China Rising, Rent-Seeking Version

The usual concern about the US-China balance of economic and political power is couched in terms of our relative international payments positions.  We’ve run a large current account deficit in recent years (imports above exports); they still have – by some measures – the largest current account surplus (exports above imports) even seen in a major country.  They accumulate foreign assets, i.e., claims on other countries, such as the US.  We issue a great deal of debt that is bought by foreigners, including China.

There are some legitimate concerns in this framing of the problem – no country can increase its net foreign debt (relative to GDP) indefinitely without facing consequences.  And the Obama administration, ever since the Geithner-Clinton flipflop on China’s exchange rate policy early in 2009, seems quite captivated by this way of thinking: Will they buy our debt? Can we control our budget deficit? What happens if China dumps its dollars?.

The reason real to worry about China, however, has very little to do with external balances, China’s dollar holdings, or even capital flows.  It’s about productivity and rent-seeking.

China mostly invests in activities that raise productivity, raising the amount of goods and services that they can produce.  This could be manufacturing or infrastructure or various kinds of services. Agriculture lags but continues to get some new investment. And of course they pour money into education.

I’m not a fan of the Chinese way of organizing their economy or their society.  They no doubt have weaknesses that will catch up with them eventually (including waves of overinvestment in some sectors), and there’s good reason to think they will be the center of a big new “Asia Century” Bubble that is just now starting to emerge.

But contrast their pattern of investment in recent years with ours.  What sector in our economy has expanded more than any other?  Where should you work if you want both the highest wages on average, potentially very big bonuses, and quasi-retirement by age 40?  Finance.

Of course, we need finance and an important part of modern economic development involves intermediating savings and investment.  The US did this well, with some bumps in the road, and built a system that worked through the 1960s or 1970s.

But finance as a share of our activities (i.e., percent of GDP) has roughly doubled in the past 40 years.  What has this really added in terms of productivity?  The ATM and the credit card were great breakthroughs, but they are old.

What has “financial innovation” brought us since the 1980s?  One answer, of course, is “hedging strategies” that lower the cost of doing business for companies large and small.  This is plausible, although not likely to be large relative to the economy – send me your favorite study on the cost of capital since 1990 (you choose the definition), and we can talk about whether this effect is significant, sustainable, or even sensible.

Because financial innovation has mostly facilitated a big increase in finance.  If a sector grows, pays more wages, and rises as a share of GDP, surely this is a good thing?  Not necessarily – if this is a rent-seeking sector.

Rent-seeking means effectively a tax extracted by one sector from the rest of the economy.  We’re used to thinking of this as something that occurs through trade restrictions and the big breakthroughs in this area came from analysis of tariffs and quotas (Anne Krueger, Jagdish Bhagwati).  If a tariff, for example, will make your life cushy, you will devote great resources to getting one established or increased – irrespective of the effects on the rest of the economy (call this strategy “let’s hammer the unprotected consumer”).

Finance is rent-seeking.  The sector has devoted great resources to tilting all playing fields in its direction.  Consumers are taken advantage of; consumer protection is vehemently opposed.  And great risks are taken, with the downside handed off to the government (and the consumers again, as taxpayers).  This downside protection allows an overexpansion of debt-financed finance – reaching the preposterous levels seen in mid-2008 and now re-emerging.

Finance in its modern American form is not productive.  It is not conducive to further sustained economic growth.  The GDP accruing from these activities is illusory – most of finance is simply a tax on what is done by more productive members of society and a diversion of talent away from genuinely productivity-enhancing activities.

The rise of China does not necessarily imply slowdown or demise for the United States. But if they specialize in making things and we specialize in finance, they will eat our lunch.

On an urgent basis, we need real consumer protection against predatory financial practices and an end to all forms of Too Big To Fail behavior – which is actually just the biggest, nastiest form of predation. 

This is our most pressing national and international strategic priority.

Originally published at The Baseline Scenario and reproduced here with the author’s permission.

31 Responses to "China Rising, Rent-Seeking Version"

  1. Free Tibet   August 12, 2009 at 9:27 pm

    I’ve been waiting for this opportunity. Ask yourself, how are wealth and prosperity created? What are the top 10 attributes of man that is responsible for its creation?Here is my list. I think the order isn’t important as they are inter-related.• Knowledge – the foundation of understandings which can be acted upon to produce new wealth.• Imagination and/or vision – the ability to see in new ways.• Innovation – the ability to apply new visions to existing knowledge.• Passion – a confidence in the “rightness” and necessity of that vision.• Persistence and/or determination – a derivative of passion, the need to continue in the face of adversity to see ideas realized.• Compassion and altruism – a willingness to make a commitment to the broader good of man and the acknowledgement that only this new wealth can provide the basis for one’s own compensation.• Courage – a willingness to forego immediate safety and satisfaction and to undertake risk for the potential of a future return.OK, that’s only seven and it’s all I’ve got. You might develop your own list or expand this one. Though, I’m not so interested in pursuing that myself. Still, all of these things are necessary to the success of enterprise.What is the #1 attribute of man that destroys wealth?• Greed – as distinguished from the wholesome desire to benefit in tandem from the creation of wealth; greed, being the voracious consumption of wealth beyond its benefit.THE EVOLUTION OF ENTERPRISEStage #1 Innovation & investmentIn parallel to the requirements of innovation described above comes investment in labor (both direct and indirect labor) and capital. Direct labor (R&D, testing, etc.) can be amortized over a finite period of time (as can debt). Indirect labor – the creative part of that innovation process – receives equity; last in line to share the benefits. It is the ambition of labor to provide and receive a lasting benefit. It is the expectation of capital to derive a lasting benefit. It’s an important distinction, but more important still is that the full value of innovation (wealth) comes as a series of flows that can only be realized over the lifetime of the benefit. To cut that lifetime short is to not realize full value. Maximum value is full value or final value (FV). Investment in risk deserves the full potential of that endeavor. Not to be cut short.Stage #2 Management & exploitationAlmost anybody will tell you that there comes a time when it’s best to avoid the distractions of the innovators and bring in the managers to concentrate on exploiting the benefits. The forward momentum can be maintained more effectively and the long-term value (FV) enhanced. It’s this evolutionary period where the costs are amortized and benefits realized. It’s where cash cows graze. It’s what equity holders wait for, but it is a perilous time in a company’s evolution. It’s a time when management can become complacent. It’s also a time that attracts parasites. Disease.Stage #3 Parasitic investment & wealth destructionAs an enterprise matures the risks become more well known. If it becomes sufficiently large and liquid it can attract a new kind of capital. Ownership can change. The enterprise can become dominated by institutional investors who’s interest are not aligned with the wealth creators that preceded them. It’s reflected as a difference in horizons. Wealth creators have a long-term full value (FV) view. Parasites see only the net present value (NPV). And NPV is FV discounted to some “discount factor”. Parasitism doesn’t require knowledge. It doesn’t require imagination or innovation. It doesn’t require courage – au contraire. Compassion? Not hardly. It only requires greed and a willingness to discount innovation and wealth creation and move those benefits forward. Much easier! Then managers are forced to accommodate the parasites. Why should we not expect them to become parasites themselves? Out with the managers, in with the greedy.Don’t be fooled to think parasites have the interests of equity holders at heart. Their interest is the attraction of equity holder capital – to themselves – by suggesting or emphasizing some surreptitious pseudo measure of “investment alpha”. But all “investment alpha” can do, all it can ever do, is to move future flows forward – at a discount. Investment alpha does not create wealth. It does not preserve wealth. It consumes wealth.Let’s be clear. If the discount factor were 0 then NPV = FV. In real terms there can never be any benefit to the intermediation of funds. Full value and wealth are destroyed in the process of discounting and front loading those flows. Also, one should not forget that money is considered the whole benefit. No intangibles. The hopes and dreams and sacrifices of innovation are sold off for cash. Therefore, it is innovation and wealth creation itself which is discounted and under-compensated.DUMB MONEYYou! It’s your money they feed on. It’s your savings which you have entrusted them to manage. (Mine too though I’m trying hard to break the habit. Cold turkey is tough.) We’ve always had parasites. We’ve always had temptations. The terrible excesses began during the Reagan administration when “retirement accounts” were initiated and incentives were given to investment at the expense of savings. The resultant cash flows provided the basis for new business models and opportunist money managers to risk Other People’s Money (OPM) rather than to secure savings. It may have seemed like a good idea at the time.It hasn’t worked. We are making the wrong investments. Misallocating capital. Banks extend credit. They make loans to credit worthy borrowers who can make repayments. Their business is about finding borrowers who have that cash flow and the collateral to insure it. Most important (of paramount importance) is the collateral. They have been loaning money to anybody that would pretend to meet those requirements. (Liar loans, >/=100% loan/equity, etc.) And the “liquid capital markets” are about finding your way onto the S&P AAA list so that your debt can be “securitized” and marketed to 3rd parties. Over and over again. Same liar loans – different liars. And the parasites take a cut both ways. Nobody seems able to ascertain the value of a business proposal. On top of that our business models are bust. The world is changed. We must find a way to adapt our businesses to that changed world. None of these economic forces that we have been talking about illustrate anything other than the abject failure of our financial system to fund the right investments.The disease is now deep and endemic. A virulent and aggressive cancer. The infection has become so systemic within us that we accept the consequences without complaining. We assume that it’s right that “shareholders” demand companies be demolished short of their full life in the interest of “shareholder (present) value”. Our Keynesian perma-growth conditioning of always positive interest rates (inflation) is so ingrained within us and our expectation of inflation so “normal” that we can’t even question it. We assume that our money should be worth less tomorrow. Therefore, we assume that NPV should contain some discount factor. We assume a yield curve. Some even assume it makes sense that taxpayers borrow money to give to banks so that it can be borrowed back at interest. Though I admit that last is a stretch for my limited intellect. And it’s all accompanied by a never ending 24/7 drivel of investment Pabulum from either complicit or ignorant media. We’ve all been infected. We need to question our assumptions. The fly in the ointment is that it doesn’t take 80 years for savers to know they are being pillaged and it sends the economy out on the risk ladder. With risk comes failure. When everybody is at high risk the failures get bigger. Eventually it gets too big to fail. Then the paradox.WHAT YOU CAN DO – SOLUTIONSReform cannot be allowed to end with a recapitalization of the very financial system which has squandered our savings. The more fundamental issue is the perverse incentives for investment and consequent misallocation of capital.The systemically important part of our economy is that which is going to pay the bills tomorrow. That which creates wealth and earnings. Not that which intermediates financial flows. And it is our savings which must be invested in productive endeavors to create that wealth. Ways must be found to circumvent today’s financial intermediaries and make those productive investments ourselves. There is quite frankly a lack of good options. No safe havens. We must create them. We must find ways to take greater control of our own production.Get smart! Leave the casino. Take your money out of their hands. Starve them of the nutrients they need to survive – your money. Amputate this parasitic growth. Drive a stake through its black rent-seeking, money changer heart.Thank you, Professor for your indulgence.

  2. Anonymous   August 14, 2009 at 4:22 am

    Simon Johnson is a spectacularly ignorant witch-hunter that is SO WRONG about banking, words are hardly enough to describe.> What has “financial innovation” brought us since the 1980s? One answer, of course, is “hedging strategies” that lower the cost of doing business for companies large and small. This is plausible, although not likely to be large relative to the economy – send me your favorite study on the cost of capital since 1990 (you choose the definition), and we can talk about whether this effect is significant, sustainable, or even sensible.What about the global economic expansion and the integration of Emerging Markets into the global economy, the globalisation of business etc etc?? Who do you think has financed all this Mr. Johnson – the Almighty?> Rent-seeking means effectively a tax extracted by one sector from the rest of the economy.Tell us Mr. Johnson, do you know of ANY sector in the economy that is not rent-seeking??????? Would you expect banks to offer free financial intermediation?>Finance in its modern American form is not productive. It is not conducive to further sustained economic growth. The GDP accruing from these activities is illusory – most of finance is simply a tax on what is done by more productive members of society and a diversion of talent away from genuinely productivity-enhancing activities.DEFINE WITCH-HUNTING for me please. My Kingdom for a well-reasoned, well-evidenced argument PLEASE. Mr Johnson – really what do you think you are achieving with such empty arguments other than embarrass yourself through such display of ignorance?If finance in its modern American form is SO counter-productive, really what has allowed US GDP to grow to give or take US$ 14trn (all the current issues aside)?GET A REAL JOB Mr. Johnson and step into the real world!!!

    • Guest   August 14, 2009 at 9:52 am

      “What has allowed US GDP to grow ..?”Work, Peter Pan. The labour of the proles.

  3. Anonymous   August 14, 2009 at 10:32 am

    A very refreshing viewpoint regarding the pervasive finance ideology and this is an insider writing.Btw, I am surprised and appalled by the aggressive arrogance and vulgarity of some comments. Behave yourselves people, debate is not about agonizing your counterpart with insults, to my understanding.

    • Guest   August 16, 2009 at 6:35 am

      Yes I enjoyed reading from Simon Johnson yet again too.I happen to agree with what Mr. Johnson has written here,and I would like to respond to the “IF our GDP has multipliedwhile our focus on finance has double THEN finance MUST beproductive.” line of reasoning. My response is simply thatthe monetary supply (and inflation) are themselves aspectsof finance, the quoted $14T isn’t what it used-to-be; just asksomeone from Zimbabwe, where $100B buys three fresh eggs.And if we concentrate on the main point of the article- thatmanufacture, art and creation are more intrinsic to thedefinition of productivity than rent-seeking (politics,stacking the odds, debasing the dollar, and borrowing fromfuture generations) then the truth of what Simon has writtenand his main intent become undeniable and quite basic.

  4. Guest   August 17, 2009 at 8:35 am

    “But if they specialize in making things and we specialize in finance, they will eat our lunch.” More specifically, the lunch of middle class America…a dying sector.

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