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Wednesday, May 06, 2009

James Suriowiecki on the banking industry: "Monsters, Inc" (New Yorker)

James Surowiecki, the financial columnist for the New Yorker, has consistently been putting out insightful columns through the course of the financial crisis.  His latest is a good one regarding the size of the banking/financial industry, aptly titled "Monsters, Inc." 

Surowiecki puts this very timely issue in historical context, addressing the widespread notion that we need to go back to a simpler financial time:

The desire to bring back the boring, small banking industry of the nineteen-fifties is understandable. Unfortunately, the only way to do that would be to bring back the economy of the fifties, too. Banking was boring then because the economy was boring. The financial sector’s most important job is channelling money from investors to businesses that need capital for worthwhile investment. But in the postwar era there wasn’t much need for this. The economy, while remarkably strong, was dominated by huge companies that faced little competition, and could finance investments out of their profits. And entrepreneurship was restrained: there were many fewer start-ups then than in the period after 1980. So the financial sector didn’t have much to do.

Two things changed this. First, in the seventies those huge companies started tottering, while the U.S. economy fell apart. Second, the corporate world was transformed by revolutionary developments in information technology and by the emergence of new industries like cable television, wireless, and biotechnology. This meant that the economy became, and has remained, far more competitive, while corporate performance became far more volatile. In the nineteen-eighties, companies moved in and out of the Fortune 500 twice as fast as they had in the fifties and sixties. Suddenly, there were lots of new companies with big appetites for outside capital, which they needed in order to keep growing. And it was Wall Street that helped them get it. Companies like Turner Broadcasting, M.C.I., and McCaw Cellular used junk bonds to turn themselves into major businesses. Venture-capital investing took off, and so did the I.P.O. market; there were twice as many I.P.O.s between 1980 and 1999 as there were between 1960 and 1979. To be sure, deregulation was also a factor, but Thomas Philippon, an economist at N.Y.U., has shown that most of the increase in the size of the financial sector in this period can be accounted for by companies’ need for new capital.

The history of the junk (i.e., high yield) bond market in the '80s is something I'm interested in reading about.  It's a story mostly associated with Drexel Burnham and Michael Milken; I bought a copy of The Predators' Ball: The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders a few years ago, but haven't yet gotten around to reading it.

Surowiecki goes back even further into the history (and reveals that he's really just outlining Philippon's paper with this column):

There have been three big banking booms in modern U.S. history. The first began in the late nineteenth century, during the Second Industrial Revolution, when bankers like J. P. Morgan funded the creation of industrial giants like U.S. Steel and International Harvester. The second wave came in the twenties, as electrification transformed manufacturing, and the modern consumer economy took hold. The third wave accompanied the information-technology revolution. Each wave, Philippon shows, was propelled by the need to fund new businesses, and each left finance significantly bigger than before. In all these cases, it wasn’t so much that the bankers had changed; the world had.

The same can’t be said, though, of the boom of the past decade. The housing bubble was unique, and uniquely awful.

Surowiecki goes on to say a few words about the housing bubble, and about how to get at "the harder task of making credit bubbles like the one we just lived through less likely."  Oddly he doesn't mention securitization and the alchemy of financial engineering as a central culprit; he just mildly mentions that "many financial innovations also seem to be overrated; it’s not clear that they actually help finance do its core job of channelling capital to businesses."

The brief sketch of the history of modern US banking reminded me of an essay that was on the WSJ Op-Ed page last October, by John Steele Gordon, titled "A Short Banking History of the United States: Why our system is prone to panics", which opens with the lines: "We are now in the midst of a major financial panic. This is not a unique occurrence in American history. Indeed, we've had one roughly every 20 years: in 1819, 1836, 1857, 1873, 1893, 1907, 1929, 1987 and now 2008." But I will leave the rest aside for now, to blog another day...
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