans) from investment banks (that negotiate the sale of bonds and stocks). The Act prohibited commercial bankers from using depositors’ money for risky investments. During the 1930’s other legislation created the Securities and Exchange Commission and outlawed some of the reckless behavior, corruption, and cronyism of the industry. But beginning in the 1980’s regulations were weakened. Glass-Steagall was repealed in 1999 leading to the 2007-08 “Great Recession.”

Along the way there have been many examples of simple criminal behavior. Fraud, insider trading, lying on financial statements, and Ponzi schemes have been frequent. The Enron collapse and Bernie Madoff’s Ponzi scheme are not aberrations. In 2015, five of the largest banks in the world pleaded guilty to criminal price fixing of foreign exchange rates. No one went to jail. The $5.7 billion in fines may sound big but hardly hurt these massive companies. Too often fines are merely a cost of doing business and do not deter bad behavior.

What needs to be done? Professor Mukunda (quoted above) says, “…we must do something to curb the enormous and disproportionate power of Wall Street.” Obviously, there should be strict enforcement of existing laws with tough penalties. But there also needs to be reforms to the markets, tax laws, and the harmful trading practices. Here are some frequently suggested reforms.

Bring back Glass-Steagall. The separation between commercial and investment banking needs to be re-established. The 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act was an effort at stronger regulation but did not go far enough.

Break up the big banks. “Too big to fail” is too big to exist. Too big is bad for competition and efficient markets. In addition, multinational companies with more assets than many countries obviously have too much political power.

Tax financial transactions. A tax on stock market transactions would raise a lot of revenue but would also discourage excessive speculation. The small amount of the tax would not affect long term investors but would impact short term trading. High frequency computer trading with very small margins would be most affected. Forty countries currently have a transactions tax. The United States had one from 1914 to 1966.

Change capital gains taxes. Current tax law treats short-and long-term capital gains income differently. Increasing taxes on short term gains would again discourage speculation versus real investing.

Treat investment income like ordinary income. Income from capital gains (from investments rather than wages) is taxed at a lower rate than regular income. There is no good economic justification for this unfair tax treatment. It doesn’t increase jobs or productive investment. It does decrease the taxes of the wealthy investor class.

I would go beyond these reforms. There are several speculative practices that need to be simply outlawed. Most egregious is high frequency trading. Morgan Stanley says 84% of stock trades are done automatically by computers. HFT programs extract extremely small profits from transactions done in fractions of a second. Obviously, this can only be destructive to real investment. It is raw price speculation to make a quick buck at the expense of market stability.

Another purely speculative practice is selling “short.” This involves borrowing shares of stock, “selling” what you don’t own to bet on a price decline, and then buying back the shares at a lower price to make a “profit.” This only makes money for the few at the expense of market stability. Borrowing to speculate in any asset market should be illegal. People should gamble with their own money.

Why do we allow Wall Street gambling and criminality to dominate, and often crash, the real economy? I don’t know. But, if changes are not made you can bet it will happen again.