Why is global finance so profitable ?

by John Quiggin on May 9, 2016

In a recent post, I asserted that

activities like tax avoidance/evasion and regulatory arbitrage aren’t peripheral flaws in a financial system primarily concerned with the efficient global allocation of capital. They are the core business, without which the profits of the global financial sector would be a tiny fraction of the $1 trillion or so now reaped annually
As I’m working on income distribution issues my long-running book project, this seems like a good time to see if this claim can be backed up by hard numbers.

First up, here’s my source for the $1 trillion number (actually $920 billion). As a plausibility check, I’ve tried to estimate the total size of the global financial sector. Various sources, including Wikipedia estimate that the banking and insurance sector accounts for 7-8 per cent of US gross product. Extrapolating to world gross product of about $80 trillion that would give around $6 trillion for the total size of the sector. The US is almost certainly more financialised than the world as a whole. Still, the profit number looks about right. A trickier question is whether the rents accruing to managers and top professional in the sector should be counted as part of profits. I’d guess that these rents account for at least another $1 trillion, but I have no real idea how to test this – suggestions welcome.

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.

Tax evasion by wealthy individuals is only a small part of the story. Legal tax avoidance is almost certainly more important. Most of that involves companies, but it’s important to distinguish between “close” corporations, which hide the activities of an individual or family and large global corporations. I don’t have any idea how to measure the cost of avoidance through close corporations. 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 . Extrapolating to the world as a whole, that would be at least $500 billion. Again, assuming the financial sector creams off half of the sum, we get $250 billion (the fact that the finance sector itself accounts for around 40 per cent of all corporate profits means there’s a problem of recursion that I haven’t worked through)

Then there’s manipulation of exchange rate and bond markets. I have no idea how to measure this, but given that the notional volume of trade in some of the markets concerned is measured in the hundreds of trillions, it seems plausible that the profits and rents from market-rigging must be at least in the tens of billions.

These are probably the biggest scams, but there’s also regulatory arbitrage, privatization (a huge source of rent over recent decades), domestic tax avoidance and more.

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.

There’s lots of potential error around these numbers, but the order of magnitude seems reasonable to me. As against the claim that the explosion in financial sector activity and profits over the past 40 years has been driven by the benefits of a more efficient allocation of capital by rational markets, the claim that it’s all about tax-dodging and socially unproductive arbitrage seems pretty plausible.

Obviously, the social cost of a financial system devoted to undermining tax and regulatory systems far exceeds the profits earned from the activity. That’s true of any kind of socially destructive, but privately profitable, activity. But the problem is greater in the case of financial sector activity because of the disastrous effects of financial crises.

{ 110 comments }

1

David Blake 05.09.16 at 7:57 am

Very interesting. But I think you have to be careful abouT including FX and Bon trading, because much of the profit within that is simply shuffling from one financial firm to another.

2

Barry Cotter 05.09.16 at 8:12 am

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?

3

Werner Pisar 05.09.16 at 8:21 am

Well, i would argue to reach a minimum tax level on global scale. Any effected tax payment in the Country X for any part of claimed Corporate Income to be aggregated and balanced against Tax Rate in Country of Residence. Obviously none of the Tax Heavens allowed to “refund” taxed from other Countries.

4

J-D 05.09.16 at 8:21 am

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.

5

Collin Street 05.09.16 at 8:23 am

You’re only counting half the impact: once the money’s been laundered, it then goes out to join the global liquidity pool. If half of all the money moved into the high-end global finance system comes from criminal activities[1], then half the liquidity pool — and so half of even the “legitimate” finance profits — comes from and relies on whitewashed money.

[1] Of which “tax evasion” is merely the one with the best PR.

6

Howard Frant 05.09.16 at 8:55 am

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.

7

John Quiggin 05.09.16 at 9:24 am

@2 The effect of double taxation treaties has been that most corporate profits aren’t taxed at all, or are taxed only at absurdly low rates (see for example Double Irish. So, yes, I’m arguing for scrapping existing provisions, and replacing them with rules that ensure that profits are taxed at least once where they are actually accrued before they can get any reduction in liability anywhere else.

8

John Quiggin 05.09.16 at 9:28 am

” One of us is missing something.”

Yes, rereading the OP might help in that respect.

9

Anon. 05.09.16 at 9:34 am

If we increased competition in the financial sector (and the only real way to do that is by eliminating tons of compliance overhead), we could probably get significant efficiency savings and eliminate rents. Tax avoiders would get to keep far more of their money, so it’s a win-win!

10

Collin Street 05.09.16 at 9:34 am

@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.

11

bjk 05.09.16 at 9:38 am

Is profitable really the word you’re looking for? In comparisons of ROE across sectors, banking almost always comes in near the bottom. GDP is not “Gross Domestic Profit” either, so looking at finance as a proportion of GDP is not answering the “why so profitable?” question.

12

reason 05.09.16 at 10:01 am

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.

13

bjk 05.09.16 at 10:10 am

Well the OP wants to include salaries in profits so he has an unconventional view of profits.

14

David 05.09.16 at 11:42 am

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 ….

15

dsquared 05.09.16 at 11:42 am

As Fermi estimates I wouldn’t quibble, but the technique of “assuming half” seems to be giving answers which imply much higher overall profitability of the banking industry than I recognise. For example, two per cent on a wealth management account would be about double current pricing for the whole thing (including the value of the legitimate services provided). And for forex, my guesstimate would go…

World daily turnover is ~5trn. Of this, 90% is between financial institutions, so the relevant basis is 500bn. Average bid ask spread is probably no more than 2.5bp, so total average revenue is 125m/day. Multiply by 250 working days and you have total annual revenue (not profit) for the whole fx industry of around USD30bn. This seems right to me based on what I know about market shares and profitability. The proportion of that which was attributable to market manipulation would be much smaller – one of the shocking things about the legal documents and judgements which I read was how little the banks earned. In the case of LIBOR, the “IB” stands for “interbank”; the profits were for the most part made at the expense of other financial institutions outside the cartel.

16

OneEyedMan 05.09.16 at 12:07 pm

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?

17

Anders 05.09.16 at 12:25 pm

JQ ought to specify whether he is interested in profit margin or absolute share of total profitability.

The “a little under 2%” reference presumably treats $100bn as profit and $6bn as revenue, but the “7-8% of gross product” is presumably referring to FIRE sector gross value added, which is analogous to EBITDA, so it’s not an appropriate ‘top line’ figure.

I’d recommend JQ look at FIRE sector value added as a % of GDP, as there is plenty of data on that eg here: http://www.people.hbs.edu/dscharfstein/Growth_of_Finance_JEP.pdf

18

SamChevre 05.09.16 at 1:32 pm

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).

19

Trader Joe 05.09.16 at 2:31 pm

Why not simply assume that the public markets have already done the work for you and tally up the Market Cap of the 20 largest global banks – all are publicly traded. If the market valuations are anywhere near efficient you can then discount that valuation to arrive at something like an annual contribution.

That figure can then be adjusted for whatever share you think the 20 largest banks constitute – which is maybe 3/4 globally. At a minimum this approach could be a check-sum against your bottom up analysis – which feels a little high (as noted by DD) but not order of magnitude high, just a little fat.

In deciding about comp ratios – you need to consider the difference between regular and incentive comp. Total comp ratios at large investment banks like Goldman or JPM tend to run around 1/3 of revenues with an incentive accural baked into that total. For more conventional banks like maybe Wells Fargo the comp ratio is higher since they have a lot more employees, but a lot less of it is the sort of incentive comp you might like to add into your figure.

20

bjk 05.09.16 at 2:58 pm

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.

21

RNB 05.09.16 at 3:02 pm

From the FT review of John Kay’s Other People’s Money:

‘One core problem is the insularity of the sector. A drive through the Wall Street canyons or the City of London leads Kay to ask, “But what do these people do?” His answer: “To an extent that staggers the imagination, they deal with each other.” Kay states that only about 3 per cent of British bank assets are loans to entities engaged in the production of goods and services. Most of the rest are loans to other banks. The primary business activity of large banks is no longer financing growth in the real economy but “exchanging bits of paper” with their peers, sometimes cutting the paper into different shapes in the name of “innovation”.

Some argue that passing these bits of paper back and forth is a valuable economic activity. According to this view, financial innovation and active trading lead to liquidity and transparency — in short, to a well-functioning market in which participants can observe prices and buy and sell at low cost. Kay doesn’t buy it: who actually needs a high level of liquidity? Why, traders, of course. According to Kay, traders trading bits of paper make things easier for other traders trading bits of paper but do little to support the real economy.

Another core problem, according to Kay, is that profits in the sector are increasingly generated by self-serving antics such as fiscal arbitrage (tax games), regulatory arbitrage (loophole games) and accounting arbitrage (reporting games). These games are profitable to banks but costly to the rest of us: authorities spend public resources trying to catch up with the antics while resources within the guild (particularly our most talented university graduates) are diverted from the core traditional value-creating activities of banking.’

22

Trader Joe 05.09.16 at 3:24 pm

@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.

23

Anders 05.09.16 at 4:11 pm

JQ – suggest you look at Thomas Philippon’s work on the unit cost of financial intermediation. I suspect that this is at least as relevant to the growing GDP share that the financial sector captures, as tax (avoidance / evasion).

http://pages.stern.nyu.edu/~tphilipp/papers/Finance_Efficiency.pdf

24

Plume 05.09.16 at 4:21 pm

“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.

25

bruce wilder 05.09.16 at 5:24 pm

There’s also straightforward usury — payday lending, credit card revolving credit, and various forms of debt peonage ranging from the court-fee scams of Ferguson MO to the brick kilns of Pakistan.

26

The Raven 05.09.16 at 5:25 pm

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.

27

bruce wilder 05.09.16 at 5:34 pm

Relative wage in the financial sector would be an indicator of relative “power”.

Phillipon’s work.

Framing the problem as “the efficient global allocation of capital” may not be the wisest first move, but one should not overlook the distorting effects of paying high wages in the financial sector itself, and drawing the best and the brightest into such predatory and parasitic activity.

28

James Wimberley 05.09.16 at 6:01 pm

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.

29

James Wimberley 05.09.16 at 6:24 pm

Is it fair to include insurance? It’s (very largely) a legitimate business with a clear social justification. It doesn’t create money, and outside life insurance, isn’t even a real financial intermediary. For practical reasons, insurance has to be carried out in financial centres close to real customers. Nobody insures their car in the Virgin Islands. Insurance policies are rarely traded. I suppose there is room for tax evasion through reinsurance, classifying other operations deceptively as insurance, and artificial corporate structures.

30

hix 05.09.16 at 6:30 pm

“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).

31

Rich Puchalsky 05.09.16 at 7:30 pm

James Wimberley: “Is it fair to include insurance? It’s (very largely) a legitimate business”

It’s a legitimate business by the standards of the financial industry, but I’m not sure how much it would be in most other industries. For most purposes, insurance has to be social insurance, or is best done as social insurance — for instance, in the U.S. you are required to have insurance in order to drive a car. But if you’re required to have insurance, then there’s no particular reason why it has to be private insurance except for the intermediary to rake off some funds that the state presumably wouldn’t rake off. Same for medical insurance, most home insurance, and really life insurance — in other words, most forms of insurance that ordinary people come in contact with.

The exceptions would be things like insurance on businesses. For those, the predatory financial sector is busily destroying the actual financial sector. For instance, this kind of insurance depends on re-insurance: the insurer can’t hold enough reserves to cover a widespread natural disaster in its area, so it goes to a reinsurance company like Munich Re or Swiss Re. And those companies are really, really concerned about global warming, because that affects the chance of widespread disasters unpredictably and may make some areas effectively uninsurable. And a lot of that problem is because the financial sector did a mixture of defending its clients and proposing solutions that had no mass political base behind them.

32

Trader Joe 05.09.16 at 8:06 pm

@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.

33

Howard Frant 05.09.16 at 10:00 pm

John Quiggin @8
“” One of us is missing something.”

Yes, rereading the OP might help in that respect.”

I reread it many times. Are you going to help me out, or just be snide?

Collin Street @10

My mystification deepens. You spent a lot of electrons telling me that it’s possible I’m wrong. I never doubted that. I said, “One of us is missing something.” If you know that it’s me, then you could have explained my error in much less space than you spent not explaining it and lecturing me on epistemology.

To repeat my question: JQ says that global profits from finance are around a trillion dollars, and provides a link. Me: That’s a little more than 1% of gross world product. Is it likely that that this is a key contributor to global inequality? Seems like a reasonable question to me.

I also raised a question about JQ’s seeming conflation of “socially unproductive” and “scam.” One could have socially unproductive acts that are completely open and honest. That doesn’t make them socially productive. Both concepts may be worthy of attention, but they should be kept separate analytically.

Finally (and this may be a bit OT) I pointed out that calling something “socially unproductive” or “rent-seeking” is not the end of the story. Probably all competitive activities (making cars, say) have a zero-sum component, but it doesn’t follow that monopoly is better.

I, your obedient servant, humbly beseech enlightenment.

34

J-D 05.09.16 at 11:31 pm

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?

35

John Quiggin 05.09.16 at 11:33 pm

@34 The OP the total size of the financial sector at around 7 per cent of world product, which is $6 trillion. If this is largely devoted to unproductive activities, that’s a big problem.

Similarly the OP estimated the total of profits and rents at $2 trillion. If a large proportion of this is going to facilitate tax evasion and so on, the total loss to the rest of the community includes not only the profits and rents but the amount gained by the tax dodgers, and the costs of capital misallocation on top of this.

Finally, as I added later, but as you’ve had the chance to read, there is the cost of effects like major financial crises.

Hopefully, this is somewhat enlightening.

36

John Quiggin 05.09.16 at 11:35 pm

The triggering event for the GFC was the collapse of AIG, so insurance is certainly part of the story. But I agree, it would be better to have more fine-grained data. If I get time, I’ll look for it.

37

Tabasco 05.10.16 at 12:40 am

Much of this tax problem. like much else, is due to the half-baked structure and governance of the EU. On the one hand, because the EU members like to think of themselves as one big family, all free flow of capital, goods and people (just like the United States!), there is no withholding tax levied by the Irish (or any other EU) government on profits earned by French companies that are resident (read: have an office in, staffed by one intern) in Ireland. The Irish give these companies a wink and a nod and say “come to us and defraud your own government as much as you like and we’ll take a small slice”. It is pure beggar-thy-neighbor behavior, but the Irish (or Dutch or Luxembourgers) don’t care. In fact they could argue, with some justification, that the EU rhetoric and economic policy, not to mention subsidies, encourages them to act as they do.

If there was a European federal government, none of this intra-EU beggaring thy neighbor would matter, because it could tax the companies federally and distribute the proceeds as it saw fit. But there is no European federal government, and this makes all the difference, as it does with so much else.

What about Google, Apple etc? The problem is that they are not taxed by the US Government until and unless they bring the money back to the United States. So they don’t. They set themselves up in a European country that is beggaring-thy-neighbor, and fund their non-US operations using the cash they accumulate by not paying tax in Europe. It’s a great racket.

38

Ecrasez l'Infame 05.10.16 at 12:57 am

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.

39

Peter T 05.10.16 at 1:01 am

First

The rates of return look a bit high to me, but I won’t quibble with this as a rough estimate. It is, I think, helpful to keep at the front of mind the differences between turnover, wealth (stock of productive processes) and cash flow. As an illustrative instance, the drug trade (which I do know a bit about) has high turnover, practically zero wealth (very few assets) and high cash flow. Profits are high but kind of pointless unless you have the stamina to party continuously, as there is nowhere to put them. Much financial trading seems to have the same profile. Some kinds of money add up to a lot less wealth than other kinds.

Second

The question – why are profits so high? puts a certain frame around the issue. Is there some natural rate of profit, beyond whatever the market can be made to bear? If not, the issue is not whether finance sector profits are high, but why finance has become the favoured channel for rent extraction – using “rent” not as a pejorative but as the flow of resources to the upper levels of the social hierarchy. And why are the upper levels trying to extract so much via this channel?

40

david 05.10.16 at 1:31 am

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,

41

Jpe77 05.10.16 at 1:33 am

“Extrapolating to the world as a whole, that would be at least $500 billion.”

The US is fairly unusual in taxing worldwide income, so you probably shouldn’t extrapolate that. I don’t see why the finance sector would take much of that: the lawyers set the structure up and the flows are pretty automatic. Not a lot for banks to do (or make money off of)

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Cola Vaughan 05.10.16 at 1:35 am

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.

43

Ecrasez l'Infame 05.10.16 at 1:50 am

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.

The 2% is an ad valorem (fees charged over client funds), not a profit margin.

Profit is income less expense (the amount paid to set up the avoidance scheme, less the cost of doing so). Profit margin is profit over income. With 50% fees charged on the 200bn tax avoidance gain at a 2% profit margin the loss to the IRS is distributed: 100bn to the client, 2bn profit to bank shareholders, and 98bn bank expenses. I’d imagine the margin is actually higher, countered by the client getting a greater share of the tax gain – but I can’t see how tax avoidance can possibly make up much of that trillion bank profit.

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david 05.10.16 at 2:00 am

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.

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david 05.10.16 at 2:14 am

Uh, not sure what happened there.

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cassander 05.10.16 at 2:29 am

>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.

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awy 05.10.16 at 2:55 am

tax avoidance is pretty different from the core business of finance. to understand expansion of finance you should look at the various core businesses of finance in relation to the financial technology employed. in many situations the financial technology plays a dominant role in terms of competitiveness, but low or no welfare increase. as an example, complexity of dela structure enabled by finance laws can be a key advantage in choosing one financial center for your m&a operation over another. having a hedging strategy that dynamically takes into account the predominant hedging strat of the market is a very big advantage. etc etc. competition gain outweighs welfare gain in most of these.

there is also playing on global trend of concentration of wealth. rich people, corrupt or not, have low % of wealth as consumption and look to invest/buy stuff. when you have a lot of disposable money ‘seeking alpha’, there is a lot of competition for financial technology. this environment also has boom/bubbles that increase leverage demand etc.

of course traditional roles like providing capital for real investment and market making has its own path and positional dependent rents. but that is not explaining the development of modern finance.

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robotslave 05.10.16 at 8:13 am

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?

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Collin Street 05.10.16 at 8:51 am

My mystification deepens. You spent a lot of electrons telling me that it’s possible I’m wrong. I never doubted that. I said, “One of us is missing something.” If you know that it’s me, then you could have explained my error in much less space than you spent not explaining it and lecturing me on epistemology.

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. Remember: you can’t recognise your own mistakes while you’re making them. You can spot other people’s mistakes, but not your own, not until later. If there’s someone making a mistake and you can’t see it… well, odds are it’s you, innit.

“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. […] 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.”

If you still don’t understand this… well.

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Peter T 05.10.16 at 8:55 am

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.

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David 05.10.16 at 10:02 am

A useful reality check on some of these numbers is Peter Andreas and Kelly M Greenville, “Sex, Drugs and Body Counts: The Politics of Numbers in Global Crimes and Conflict”, especially Andreas’s own essay on illicit flows. The data is a little out of date now, but the message, “Nobody Knows Anything” is still valid.

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Ebenezer Scrooge 05.10.16 at 10:31 am

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.

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Ebenezer Scrooge 05.10.16 at 10:40 am

In totting up the spoils of financialization, I would look to credit derivatives, which are a pretty big chunk of profits. 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.

These products have several functions: none of them pleasant. They’re very useful for tax arbitrage. They are wonderful at concealing ownership information. They are excellent for playing predatory bankruptcy games, extracting wealth from less sophisticated creditors. They likely have other similar functions.

It’s important to note here that the banks are mostly intermediaries here, providing market liquidity through internal hedging operations. They make a nice little profit, but it is a typical risk intermediation operation of the sort banks have always done. The real beneficiaries are the hedge funds–the end-users of these things.

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Cranky Observer 05.10.16 at 11:30 am

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.

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Cassander 05.10.16 at 3:26 pm

@Cranky Observer

>There is absolutely no conceivable economic or social benefit to mankind from this kind of activity

There most certainly is. High speed trading increases market liquidity. It decreases the disproportionate market power of institutional investors like pension funds. Both of these result in markets that operate more smoothly and predictably, something that benefits everyone who owns any assets. You are fixating the method of competition and ignoring the results.

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merian 05.10.16 at 3:37 pm

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.

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Cranky Observer 05.10.16 at 3:43 pm

“Both of these result in markets that operate more smoothly and predictably, something that benefits everyone who owns any assets. “

Assumes facts not in evidence.

“High speed trading increases market liquidity”

If you want to argue that speeding up trades/clearances from months to weeks, from weeks to days, OK. From 1-3 days to an hour, perhaps. At 75 milliseconds the system has no relationship to allocating resources and resembles a casino.

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RNB 05.10.16 at 4:04 pm

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.

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bruce wilder 05.10.16 at 4:13 pm

Cassander @ 56: It decreases the disproportionate market power of institutional investors like pension funds.

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

Cassander @ 56: . . . these result in markets that operate more smoothly and predictably . . .

Except when they don’t. 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.

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T 05.10.16 at 4:14 pm

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

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Rich Puchalsky 05.10.16 at 4:19 pm

Ebenezer Scrooge: “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. “

As above, I think that certain activities are “legit activities” in that they seem to carry out a legitimate purpose, but are dodgy because of who is doing them. If the government built water suppling facilities for everyone, then decided that the private sector had to operate them and let the private sector do so and charge what the market would bear, providing water would be a legit activity, but the whole thing would be more than a bit dodgy.

In a similar way, most private insurance couldn’t really function without governmental services backstopping the private ones. Without both laws that force people to buy insurance (in the U.S.) and direct governmental provision of money and services to people without insurance who would otherwise need to be paid for and bankrupt the insurance companies, private insurance couldn’t really do what it does. So most of it is parasitic.

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bruce wilder 05.10.16 at 4:44 pm

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.

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James Wimberley 05.10.16 at 4:59 pm

Another footnote on insurance. If health insurance is included in the US financial sector, and public social insurance excluded elsewhere, this could seriously distort international comparisons. Administrative costs – the gross revenue of health insurers – are capped in the US, IIRC at 20% for ACA policies. If total health expenditures are 10% of GDP, that would give ballpark health insurance revenue of 2%. It’s certainly a massive amount, and not internationalised.

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bruce wilder 05.10.16 at 5:10 pm

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.

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SamChevre 05.10.16 at 5:20 pm

RNB @ 58

Thanks for the reference–this is a much more thoroughly worked out version of my suggestion from #18.

I’m taking it one step farther, though: I think finance profits have grown BECAUSE promoter’s profit has grown as a component of the economy.

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Howard Frant 05.10.16 at 5:37 pm

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.

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Brett Dunbar 05.10.16 at 6:00 pm

Ze K @ 62

Speculators make profits when an asset is mispriced. This tends to move the asset prices towards what they should be, by either increasing demand or supply. Correct asset pricing is generally beneficial.

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casssander 05.10.16 at 6:44 pm

@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

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Brett Dunbar 05.10.16 at 6:52 pm

For a bond that would be a price that didn’t reflect the actual expected pay out on maturity. A misprice is where the asset price doesn’t reflect the actual value of the thing.

Adam Smith discussed this in Wealth of Nations when talking about wheat speculators evening out demand following a bad harvest. By buying and storing wheat at the harvest they increase the price in the short term and sell late in the year lowering the price then. So rather than a normal prices at the start of the of the year and famine towards the end you have high but tolerable prices throughout. Wheat speculators were popularly viewed as villains profiting from misery Smith was being deliberately provocative by defending them.

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Brett Dunbar 05.10.16 at 7:35 pm

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.

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Bruce B. 05.10.16 at 8:33 pm

Could someone with better/more relevant research fu please confirm whether debt markets actually are more stable now than in days gone by?

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Brett Dunbar 05.10.16 at 8:40 pm

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.

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reason 05.10.16 at 9:11 pm

I’ve made this point before and nobody has kindly explained to me what is wrong with it, so I’ll try again. What we have definitely, indisputably seem in the last 30 years (well up until 2008 anyway) is a massive increase in leverage, and massive increase in all sorts of asset prices and massive fall in interest and yields. A lot of this is driven by exploiting irrationality in the tax system. It seems to me that when someone borrows a lot of money to buy an asset from somebody else to buy an asset which is then used as collateral, the bank is gaining defacto ownership of the asset and rents on that ownership. They also get liabilities, but those liabilities in a falling interest environment are cheap and getting cheaper (and besides will just sit there as they are for the most part government guaranteed). So why isn’t this flow of rents to the banking sector just a reflection of increasing leverage?

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reason 05.10.16 at 9:12 pm

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

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casssander 05.10.16 at 9:31 pm

@reason

>So why isn’t this flow of rents to the banking sector just a reflection of increasing leverage

A lot of it is. Debt is massively tax advantaged over all other forms of finance, so it makes sense that we see massive increases in debt and, consequently, in dealers and traders of debt.

@ bruce B

>Could someone with better/more relevant research fu please confirm whether debt markets actually are more stable now than in days gone by?

It’s called the great moderation: http://economistsview.typepad.com/.a/6a00d83451b33869e20120a75b191c970b-pi

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Howard Frant 05.10.16 at 9:43 pm

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.

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J-D 05.11.16 at 1:12 am

cassander @56

‘ It decreases the disproportionate market power of institutional investors like pension funds.’

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). It’s not clear to me, however, that there’s any way of establishing what level of market power for pension funds would be the ‘proportionate’ level of market power. I don’t grasp what (it is being supposed) the market power of pension funds should be proportionate to.

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Jestyn 05.11.16 at 7:13 am

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/

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reason 05.11.16 at 7:14 am

If cassander thinks I’m right, then I must be wrong – come on guys what is wrong with that story (P.S. I know that the finance industry now packages up the rent flows and sells them on, but it seems to me that is just bringing profits forward and reducing risk – the source of the revenue remains the same)?

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Howard Frant 05.11.16 at 7:20 am

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.

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Howard Frant 05.11.16 at 7:41 am

Better yet, why not drop it altogether and say, “…decreases the market power…”?

Which is not to say that the full claim seems plausible.

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T 05.11.16 at 6:13 pm

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

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bruce wilder 05.11.16 at 8:39 pm

JQ may well identify with Chris Dillow’s (stumbling and mumbling) sentiment: “Conventional economics is not only correct in some ways, but can serve a radical purpose.” But, anyone who starts out quoting Simon Wren-Lewis complaining of someone else’s mystifications does not deserve to be taken seriously. The Dillow post linked in the immediately preceding comment presents a grab bag of points sometimes made by economists, without any critical framework or acknowledgment that conventional economics has been complicit in financialization of the global economy. You don’t get to tout the efficient markets hypothesis as a lead-in to claims of endemic fraud. An effective economics is not a potpourri.

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John Quiggin 05.11.16 at 10:51 pm

“It’s called the great moderation”

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

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RNB 05.11.16 at 11:26 pm

@89 I learn a lot from Dillow’s blog. He’s really good at showing how a variety of widespread cognitive errors plays a huge role in economic dynamics, and in stabilizing class-riven societies. He says a lot of interesting things about how empirically valid parts of conventional economics really do a lot of damage to the overblown claims of money managers and CEO’s about their marginal productivity. He explains how power imbalances and information asymmetries affect outcomes. Granted it’s small stuff compared to the awesome insights we achieve here, but I still do recommend checking out his blog.

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RNB 05.11.16 at 11:27 pm

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.

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Peter T 05.12.16 at 12:36 am

One explanation for the shift to finance could be that it offers the only means of shifting future income (of students, mortgagees and so on) to the present. The future income may, of course, not materialise (in fact the shift itself often makes it more likely that it will not), but the present beneficiaries of the shift will not bear the loss if they play their cards right.

Why would the wealth-holders want to be so aggressive in pursuing this? One factor might be a mismatch between present incomes and elite expectations, due to higher relative growth of elites (Jack Goldstone offers this in explanation of C17 crises). Another might be a fall in the rate of growth of incomes from other sources. In the late C19, for instance, landowners hit by the fall in agricultural incomes turned to other sources – government office, imperial loan-sharking – to make up the difference. This latter is plausible, and would link to diminishing returns as environmental pressures slowly increase.

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cassander 05.12.16 at 4:29 am

>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.

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reason 05.12.16 at 8:47 am

Cassander – you are correct of course if all that matters is volatility. A slow up followed by a sudden down and slow recovery IS a great moderation. But good it isn’t.

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reason 05.12.16 at 8:49 am

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).

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reason 05.12.16 at 8:55 am

Oh and another component I almost forgot massive secular financial flows (otherwise called trade deficits). These made people think that the debt increases where incidental and not intrinsic because there were counter examples that always happened to be trade surplus countries.

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Dipper 05.12.16 at 11:30 am

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.

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Trader Joe 05.12.16 at 11:56 am

@77
“Could someone with better/more relevant research fu please confirm whether debt markets actually are more stable now than in days gone by?”

I can’t answer this with data, but as a practitioner I would say that ‘stable’ isn’t really the adjective that’s important….let me explain.

The main thing that’s changed in the last 10 years is market visibility – its far easier to see who has what and what inventory of bonds are available to buy and sell, at what prices (or spreads really) and at what size. The visibility to this information makes transactions easier to complete and accordingly makes the market depth and liquidity comparatively greater – that’s a positive thing in normal situations when markets are functioning smoothly. A bond only has value if it can be traded, a market with no liquidity isn’t really a market, its a museum.

That visibility is a disadvantage when markets are disrupted, usually due to some exogeneous market cause/perception. The visibility and market depth makes it a lot quicker for a lot of bonds to shift quickly and the price visibility encourages further volume to shift and so on until market depth is eliminated and bargin buyers begin to stabilize it.

If your sitting on a position that’s losing value, market depth allows you to get out and redploy that money to something else you find more attractive – visibility encourages activity which encourages more activity. Again, positive for markets reaching clearing prices, but negative in any given moment as the market works to find that clearing price.

Allow me an analogy. Imagine 1000 people standing up in a giant row boat, 500 people on a side. In the old days, all of these people were blindfolded and had ear-plugs so they relied on their other sense to decide whether they wanted to stand on the left or right side of the boat – when everyone had less information, a lot fewer people moved from side to side, but if they did, the other side of the boat was slower to react so imbalances could last longer – now, people are moving all the time which means there is a constant rock and sway, but equilibribum is restored a lot quicker.

Going back to the financial crisis – there were many cross-currents and the aforementioned visibility/market depth created as many problems as it solved – that said, in my opinion, the only reason the market reblanced itself as quickly as about 6 months is better visibility to price discovery and market depth which very quickly cleared out the losers and replaced the lost capital with new. If that wasn’t available, markets would have remained in tumoil for far, far longer.

Hope that helps.

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John Quiggin 05.12.16 at 10:01 pm

” If that wasn’t available, markets would have remained in tumoil for far, far longer.”

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.

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Bernard Yomtov 05.12.16 at 11:17 pm

JQ,

It’s not clear to me what you mean by the costs of legal tax avoidance. If my accountant does a better job than I would do in minimizing my taxes, legally, is the fee I pay him part of that cost? Or is the cost the extra amount I would have paid had I filled out the tax return myself?

In either case it seems to me that a chunk of this is just due to the complexity of tax codes. That complexity may be necessary, or desirable, or just unavoidable in modern economies. I don’t know. But if the complexity is there then dealing with it seems to be a legitimate service.

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Howard Frant 05.13.16 at 12:08 am

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.

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Bernard Yomtov 05.13.16 at 12:36 am

Howard,

Yes. I understand that.

I’m just asking what definition JQ is using, because it is not clear to me that it is the one you describe.

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J-D 05.13.16 at 12:53 am

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.

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Howard Frant 05.13.16 at 1:36 am

J-D @104

Can you explain this a little further? Is the distinction that one type results in an actual social cost from misallocation (i.e., not the legislatively intended allocation)? Or is it perceived as illegitimate to take advantage of things that other people can’t take advantage of?

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Bernard Yomtov 05.13.16 at 2:39 am

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.

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geo 05.13.16 at 3:40 am

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Sebastian H 05.13.16 at 3:56 am

“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.

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J-D 05.13.16 at 5:09 am

Howard Frant @105

I am sure that in specific instances there will be disagreement about what is legitimate and what is a rort. It isn’t necessary to establish that there is a universally agreed procedure/criterion (or even a generally agreed one) for distinguishing between the two categories in order to show that it’s a meaningful distinction for many people. If you want to describe particular cases to me and have me explain whether I think they’re legitimate, and why, I’m more than happy to do so, but the nature of my judgement of particular cases doesn’t affect the general point.

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J-D 05.13.16 at 5:11 am

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.

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dax 05.13.16 at 11:29 am

Some remarks:

1/ The article that JQ links to showing 920 B Usd in financial profits has a break-down by country. 292 B goes to China, 183 B goes to the US. So more than half in financial profits belong to the top 2 countries. Not knowing anything about the specificities of the Chinese banking sector, I can’t make any comment about how much of the banking sector’s profits are due to taxation issues. As to the US much of the banking sector’s profits come from rents: fees on checking accounts, fees for mortgages, etc. The US bank making the most profit – Wells Fargo – has a small investment bank footprint and is making the money the old-fashioned way – skimming it off on every legal financial operation it can. Sure, some of banking profit comes from tax avoidance, but the kind of tax avoidance JQ is thinking of – wealthy American individuals, international American corporations – doesn’t go through much American (or foreign) banks any more. Google, Apple, Facebook, Uber, Starbucks – the big American corporations – used lawyers not banks to set up their structures; the banks are only making money for secondary services, pretty much peanuts. Investment Banking M&A does – or did – make money on proposing inversions, but the big winners there were shareholders.

2/ “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 .” About a third of U.S. corporate sales revenue comes from overseas, matching pretty exactly that third of corporate profits. So that cost to the U.S. is (in general) fictional; it’s a cost only according to a bizarre idea that profit earned by an American company overseas belongs to the U.S. government, which it most certainly does not – the money belongs to the governments overseas.

3/ Surely the biggest American tax-avoidance scheme is the mortgage interest-rate deduction. Millions of Americans buy a house partly because they know they will be avoiding taxes. Another big one is charitable donations to non-profits, especially higher education.

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Trader Joe 05.13.16 at 11:29 am

@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.

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Bernard Yomtov 05.13.16 at 12:47 pm

J-D @106,

I apologize for misunderstanding your earlier comment.

Sebastian,

I don’t quite get yours either. Maybe I’m having a slow week.

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Dipper 05.13.16 at 1:16 pm

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

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James Bonilla 05.14.16 at 12:40 am

@OP (Original Poster): Part of the problem it is so difficult to change anything is that universities in America have become hedge fund dependent money management companies with an educational arm attached. Virtually, all decisions of Harvard Management Company is influenced by the financial imperatives of hedge fund management. This is true for all universities and it is true even at the level of business schools.

If one should look at the history of Harvard Business School, for instance, one could identify three phases- (1) the Kim Clark and pre-Clark phase, when HBS was relatively free of the venality and list for gilded endiwments;(2) the Jay Light phase where it took a turn for the worse; and (3) the Nitin Nohria phase where Nohria and his protégés act like complete assholes, not only in how they treat people but also in how venal they have allowed the system to be one.

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Sebastian H 05.15.16 at 12:47 am

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”.

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