The Price of Wall Street’s Power (Digest Summary)

Companies tend to take Wall Street’s focus on the return on net assets strongly into consideration when making strategic decisions. Boeing, which used to focus on technical excellence, is a case in point. After the merger with McDonnell Douglas, the company’s focus turned to cost cutting and it became driven by financial performance. Wall Street’s focus on short-term gains can hurt a company, foster dishonesty in executives, and reduce innovation. Possible solutions to curb the influence of the financial sector would be to limit the size and leverage of financial institutions, remove the preferential treatment of debt in the US tax system, and introduce a tax on financial transactions.

Analyzing changes in the financial sector in the United States over past decades, the author concludes that changes in financial regulations are necessary. First, both the size of banks and the use of leverage should be reduced. The assets of the six largest US banks have increased from 17% to 58% of GDP between 1995 and 2013, partially because of an indirect government guarantee that allows banks to borrow relatively cheaply. Having smaller banks would reduce both the subsidy and the power of banks.

Second, because of high leverage, small risks have resulted in huge losses that the public has had to pay for through bailouts. Capping the leverage at a debt-to-equity ratio of 3:1 would reduce risks and the need for government subsidies. In addition, there should be an equal playing field between debt and equity financing, which could be achieved by limiting debt-related tax deductions.

A tax on financial transactions could encourage investors to invest long term and avoid speculation. Treating investment income like ordinary income would also help equalize the after-tax income of those whose source of income is labor rather than investments. To support this idea, studies have shown that there is no relationship between economic growth and capital gains tax rates.

Although deregulation might have worked for some markets, financial markets work differently and instead require a rebalancing of power. The US financial sector has been heavily regulated since the Great Depression, which resulted in stability. Subsequent deregulation has resulted in an increase in the size of the financial sector from 2.8% of GDP in 1950 to 6.6% in 2012 and an increase in profits from 24% of all sector profits in the 1970s to 37% in 2013. This increase in both size and profits has resulted in an increase in the political power of the sector.

When a financial sector becomes too powerful, a reduction in growth and an increase in volatility occur because, first, highly complex financial systems have a larger probability of failing and, second, an imbalance of power may result in resource misallocation. Economist James Tobin pointed out that this misallocation results in high private gains that are not accompanied by similar social productivity. Other economists have said that industries are usually categorized as creative or distributive and that the financial sector is mainly distributive, which means that it is not focused on the creation of wealth. As rent seeking becomes more attractive than creating value, economic growth slows down. Many financial transactions are zero-sum games—some party gains while the other party loses—whereas in other industries, transactions are usually beneficial for both parties.

Although the 2008 financial crisis spurred the debate on the limits of financial institutions, the balance of power itself has not changed much. The author provides a clear overview of past and recent developments in the financial sector and supports his views with appropriate data and figures. The general line of argument is very clear, and the solutions provided in the conclusions are well aligned with the rest of the story line. This article will be particularly interesting for financial professionals working in governance, legal, and ethical professions.