The Road to Recovery: How and Why Economic Policy Must Change

6

The Particular Problem of Finance and Banking

The authors of the New York Fed's paper point out: “Financial firms seem particularly prone to lavish convex compensation practices. We are reminded of the financial crises surrounding the collapse of LTCM. In the year preceding its bankruptcy, the partners took the deliberate decision to reduce the firm's capital, as a device for maximising returns.”¹ The fact that the distortions of the bonus culture are particularly acute with regard to financial companies aggravates the way in which business has sought to increase its cash flow. This is because financial companies are not likely to invest heavily in new physical equipment, even if they are exceptionally profitable. As I show in Chart 50, their share of business output is much higher than their share of business investment.

Chart 50. US: Financial and Non-financial Investment & Output.Sources: Federal Reserve Z1 Tables F.101 & F.107 & NIPA Table 1.14.

The problem for the economy that has arisen because of the rise in the cash flow of the business sector comes from the combination of higher profit margins and lower investment spending. Since financial companies invest less, relative to their output, than non-financial companies do, the problem is magnified if finance becomes relatively more important and, as Chart 51 illustrates, this is exactly what has occurred.

Chart 51. US: Financial ...