Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He is a white-collar criminologist who has spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Originally published at New Deal 2.0


What exactly is the function of the financial sector in our society? Simply this: Its sole function is supplying capital efficiently to aid the real economy. The financial sector is a tool to help those that make real tools, not an end in itself. But five fatal flaws in the financial sector’s current structure have created a monster that drains the real economy, promotes fraud and corruption, threatens democracy, and causes recurrent, intensifying crises.

1. The financial sector harms the real economy.

Even when not in crisis, the financial sector harms the real economy. First, it is vastly too large. The finance sector is an intermediary — essentially a “middleman”. Like all middlemen, it should be as small as possible, while still being capable of accomplishing its mission. Otherwise it is inherently parasitical. Unfortunately, it is now vastly larger than necessary, dwarfing the real economy it is supposed to serve. Forty years ago, our real economy grew better with a financial sector that received one-twentieth as large a percentage of total profits (2%) than does the current financial sector (40%). The minimum measure of how much damage the bloated, grossly over-compensated finance sector causes to the real economy is this massive increase in the share of total national income wasted through the finance sector’s parasitism.

Second, the finance sector is worse than parasitic. In the title of his recent book, The Predator State, James Galbraith aptly names the problem. The financial sector functions as the sharp canines that the predator state uses to rend the nation. In addition to siphoning off capital for its own benefit, the finance sector misallocates the remaining capital in ways that harm the real economy in order to reward already-rich financial elites harming the nation. The facts are alarming:

• Corporate stock repurchases and grants of stock to officers have exceeded new capital raised by the U.S. capital markets this decade. That means that the capital markets decapitalize the real economy. Too often, they do so in order to enrich corrupt corporate insiders through accounting fraud or backdated stock options.

• The U.S. real economy suffers from critical shortages of employees with strong mathematical, engineering, and scientific backgrounds. Graduates in these three fields all too frequently choose careers in finance rather than the real economy because the financial sector provides far greater executive compensation. Individuals with these quantitative backgrounds work overwhelmingly in devising the kinds of financial models that were important contributors to the financial crisis. We take people that could be conducting the research & development work essential to the success of our real economy (including its success in becoming sustainable) and put them instead in financial sector activities where, because of that sector’s perverse incentives, they further damage both the financial sector and the real economy. Michael Moore makes this point in his latest film, Capitalism: A Love Story.

• The financial sector’s fixation on accounting earnings leads it to pressure U.S manufacturing and service firms to export jobs abroad, to deny capital to firms that are unionized, and to encourage firms to use foreign tax havens to evade paying U.S. taxes.

• It misallocates capital by creating recurrent financial bubbles. Instead of flowing to the places where it will be most useful to the real economy, capital gets directed to the investments that create the greatest fraudulent accounting gains. The financial sector is particularly prone to providing exceptional amounts of funds to what I call accounting “control frauds“. Control frauds are seemingly-legitimate entities used by the people that control them as a fraud “weapons.” In the financial sector, accounting frauds are the weapons of choice. Accounting control frauds are so attractive to lenders and investors because they produce record, guaranteed short-term accounting “profits.” They optimize by growing rapidly like other Ponzi schemes, making loans to borrowers unlikely to be able to repay them (once the bubble bursts), and engaging in extreme leverage. Unless there is effective regulation and prosecution, this misallocation creates an epidemic of accounting control fraud that hyper-inflates financial bubbles. The FBI began warning of an “epidemic” of mortgage fraud in its congressional testimony in September 2004. It also reports that 80% of mortgage fraud losses come when lender personnel are involved in the fraud. (The other 20% of the fraud would have been impossible had these fraudulent lenders not suborned their underwriting systems and their internal and external controls in order to maximize their growth of bad loans.)

• Because the financial sector cares almost exclusively about high accounting yields and “profits”, it misallocates capital away from firms and entrepreneurs that could best improve the real economy (e.g., by reducing short-term profits through funding the expensive research & development that can produce innovative goods and superior sustainability) and could best reduce poverty and inequality (e.g., through microcredit finance that would put the “Payday lenders” and predatory mortgage lenders out of business).

• It misallocates capital by securing enormous governmental subsidies for financial firms, particularly those that have the greatest political power and would otherwise fail due to incompetence and fraud.

2. The financial sector produces recurrent, intensifying economic crises here and abroad.

The current crisis is only the latest in a long list of economic crises caused by the financial sector. When it is not regulated and policed effectively, the financial sector produces and hyper-inflates bubbles that cause severe economic crises. The current crisis, absent massive, global governmental bailouts, would have caused the catastrophic failure of the global economy. The financial sector has become far more unstable since this crisis began and its members used their lobbying power to convince Congress to gimmick the accounting rules to hide their massive losses. Secretary Geithner has exacerbated the problem by declaring that the largest financial institutions are exempt from receivership regardless of their insolvency. These factors greatly increase the likelihood that these systemically dangerous institutions (SDIs) will cause a global financial crisis.

3. The financial sector’s predation is so extraordinary that it now drives the upper one percent of our nation’s income distribution and has driven much of the increase in our grotesque income inequality.

4. The financial sector’s predation and its leading role in committing and aiding and abetting accounting control fraud combine to:

• Corrupt financial elites and professionals, and

• Spur a rise in Social Darwinism in an attempt to justify the elites’ power and wealth. Accounting control frauds suborn accountants, attorneys, and appraisers and create what is known as a “Gresham’s dynamic” — a system in which bad money drives out good. When this dynamic occurs, honest professionals are pushed out and cheaters are allowed to prosper. Executive compensation has become so massive, so divorced from performance, and so perverse that it, too, creates a Gresham’s dynamic that encourages widespread accounting fraud by both financial firms and firms in the real economy.

As financial sector elites became obscenely wealthy through predation and fraud, their psychological incentives to embrace unhealthy, anti-democratic Social Darwinism surged. While they were, by any objective measure, the worst elements of the public, their sycophants in the media and the recipients of their political and charitable contributions worshiped them as heroic. Finance CEOs adopted and spread the myth that they were smarter, harder working, and more innovative than the rest of us. They repeated the story of how they rose to the top entirely through their own brilliance and willingness to embrace risk. All of their employees weren’t simply above average, they told us, but exceptional. They hated collectivism and adored Ayn Rand.

5. The CEOs of the largest financial firms are so powerful that they pose a critical risk to the financial sector, the real economy, and our democracy.

The CEOs can directly, through the firm, and by “bundling” contributions of its officers and employees, easily make enormous political contributions and use their PR firms and lobbyists to manipulate the media and public officials. The ability of the financial sector to block meaningful reform after bringing the world to the brink of a second great depression proves how exceptional its powers are to corrupt nearly every critical sector of American public and economic life. The five largest U.S. banks control roughly half of all bank assets. They use their political and financial power to provide themselves with competitive advantages that allow them to dominate smaller banks.

This excessive power was a major contributor to the ongoing crisis. Effective financial and securities regulation was anathema to the CEOs’ ideology (and the greatest danger to their frauds, wealth, and power) and they successfully set out to destroy it. That produced what criminologists refer to as a “criminogenic environment” (an atmosphere that breeds criminal activity) that prompted the epidemic of accounting control fraud that hyper-inflated the housing bubble.

The financial industry’s power and progressive corruption combined to produce the perfect white-collar crimes. They successfully lobbied politicians, for example, to legalize the obscenity of “dead peasants’ insurance” (in which an employer secretly takes out insurance on an employee and receives a windfall in the event of that person’s untimely death) that Michael Moore exposes in chilling detail. State legislatures changed the law to allow a pure tax scam to subsidize large corporations at the expense of their taxpayers.

Caution: Never Forget the Need to Fix the Real Economy

Economic reform efforts are focused almost entirely on fixing finance because the finance sector is so badly broken that it produces recurrent, intensifying crises. The latest crisis brought us to the point of global catastrophe, so the focus on finance is obviously rational. But the focus on finance carries a grave risk. Remember, the sole purpose of finance is to aid the real economy. Our ultimate focus needs to be on the real economy, which creates goods and services, our jobs, and our incomes. The real economy came off the rails at least three decades ago for the great majority of Americans.

We need to commit to fixing the real economy by guaranteeing that everyone willing to work can work and making the real economy sustainable rather than recurrently causing global environmental crises. We must not spend virtually all of our reform efforts on the finance sector and assume that if we solve its defects we will have solved the other fundamental reasons why the real economy has remained so dysfunctional for decades. We need to be work simultaneously to fix finance and the real economy.

Category: Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

9 Responses to “How the Servant Became a Predator: Finance’s Five Fatal Flaws”

  1. eightnineEmous says:

    We take people that could be conducting the research & development work essential to the success of our real economy

    We don’t have a shortage of engineers, mathematicians, etc; we have a shortage of R&D.

    If engineers were in short supply their salaries would be rising, unemployment rates would be down around 2%, and experienced techies wouldn’t be put to pasture after the age of 40. But tech salaries have been very stable for years now, the unemployment rate is right around national averages, and keeping a job in tech after the age of 40 is a tricky proposition.

    Expanding R&D budgets would increase demand for tech, boost salaries, and provide an incentive for college grads to pursue careers in tech, which is exactly what we saw in the late 90′s.

    Producing more grads without increasing underlying demand does nothing but produce unemployed engineers and drive down wages in the sector.

    Of course that’s the real goal underlying all this talk about not having enough scientists and engineers.

  2. stevphel says:

    Great article, Professor Black, the silence is deafening…

  3. NormanB says:

    To go along with the outsized influence and income that financial ‘institutions’ have I believe that 17% of the S&P 500 is made up of financial companies. And all they are is middlemen. Raise capital? With the internet they aren’te even needed for that. Lets all quit paying them fees they don’t earn.

  4. [...] the Servant Became a Predator: Finance’s Five Fatal Flaws (Big Picture) ND20 contributor Bill Black explains that the modern financial sector is monstrously large, [...]

  5. roger erickson says:

    If you can follow this, why not read & endorse open monetary operations as well? Bill Black & Warren Mosler are friends, & well acquainted.
    Seven Deadly Frauds of Economic Policy (June 17, PDF Link)

    What’s the difference? Black focuses only on criminology in his 5 steps (most are borrowed straight from Mosler). Mosler adds two operational causalities in his 7 innocent frauds. If you’re going to counter a complex task, you have to understand the causality.
    Complaining isn’t enough. What to do about it is all that matters.

  6. Tom Hickey says:

    BR, following up on Roger above, you think Bill Black is right, and Bill Black thinks Warren Mosler is right. Maybe you should look at Warren’s math a bit more closely. :)

  7. TGGP says:

    There was negligible evidence given that Ayn Rand is popular on Wall Street. I’ve never bothered to read Rand, buy my impression is that she’s a terrible writer who managed to create a cult around her. Randroids tend not to be the people who actually have high status, but those who think they deserve it and denigrate the rest of society for not granting it to them.


    BR: Alan Greenspan, Fed Chair, was a huge Rand acolyte.


  8. BigGuy says:

    Much of modern finance is predicated upon the assumption that increased trading volume with lower costs will make things better for all of us. I disagree. I believe the preponderance of stock trading volume consists of IT trading that in substance, though not form, is actually front-running and piggy backing. Front running is buying shares in front of other buyers, or selling in front other sellers. Piggy backing is copying other buyers in order to sell to buyers behind them.

    More than half the NYSE daily trading volume arises from analysis programs that determine that if firm A in industry A is moving up in price for a few minutes, firms B, C, D, E, and F in industry A are also likely to move up so shares are very briefly owned to grab a small amount of price appreciation.

    The primary reason this is presumed good is that it is presumed that increased trading volume increases market liquidity. It’ll be easier for people who are not trading like the big players to buy and sell their shares because of all that trading volume.

    But that’s not true. The increased volume has made it harder for individual investors, who do not have millions of dollars, to buy and sell shares.

    Capturing a few cents a day, up or down, on over 2 billion shares traded — that’s just for NYSE listed — worldwide, on and off exchanges, it’d be more than double that, so perhaps 5 billion shares are traded daily, worldwide, to capture 2 to 10 cents of profit — $100 to $500 million a DAY, $20 to $100 billion a year from trading. That trading is doing NOTHING for the general public anywhere. It’s making traders richer. That’s all it is doing.

    A tax of a penny a share on every share and every share derivative traded would substantially reduce trading volume, which I would argue would be a good thing.

    Even a tax of 1/100 of 1% upon daily trading volume would strengthen our world economy and reduce trading that is not beneficial for anyone other than traders. Those 5 billion shares worldwide at say $20 a share would be $100 billion a day — so $10,000,000 or so would be due daily — over $2 billion a year.

    In fact, we should tax all trading — including the trading of otc derivatives — based on the FACE value, or nominal value, of the dollars being traded. Credit default swaps made our financial crisis worse. If the players who created $100 trillion nominal value derivatives — several times greater than the total world GDP — were forced to pay $1 trillion in real dollars to the government authorities that came to their rescue, they would have been very strongly motivated not to have allowed things to have gotten out of hand as they did.

  9. BigGuy says:

    In other words, the fundamental assumption of modern trading is that lower costs for traders and lower taxes upon the trades are better for all of us.

    That’s not true. That’s false.

    Lower costs for traders and lower taxes upon trades make traders richer. Everybody else gets less.