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The fundamental question

James DeLong asks the right question. What has the financial sector contributed that justifies this:

DeLong writes:

So what do the bankers really claim as the business model that enabled them over the past decade to collect such a huge portion of all corporate profits? There are several possibilities, none of them flattering to the industry:

• That bankers actually did nothing and had no expertise, but clients thought, albeit wrongly, that they were getting something (no doing of the banks, of course—can’t imagine where the clients got this impression).

• That the government has created such market power in the financial world that anyone grandfathered in with a franchise can reap enormous rents.

• How about: “We aggregate the information we get from our blue-chip clients and use it to get an edge in our proprietary trading”? (Robert Samuelson: “In the first quarter of 2010, about 80 percent of Goldman’s $12.8 billion in revenues came from its trading and proprietary investment accounts.”)

• Or, “We borrow from the government at low rates and lend back to the government at a premium, and for that we get paid a lot.” (From the investment analyst GaveKal, on the Greek bailout: “European banks should now make enormous profits by acting as a permanent conduit for ECB [European Central Bank] lending to various weak EMU [Economic and Monetary Union] governments. After all, borrowing money from the ECB at 1% to lend it back to EMU governments at 5% plus, while enjoying a permanent liquidity guarantee from the ECB, is not a bad business to be in!”)

The other possibility is related to DeLong’s last point and comes from my paper on the crisis. Starting in 1984, with the bailout of the creditors of Continental Illinois, it became cheaper to borrow money and financial institutions responded by taking on higher levels of debt. This in turn inflated profits as long as times were good.

Does anyone out there know how the numbers in DeLong’s chart are measured? Are Fannie and Freddie included? Hedge funds? All banks? Venture capital funds?

I would also like to see a time series on leverage among the top five investment banks over time.


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