Mon, Jul 30, 2007 page9

• The spreading fear of finance

  Eighteenth-century physiocrats believed only farmers were productive; Marxists thought so about workers. Both are wrong

  • By J. Bradford Delong
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  Fear of finance is on the march. Distrust of people with high salaries who work behind computer screens doing something that doesn't look like productive work is everywhere. Paper shufflers are doing better than producers; speculators are doing better than managers; traders are doing better than entrepreneurs; arbitrageurs are doing better than accumulators; the clever are doing better than the solid; and behind all of it, the financial market is more powerful than the state.

  Common opinion suggests that this state of affairs is unjust. As US president Franklin D. Roosevelt put it, we must cast down the "money changers" from their "high seats in the temple of our civilization."

  We must "restore the ancient truths" that growing, making, managing and inventing things should have higher status, more honor and greater rewards than whatever it is that financiers do.

  Of course, there is a lot to fear in modern global finance. Its scale is staggering. This year alone mergers and acquisitions will amount to US$4 trillion, with tradable and -- theoretically -- liquid financial assets perhaps reaching US$160 trillion by the end of this year, all in a world where annual global GDP is perhaps US$50 trillion.

  The McKinsey Global Institute recently estimated that world financial assets today are more than three times world GDP -- triple the ratio in 1980, and up from only two-thirds of world GDP after World War II. And then there are the numbers that sound very large and are hard to interpret: US$300 trillion in "derivative" securities; US$3 trillion managed by 12,000 global "hedge funds;" US$1.2 trillion a year in "private equity."

  But important things are created in our modern global financial system, both positive and negative. Consider the US$4 trillion of mergers and acquisitions this year, as companies acquire and spin off branches and divisions in the hope of gaining synergies or market power or better management.

  Owners who sell these assets will gain roughly US$800 billion relative to the pre-merger value of their assets. The shareholders of the companies that buy will lose roughly US$300 billion in market value, as markets interpret the acquisition as a signal that managers are exuberant and uncontrolled empire-builders rather than flinty-eyed trustees maximizing payouts to investors. This US$300 billion is a tax that shareholders of growing companies think is worth paying -- or perhaps cannot find a way to avoid paying -- for energetic corporate executives.

  Where does the net gain of roughly US$500 billion in global market value come from? We don't know. Some of it is a destructive transfer from consumers to shareholders as corporations gain more monopoly power, some of it is an improvement in efficiency from better management and more appropriately scaled operations, and some of it is overpayment by those who become irrationally exuberant when companies get their names in the news.

  If each of these factors accounts for one-third of the net gain, several conclusions follow. First, once we look outside transfers within the financial sector, the total global effects of this chunk of finance is a gain of perhaps US$340 billion in increased real shareholder value from higher expected future profits. A loss of US$170 billion can be attributed to future real wages, for households will find themselves paying higher margins to companies with more market power. The net gain is thus US$170 billion of added social value this year, which is 0.3 percent of world GDP, equal to the average product of seven million workers.

  In one sense, we should be grateful for our hard-working merger and acquisition technicians, well-paid as they are: it is important that businesses with lousy managements or that operate inefficiently be under pressure from those who may do better, and can raise the money to attempt to do so. We cannot rely on shareholder democracy as our only system of corporate control.

  The second conclusion is that the gross gains -- fees, trading profits, and capital gains to the winners totaling perhaps US$800 billion from this year's mergers and acquisitions -- greatly exceed the perhaps US$170 billion in net gains. Governments have a very important educational, admonitory and regulatory role to play: People should know the risks and probabilities, for they may wind up among losers of the other US$630 billion. So far there is little sign that they do.

  Finally, finance has long had an interest in stable monopolies and oligopolies with high profit margins, while the public has an interest in competitive markets with low margins. The more skeptical you are of the ability of government-run antitrust policy to offset the monopoly power-increasing effects of mergers and acquisitions, the more you should seek other sources of countervailing power -- which means progressive income taxation -- to offset any upward leap in income inequality.

  Eighteenth-century physiocrats believed that only the farmer was productive, and that everyone else was somehow cheating the farmers out of their fair share. Twentieth-century Marxists thought the same thing about factory workers.

  Both were wrong. Let us regulate our financial markets so that outsiders who invest are not sheared. But let us not make the mistake of fearing finance too much.

  J. Bradford DeLong is a professor of economics at the University of California at Berkeley and was assistant US Treasury secretary during the Clinton administration.

  Copyright: Project Syndicate
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