Why Wall Street Reform Should Hammer Bank Profits

Of the universal-policy-bloggers who occasionally wade into financial waters, Matt Yglesias is generally one of the best. But sometimes he's just flat wrong, and his post today [1] on financial profits is one of those times. Matt argues that looking to financial profits to measure the effectiveness of Wall Street reform is not a good idea, and he's missing the point. The good news is, Annie Lowrey wrote a great piece [2] explaining the current landscape surrounding Wall Street reform, one in which responsible policymakers understand that lower bank profits are an important sign of economic progress.

Here's the key passage [1] from Matt's blog:

"Much has been made, for example, of financial sector profits as a share of overall corporate profits. The numbers are sufficiently striking as probably constitute cause for alarm, but as a metric this is an odd one. If competition between cell phone carriers becomes more robust, leading to falling prices for consumers that’s a good thing. But since it implies smaller profits for Verizon and AT&T it means banking sector profits will rise as a share of overall profits. But who cares?"

This is silly. When people cite this statistic—and I'm one of the people who like to [3] do so—they're not comparing Citibank's profitability to Verizon's. They're comparing the entire financial sector to the entire corporate economy. The idea that innovations in corporate governance, technology and overall corporate efficiency could be applicable to the entire economy except finance should be extremely suspect. Many of these innovations should apply to corporations generally—whether they're banks or boat-manufacturers. Moreover, there is no reason to believe that literally every sector of the economy except finance has found a way to make itself more efficient over the past few decades, while finance has remained the same old bloated bureaucratic beast.

And if we look at the actual recent history of finance, we see that there have, in fact, been dozens of major financial innovations—but innovations that served to extract rents from other players in the economy. Finance, and banks in particular, figured out great ways of simply gobbling up other peoples' money. This didn't create new, better economic activity—it destroyed economic activity and converted it into bonuses for bankers and traders.

And you can measure this phenomenon by examining financial profits as a share of overall corporate profits. It's one way of analyzing the extent to which finance is cannibalizing the real economy. That problem is very significant, even if you ignore the fact that big banks need to be bailed out and create financial crises that have brutal effects on the broader economy. The crashes and bailouts are bad, but finance is eating jobs and converting them into bonuses without them. That's worse.

Matt also emphasizes the need for international coordination on financial reform. It's true to a point, but essentially meaningless so far as U.S. policy is concerned. Sure, if the U.S. adopts really tough Wall Street regulations, and the rest of the world doesn't, then reckless financial activity will move overseas. And eventually, financial excess elsewhere can create trouble here.

But financial recklessness abroad doesn't create the same kind or degree of economic fallout that financial excess at home does. It's bad for the U.S. if global credit markets freeze up because of a real estate bubble in France. It's much worse for the U.S. if global credit markets freeze up because millions of Americans are in foreclosure. "International cooperation" has become a lame excuse not to regulate finance at home, but we can only expect our friends abroad to be as stringent as we are here. If the U.S. continues to allow its banks to take on huge risks as taxpayers guarantee losses, then we're setting ourselves up for economic trouble—much worse economic trouble than we'd have if Europe alone was allowing financial excess.

Matt is commenting on Annie Lowrey's excellent write-up [2] of the Roosevelt Institute conference organized by finance blogger Mike Konczal [4]. Lowrey's piece is a superb summation of the event, and an excellent snapshot of where financial reform stands at this moment—both its enormous economic potential and its perilous political straits.

I'll have my own write-up on the conference tomorrow, but here's a quick summary: Getting Congress to pass any legislation reining in Wall Street was a major task, and the bill we got gives regulators several useful tools. The trouble is, it doesn't give regulators all of the tools, and the regulators who want to fix problems are about to get badgered to death by a Republican Congress that has already threatened to de-fund key parts of the legislation. We'll know if Wall Street reform works if bank profits decline for the right reasons-- not just because the economy sucks, but because banks aren't devouring other economic activity.

[5] [6]