Mon, Jul 30, 2007 - Page 9 News List

The spreading fear of finance

By J. Bradford Delong

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.

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