Why is global finance so profitable ?

As regards global corporations, Zucman estimates that “a third of U.S. corporate profits, or $650 billion, are purportedly earned outside the country, with a cost to the US of $130 billion a year .

Are you arguing for double taxation of corporate profits, whereby profits earned outside the USA are taxed again when repatriated to the parent company in the USA?

Barry Cotter @2

No, he’s doing a bit of Fermi estimation.

For the purpose of Fermi estimation, the assumption is that one major reason that US corporations report profits as earned outside the country is that they have deliberately arranged their affairs that way in order to reduce their aggregate tax bills, which seems reasonable enough.

John Quiggin may in fact want to argue for a change in the tax arrangements for corporate profits — I don’t know — but that’s not what he’s doing here.

I’m not following you at all. You’re using $1 trillion as your estimate for total income of the finance sector, worldwide, most of which you say is wasteful. So what you’re saying is that a little over 1% of world output of $75 trillion) goes to the finance sector. Hard to see this as a big contributor to inequality. One of us is missing something.

Also, “socially unproductive” and “scam” are not the same thing. Finally, the fact that a particular activity has a big socially unproductive component does not logically imply that there’s a better way of doing things. Maybe the alternatives are worse. Maybe not.

@Howard: if you disagree with someone, then either there’s something you know that they don’t, or there’s something they know that you don’t.

Now. If you know something that I don’t, then you can imagine not knowing that something, and you can imagine the conclusions that that might lead to, possible conclusions that would include my conclusions. My conclusions would make sense to you, even if you disagree with them.

If I know something you don’t, though… you can’t imagine knowing that something. You’re not even aware of the possibility of knowing that something: “what if I knew this thing that I don’t even know is possible” isn’t a thought that it’s actually possible to think. You can’t understand someone’s thoughts if they’re acting on the basis of knowledge you don’t have, that much is obvious.

So. If someone has come to conclusions that you not only can’t agree with but can’t see any reason to believe, it pretty solidly means that that person is acting on the basis of things you’re not aware of.

That doesn’t mean they’re right. They could be acting on the basis of mistaken knowledge, things they know but that ain’t so. BUT. Most people are reasonably clever, and the average person is as clever as any other average person. And “reasonably clever” means that genuine true beliefs are more common than mistakes, no? Most people are more right than wrong, which means that correct beliefs are more common than false ones. And that means that if someone’s acting on the basis of knowledge/”knowledge” you don’t have — if someone’s making choices you not only don’t agree with but don’t understand — more likely than not, significantly more likely than not, it’s because they have true knowledge of which you are unaware.

If you don’t understand why people come to a conclusion they have, it is pretty likely that this is a result of ignorance on your part. And for me too: if people do things that I don’t understand, I look for reasons, and usually I find them. Sometimes I don’t. In those cases, I look, and sometimes I find a belief I can identify as false. More often, I find a belief I can identify as true which I then adopt and change my mind on [because people are right more often than not, and that even includes people other than me]. Not uncommonly, I can’t find either; usually in those cases I presume that it’s probably my error but not one I’m in a position to identify.

But the take-home message here is that not being able to understand a person’s motivations is a pretty big warning sign that your thinking on that topic has some holes.

bjk
Not sure that ROE is a good measure of anything these days. Banks have had to issue lots of equity because of regulators, whereas industrial companies often try to reduce equity and replace it with debt.

There’s a cost-effectiveness dimension to this as well, surely? in traditional commerce you had to actually buy and sell things, make products, employ people etc. Whilst you can’t entirely dispense with these tedious requirements in finance, it’s surely much more cost-effective to sell you clients entirely hypothetical financial products which exist only because you say they do (see Franco Berardi on this). But once you start doing that, then why not make the modest investment required to buy a few politicians in order to get the law changed, to enable you to “increase profits”? There’s no way that investment in plant, machinery, manufacturing processes, training etc. can improve profits in the way that playing the tax system, changing laws or taking advantage of accounting tricks can. Which is why the finance industry tends ineluctably to crime, since in the end the easiest way of getting money is to steal it, and the greatest rewards are for those with the least ethical scruples. But then arguably crime is just economic activity that hasn’t been deregulated yet ….

The OP says “A trickier question is whether the rents accruing to managers and top professional in the sector should be counted as part of profits.” Shouldn’t finance’s share of GDP = returns on capital + returns on labor in the financial sector and therefore shouldn’t this already be in the the industry’s share of GDP?

I’ve been thinking about this question since the earlier post, and have a considerably different point of view.

You can think of an economy as two kinds of thing: one is a stream of consumable products, two is the value of those future streams of consumable products (AKA “prospective capital”).

In my model, the key thing the finance industry has done, over the past 50 years, is try to increase two for a given value of one. This makes local sense: in any case, it’s to an owner’s short-term advantage to have their house/store/copyright more valuable. However, the social effects are much more mixed: as everyone tries to maximize the value of future product streams, the value of profit streams increases pretty much without limits, and entry gets more and more difficult. You can see this dynamic across the economy–house prices, stock prices, copyright values. The finance industry enables this dynamic, and profits from it, but it isn’t the underlying driver.

I also think that (a) the tax system for corporate profits is a mess and (b) I don’t see why profits from phone manufactured in China and sold in Japan, with the profits earned by a US company’s Hong Kong sub, would be naturally taxed in the US. (I’ve proposed taxing corporate profits on a GAAP basis, net of dividends, proportionally by proportion of sales).

TJ, if you did that, finance would have a negative contribution because the banks are in many cases trading below tangible book value. That’s why I say it’s impossible to look at revenues or profit margins, you have to look at return on equity. The banks earn very poor returns on equity ie they are highly unprofitable.

@20 bjk
I think you’re mixing apples and pears.

Market cap tells me (in theory) the discounted value of all expected future cash flows of a business. Book value tells me the accumulated value net value of all histocial cash flows – operating, financing and investing.

Yes, one can compare the two values and decide that the value of future cash flows is less than the value of liquidating the existing business (as you have done). But that doesn’t mean that all future cash flows are either not valuable or unprofitable – as an investment you may believe they are less valuable than alternative uses, but compound cash flows, particularly when done on mult-hundred billion$ asset bases, is an incredible source of wealth creation.

When you say they make poor ROEs what you are comparing that to? Banks are among the most profitable businesses ever created (extractive and addictive industries are the only ones better). There are not many businesses that routinely and annually produce 10 figure earnings numbers for their shareholders – and which could be more but for the amounts paid to employees (some of whom well deserve it and others whom do not). Don’t lose sight of scale. Its easier to make a 15% ROE on $1 billion than on $100 billion, but a 2% ROE is still way more actual earnings.

“Is tax avoidance/evasion and regulatory arbitrage a big enough activity to account for a substantial share of a trillion dollars a year? Gabriel Zucman estimates that there’s $7.5 trillion stashed in tax havens, of which around $6 trillion is untaxed. He estimates the tax avoided at $200 billion . I’ll estimate that half of that ($100 billion) is creamed off in financial sector, mostly as profits or rents. That implies a profit margin of a bit under 2 per cent, which seems reasonable.”

Further along in your OP, it appears you’re contradicting these numbers. Or is the point just to show various estimates? Because that 200 billion seems very, very low, if the figure of 6 trillion “untaxed” is correct. Even at just 10%, that would be an additional 600 billion, not 200 billion, and that 10% figure would likely be far lower than any nation’s actually tax percentage.

Also, am a bit confused by the concept of the tax haven itself, as used in the OP, as the total differs from the untaxed amount. I would have thought a “tax haven” meant that 100% (7.5 trillion) would escape taxation, at least temporarily.

Perhaps, however, the best way to escape all of this is to get rid of all corporate and business taxes, and switch them to personal income, only, while rewriting the rules to include all income. From anysource. And dramatically increase this for the wealthy, make it far more “progressive,” and as difficult to game as humanly possible. Radically increase the tiers as well. Modernize and update to match the ginormous increases in personal wealth, etc. A top rate of 400K (America), for example, is absurd, given the fact that people earn billions per year.

I think Akerlof and Shiller’s idea of a fraud equilibrium is relevant here; fraud as a kind of product of the current global financial system.

dsquared@15: well, you would know. My sense is that the product of the system is not wealth in the usual sense but rather power; the power that comes from a highly unequal distribution of wealth and income. There ought to be a way to measure this, some sort of index that expresses the relative “power” of individual and collective actors in a political economy.

Then again, maybe there is such at thing and this dilettante bird is just not aware of that work.

Can anybody explain why international tax reformers like the OECD are not pressing for unitary taxation of corporate profits (aka “formulary apportionment”)? It’s widely used inside the United States. The commonsense idea is that profits are fungible, so a decent accountant for a company active in multiple jurisdictions can easily shift them to the lowest-tax ones. So you look at less manipulable indicators of real economic activity – sales or value-added or payroll, or some combination – and allocate profits accordingly for tax purposes.

“For example, two per cent on a wealth management account would be about double current pricing for the whole thing”

Whats the assumption here? 4% real return and no additional costs beyond the visible 1% fee? While that wealth management stuff is outside my social circle, the last crap someone got sold there had 2 additional layers with similar costs as the headline rate (an fund wraped in an insurance containing only warrents issued by the seller).

@32 and @30
For property coverage, insurance is primarily financing activity. For both property and liability coverage, it is also a surety activity.

If you and I get in a car accident and I’m at fault, it might be I can pay to fix both cars or maybe not. Insurance provides a funding mechanism to handle the property portion of the loss. This is all based on the actuarial tables and actual loss histories across populations.

If we have an accident and you are seriously injured, the question is no longer whether I might or might not have the money to pay (few people would). What’s more important is that there is a responsible party legally obliged to pay. Absolutely there will be some hoops to jump through, but you have a far better of chance of actually seeing payment if there is an insurance company than if you had to settle it with an individual (they’d just declare bankruptcy and you’d get nothing).

These same analogies are true in commercial insurance. Only 25% of all insurance payouts are for property – 75% are for casualty/liability. This is a significant social function. The reason it works is time value of money. There is routinely some absolute profit on property coverage since the time between premium earnings and payout is short. Most companies don’t make much writing liability – they do so primarily to invest the premiums and make money on the money between underwriting, claim and collection.

Vis a vis JQs concerns about tax avoidance and regulatory arbitrage – its the reinsuance industry where you’d want to focus. That said, its only about 25% of the global P&C market and a much smaller portion of all insurance (aggregate capital of about $300B) – maybe worth considering, but the whole industry is about 1/3 the size of a top 20 bank.

Am I wrong in thinking that the Credit Default Swaps that played such a large part in bringing about the Global Financial Crisis were, in form, a kind of insurance?

Further along in your OP, it appears you’re contradicting these numbers. Or is the point just to show various estimates? Because that 200 billion seems very, very low, if the figure of 6 trillion “untaxed” is correct. Even at just 10%, that would be an additional 600 billion, not 200 billion, and that 10% figure would likely be far lower than any nation’s actually tax percentage.

The 6tn is capital, it’s usually income which is taxed. So 6tn capital at 10% interest = 600bn income at 33% tax = 200bn tax charge.

1. GDP is a flow, the Zucman $7.6t figure is a stock. His $190bn “revenue lost” figure is a flow, though.

2. The main problem in your argument is that you’re taking headline figures and speculating what could make them up, when you don’t really have to. Zucman’s figures are given here: http://gabriel-zucman.eu/hidden-wealth/

2b. Annually: 125bn income tax evasion, 55bn estate tax evasion, 10bn wealth tax evasion. So that gives you your corporate tax evasion figure. Fully 65bn is evading claims on static wealth.

2c. extrapolating from US figures is extremely dangerous. Zucman has Europe accounting for 41% of all revenue lost. His figures on Asia are atrocious (but afaik he acknowledges poor data).

2d. Russia, Canada,

If that $500 billion were converted to a measurement of distance by creating $10,000 “feet” comprised of some denomination of bills… maybe $5.00 bills? ; A seat of the pants calculation is the number of these “feet” would be sufficient to reach the @ 10,000 miles from New York to Sydney.

1. GDP is a flow, the Zucman $7.6t figure is a stock. His $190bn “revenue lost” figure is a flow, though.

2. The main problem in your argument is that you’re taking headline figures and speculating what could make them up, when you don’t really have to. Zucman’s figures are given here: http://gabriel-zucman.eu/hidden-wealth/

2b. Annually: 125bn income tax evasion, 55bn estate tax evasion, 10bn wealth tax evasion. So that gives you your corporate tax evasion figure. Fully 65bn is evading claims on static wealth.

2c. extrapolating from US figures is extremely dangerous. Zucman has Europe accounting for 41% of all revenue lost. His figures on Asia are atrocious (but afaik he acknowledges poor data).

2d. Russia and the Gulf States account for a large chunk of offshore wealth (about 1t), but legally lose 0 revenue from it. Africa and Latin America account for another 1.2t, but lose about 35bn – much more, proportionally, than Asia/US/Europe. Again, extrapolation is dangerous.

3. The claim that finance siphons/launders fully half of the evaded amount, if true, severely weakens the argument for pursuing tax havens, since that amounts to a ‘recovery’ of 50% of the lost revenue (albeit to other nationals in the developed world rather than the state fisc). Intuitively, the larger the degree to which finance intercepts the hidden flow, the weaker the argument.

3b. That being said, the problem is that of ~700bn US fin industry revenue, ~350bn appears to be from asset management (i.e., of acknowledged onshore wealth). About half of assets under management are institutional rather than retail. Aha, corporate activity at last! – but about two-thirds of that appears to be pensions and mutual funds. So, uh.

3c. there’s definitely a problem here, but eyeballing it, the problem appears to be a desire by these funds to seek “reverse maturity transformation” rather than, you know, what finance as an industry is supposed to do. A lot of money is going to asset managers to reduce risk, but risk has not been reduced. A post-Keynesian would be very happy to say more, maybe.

>These are probably the biggest scams, but there’s also regulatory arbitrage, privatization (a huge source of rent over recent decades),

not nearly as big a source of rents are nationalized companies were before being privatized.

>Adding them up, I’d suggest that $500 billion a year is a low-end estimate for the profits and rents associated with various forms of anti-social financial sector activity.

so, in other words. about one half of one percent of global GDP. That’s a pretty damned good rate of efficiency in my book.

All well and good, but not particularly useful for policymaking without data putting the issue in context with the rest of the problems the world faces.

How does your $500b figure compare, for example, to the total annual global profit taken from government corruption? From illegal drugs manufacture and distribution? From production of greenhouse gasses?

robotslave

The UN puts the illegals drug trades in the same ballpark for turnover – around $500 billion a year. But that’s turnover. And the bulk of that turnover is local deals for marijuana or similar. So if JQ’s estimate is anywhere near right, financial rents are a bigger deal by at least one order of magnitude – more probably two.

Wimberley@30:
I think you are a bit too Panglossian about insurance. Property and casualty insurance is a legit activity, but life insurance is more than a bit dodgy. There are a number of potentially honest life products: straight term and immediate annuities (i.e., purchased pensions) come to mind. But most life products are way too expensive for what they deliver, and largely priced with default by the insureds in mind. Much better to buy a mutual fund.

I wouldn’t count out Gresham’s law. Acquaintances spent the oughts moving the transaction processing systems of the Chicago commodities exchanges from downtown Chicago to as close as possible to the NYSE’s data center in New Jersey. Why? Because transactions executed from a computer on the same block could execute in 20 milliseconds compared to the 75 millisecond round trip for a data packet traveling from Chicago to New York/New Jersey. Of course it was a bit late since many of the NY-based firms had already located _their_ data centers in the immediately surrounding buildings where transaction times to NYSE were 12 milliseconds…

There is absolutely no conceivable economic or social benefit to mankind from this kind of activity (it takes a minimum of 2.208e+11 milliseconds to build a utility-scale solar power plant for example; whether the bonds financing it trade in 25 milliseconds or 3 days as they did up to 2000 is immaterial) but once one party starts doing it the others have no choice – and a lot of skimming money gets made while the “weaker” parties are eaten.

Colin Street @10:

Most people are reasonably clever, and the average person is as clever as any other average person. And “reasonably clever” means that genuine true beliefs are more common than mistakes, no? Most people are more right than wrong, which means that correct beliefs are more common than false ones.

Where does this come from? I’ve always been assuming that most people are ignorant about most things, and therefore my assumption is that most of us are at least partly wrong about most things. Your affirmation to the contrary is very surprising.

I have posted this idea about why finance is so profitable a couple times here before, in 2015 and 2011. Here it is again.

I am wondering what people make of the old the then Marxist Hilferding’s concept of promoters’ profit as a way to understand some financial sector activity.

Here’s his example, and I am trying to figure out to the extent that it throws light on the recent activity of Wall Street.

Start with an industrial firm with a capital of 1,000,000 marks that makes a profit of 150,000 marks with the average profit of 15 percent.

With an interest rate of 5% straight capitalization of income of 150,000 marks will have an estimated price of 3,000,000 marks (150,000/.05=3,000,000 marks)

A deduction of 20,000 marks for the various administration costs and directors fees would make the actual payment to shareholders 130,000 rather 150,000 marks

A risk premium of, say, 2% would be added to a fixed safe rate of interest of 5% in estimating the actual stock price

So what, then, is the stock price (130,000/.07)? 1,857,143 or roughly 1,900.000 marks

This 900,000 is free after deducting the initial investment of 1,000,000 marks

The balance of 900, 000 marks appears as promoters’ profit which arises from the conversion of profit-bearing capital into interest bearing capital.

In 1910, Hilferding called this promoters profit, an economic category sui generis; it is earned by the promoter by selling of stocks or the securitizing of income on the capital market.

For Hilferding the investment bank, which promotes the conversion of profit-bearing to interest-bearing capital, claims the promoters profit.

The analysis seems pertinent to the securitization process today.

As Roubini and Mihm have pointed out, we have seen the securitization of mortgages, consumer loans, student loans, auto loans, airplane leases, revenues from forests and mines, delinquent tax liens, radio tower loans, boat loans, state revenues, the royalties of rock bands!

We have seen, in their words, an explosion in the selling of future income of dependable projected revenue streams such as rents or interest payments on mortgage payments as securities.

That securitization been driven by investors’ quest for yield lift given the low rate of interest, itself the result of the global savings glut and Fed policy.

And it seems that Wall Street, with the connivance of the credit agencies, was able to appropriate value from the purchasers of securities by understating the risk premia.

The risk premium and promoters’ profit are inversely correlated (this is what I see as my contribution here) so there is a strong incentive to understate the former. This is what Hilferding did not say, but seems worth emphasizing today.

John —
This doesn’t count profits from private equity, family offices, etc. Seems the PE profits garnered from throwing off pension liabilities to gov’t/taxpayers is a form of regulatory arbitrage. And the returns to PE general partners from that $4T in PE investments has been called a bit of scam. The dumb money in all of this is from US pension funds where principal/agent problems are notorious. Finally, it’s worth to take a look at the rents embedded in financial sector labor compensation as you suggested.
http://www.nakedcapitalism.com/2016/05/smart-money-abandoning-private-equity-as-general-partners-warn-of-lower-returns-dumb-money-pours-in.html

RNB @ 58

Interesting.

Savings gluts are normal and functional financial intermediation is a dam that holds that back. Except all the money is made by intermediaries from the flow over the dam into toxic assets (aka assets with a negative present value). And, promoters who can best disguise the toxicity are highly rewarded.

JW: Administrative costs – the gross revenue of health insurers – are capped in the US, IIRC at 20% for ACA policies.

Of course, that’s a kind of soft cap on a headline number, while the deep issue is “bending the cost curve” — that is, whether ACA, as it evolves, will do anything to reduce medical service costs. The U.S., as is well known, spends roughly twice as much as any other developed country on health care and this cost inflation is due in part to the long practice of for-profit insurance.

Financialization has a similar effect as it spreads to other sectors. Vet services inflated over the last ten years. Dental procedures are inflating.

I don’t have any brilliant suggestions about how to measure this cost of financialization, beyond pointing out that it doesn’t make sense to ignore it, just because some salient headline number is out there to distract us.

John Quiggin@36:

Thanks. That was very helpful.

I’m still not sure, though, what number you’re trying find. Does the size of the profits/rents tell you anything, really, about the amount of unproductive effort? You could imagine a financial sector that has many productive people at the bottom who are insurance salesmen, real estate agents, bank tellers ,etc., with a small elite at the top that makes a lot of money and that that is the source of most the rents (and most of the systemic risk) but is relatively small fraction of the total real resources used. Are you more interested in Main Street or Wall Street?

Seemingly you’re more interested in Wall Street. But then (a) the $6 T is irrelevant unless you can show that most of it is Wall Street rather than Main Street (b) while $1 T certainly sounds like a scary number (cf. US Obamacare debate), you’re still open to the criticism that it’s about 1.2% of GWP.

@Ebenezer Scrooge

>. There is no simple microeconomic justification for these things. The industry usually tries to divert attention by pointing to things like airline fuel derivatives, which are much easier contracts to justify. But their defense for credit derivatives is the usual “sophisticated consenting parties” stuff. We saw how well that worked with asset securitization.

The secondary debt market is incredibly important to keeping debt markets stable. Such contracts achieve the same thing for debt that they do for other commodities.

@Bruce Wilder

>And, we don’t want pension funds to have “disproportionate market power” because . . . ??!?

Because if they do, they can use their size to manipulate the market.

>Except when they don’t.

that markets don’t always move smoothly is not evidence that certain practices haven’t made them them more smoothly than they would have otherwise been. That fertilizer improves crop yields is not disproven by the occasional bad harvest.

>And, in the meantime, “more smoothly and predictably” cui bono? might be a relevant question to ask. Your answer — a diffuse “everyone” — is simply not credible.

I didn’t say everyone. I said individuals that own assets. But that is perhaps over broad. It’s easier to to talk about those who don’t benefit. The people who lose are those who speculate the wrong way and those that profit from big market swings (both speculators and brokers). I suppose you could also include in that category the long holders who fortuitously buy/sell right before the big swing. Most people though benefit from from smooth, predictable markets where prices shift more slowly

Basically the expected pay out gives the asset a value that it ought to have in a rational market. For assets with a set maturity they will tend to converge on the rational value over the lifetime of the asset.

Most people are excessively risk averse so low risk asses are underpinned and high risk assets underpinned. This means that most of the time a useful investment strategy is to buy a wide variety of uncorrelated risky assets. Sociopaths tend to like risk, so they tend to be rather successful. The problems occur when a lot of risky investments go bad at once, for example they are unexpectedly correlated.

They reduce the difference between the what the price is and what the rational price ought to be. It is generally beneficial for assets to have the correct prices, this for example means that the price of credit reflects the risk.

oops – remove the second “to buy and asset”.

Collin Street@50

“Well, no. Beyond that, “if one of us must be wrong” and you don’t know who exactly it is, it’s pretty likely that it’s you.”

You can’t possibly be that naive, can you? Obviously what I was saying, using normal English euphemism, is that I thought JQ was wrong. Not only politely but realistically, I recognized that it could be that *I* was wrong. Apparently your claim is that anyone who thinks that is ipso facto probably wrong.

I don’t think I said anything about JQ’s motivations. I didn’t understand your motivations, and I accept the fact that my thinking on this topic has, as you said, some holes. In particular, I didn’t give adequate weight to the possibility that some people on this blog are simply trolls. This is a failure of imagination on my part; I can never imagine why someone would enjoy that.

I doubt that straight tax evasion support is that profitable – it’s a commodity business, part of why MossFon appear to have spent so little time on due diligence. Too big to fail is a much bigger subsidy

https://bankunderground.co.uk/2015/07/08/who-benefits-from-the-implicit-subsidy-to-too-big-to-fail-banks/

J-D@85

“Unless there is some way to give meaning to the concept of ‘proportionate market power’, the concept of ‘disproportionate market power’ is meaningless (and then so is this statement).”

How about if we replace the word “disproportionate” with “excessive”? Everyone OK with that? I don’t know how much hat is, but it’s discussable.

JQ —

You may find this post and the embedded links interesting if you haven’t seen it already. (It links to your post as well.)

http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2016/05/economics-vs-bankers.html

And I say this off top of my head, without checking his blog presently. I am sure that those who take the time will leave with other valuable insights in mind.

>John Quiggin 05.11.16 at 10:51 pm

>You are joking, right? Or did your timeline diverge from mine somewhere around 2008? That would explain a lot.

No, I just have a sense of history and can do math. The 2008 crunch doesn’t add anywhere near enough volatility to undo the trend. IF you’re going to mock, do it about things where I can’t be easily proven correct.

By the way the great moderation was NEVER possibly sustainable because it involved secular trends that couldn’t possibly continue (secular increased in debt ratios and secular falls in interest rates).

a very brave enterprise from Prof Q.

A counter argument is that from the 1980’s onwards the world has experienced significant growth and wealth creation. SE Asia is the most spectacular example but South America, and Sub-Saharan Africa have experienced significant increases in living standards. All this was made possible by the global financial system providing liquidity for trade to be spread, and developing financial instruments and markets that enabled risk to be spread and mitigated.

I would guess that many on here will dispute that, but can you prove it?

Secondly, Global finance may have made a lot of money but surely to prove it was ripping everyone off you would have to show that the return on capital was in excess of a global average for an extended period. Can you show that?

Finally , the suggestion that bond price and FX fixing in some way hunkered away hundreds of billions of dollars will be quite hard to prove. Judgements and fines have been for behaviour and lack of integrity and are punitive in nature, so you cannot interpret the fines as being measures of actual money made from fixing. There is very little in the way of hard numbers in any of the regulatory reports and one reason for that may be because the numbers are a lot less than the fines. The FCA have published examples on their web site of FX price fixing, and whilst the the behaviour is at the very least reprehensible and in at least one case criminal, its hard to conclude that the numbers involved are systemically significant. Furthermore, it may be possible to argue that the revenues from collusion and price fixing enabled the banks to offer tighter spreads than would otherwise be the case, and that eliminating collusions in fixings will result in a widening of spreads to replace the lost revenue.

Banking is being reshaped by regulators to eliminate the kind of behaviour in collusion and risk taking that is noted above. the industry is shifting substantially, so much of the commentary on the GFC is of historical, rather than present interest. Personally I think the changes are to be welcomed and could lead to a significantly more transparent and beneficial financial sector, but an obvious negative consequence is a possible decrease in liquidity, and give the primary purpose of financial markets is to provide liquidity this could prove to be a major global economic problem.

Personally Prof I think you are connecting too many things. FX spot traders colluding to make some money from fixings are not in a common enterprise with children of oligarchs hiding cash in tax havens. So you need to be a bit more forensic about a specific aspect of finance if you really want to make a lasting impact.

Bernard Yomtov

The standard social cost-benefit analysis would be that whatever money changes hands is not a cost, because what’s lost on one side is gained on the other. The costs are the resources used up, which is to say (aside from pencils, etc.) the labor of doing the taxes. So the idea is that if people spend more effort trying to squeeze extra money out of the tax code, that’s a real cost iin that s uses up real resources.

But compliance costs, not just avoidance costs, are real costs. The reason they’re not talking about them here, I presume, is that they’re just interested here in avoidance.

Bernard Yomtov @101

Many people are prepared to distinguish between, on the one hand, legitimately reducing the amount of tax you pay (for example, when a good accountant makes you aware of exemptions or deductions that you are entitled to claim but which might entirely have escaped your own attention) and, on the other hand, making artificial accounting arrangements entirely (or almost entirely) for the purpose of reducing the amount of tax payable, in a manner that is legal but nevertheless regarded (by many people) as reprehensible/illegitimate. Usually when people talk about ‘tax avoidance’ they’re making this kind of distinction and it’s the second kind of activity they have in mind and not the first: the first kind of activity is perceived as fairly making use of fair provisions in the law, while the second kind of activity is perceived as unfairly taking advantage of unintended effects of the law (in Australian English, a ‘rort’). I am fairly confident that when John Quiggin refers to the ‘cost’ of tax avoidance, he has in mind the total reduction in tax paid resulting from tax avoidance in this particular sense of the term.

J-D,

No doubt. But I am not actually trying to make any kind of point.

Instead, I am trying to understand how the costs referred to are defined, who is bearing them, and how they are measured. These things seem to me to be inadequately explained in the OP.

“Instead, I am trying to understand how the costs referred to are defined, who is bearing them, and how they are measured.”

I’m not entirely sure, but my sense is that for at least some of the costs Quiggin is treating it as completely dead weight loss. I.e. if an illegitimate transaction has ‘cost’ of $1 million to a financial institution, that can be subtracted from a profit/loss statement, but should not be subtracted from our calculation.

Bernard Yomtov @106

I am puzzled by your writing, in response to me, that you are ‘not actually trying to make any kind of point’. I didn’t intend to suggest that you were trying to make any kind of point. You asked for clarification of what John Quiggin had written and I did my best to provide some — at least, that’s how it appeared to me.

@100 JQ
“But real economies are still in turmoil a decade later, so the fact that markets have recovered and that the financial sector is as profitable as ever is not a good outcome.”

I’m not sure which economies you are speaking of that are in ‘turmoil’ in any classic sense of the word. I’d fully agree however that few economies are performing anywhere near their potential. While its likely this has something to do with financial markets, I’d be hard pressed to lay even the majority of the blame there.

I’d also posit that smoothly functioning financial markets would be a condition precedent to improvement in real economies as I can’t really think of any instances where a real economy came out of ‘turmoil’ but markets remained within them. For all their faults, of which there are many, bond markets in particular are amazingly efficient in anticipating economic growth.

why no mention of PPI? That’s quite big in the UK – £30 Billion and counting,

Bernard, I’ll try again, but please realize that I’m extrapolating from what JQ wrote so I may be confused.

I think he is suggesting something like the following

Imagine that there is some complicated transaction that is nearly devoid of social value. Imagine that it is very difficult to pull off for some reason such that doing it requires a vast set of skills and/or contacts that most people can’t do it.

Imagine that there is a division of a big banking firm that does this thing exclusively. It doesn’t really work like that, but we are talking about it that way so we can talk about the accounting of transactions with little or no social value. This division takes in $50 million to do the dubious transaction. However because the skills/contacts are tricky they end up having to pay $30 million in compensation to the five people in the division who can pull it off.

In a normal accounting of ‘profit’ you take the amount in, subtract the ‘costs’, and calculate the profit. Under that accounting the profit is $20 million.

But in terms of amount of money being paid in the support of this useless transaction the amount is more than $20 million. The amount of money paid to the well connected tricky bankers is just as much a part of the problem as the other $20 million.

So when you are thinking about the idea of finance being ridiculously profitable off of useless transactions, the normal ‘profit’ of the financial sector (ridiculously high as it is) doesn’t necessarily give you the true upper bound of the problem because the ridiculously high pay to people conducting the useless transactions is an additional part of the problem.

The same may also be true of physical costs–i.e. very high frequency trading outfits.

So for firms that have a high percentage of socially useless transactions, it is very possible that the amount of money going down the drain for these useless transactions is closer to their entire gross revenue rather than their net profits.

So the question “why is the finance sector so profitable” is a broader question than “what profits do finance sector businesses book at the end of the day”.