Misplaced Values Distorted Our Financial System

Friday, 19 Nov 2010 08:13 AM

By Barry Elias

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Last week, I discussed how modern economists were insufficient in modeling real world financial decision-making.

My son, a junior at Stuyvesant High School in Manhattan, recalls our evening time spent working with his “math folder” when he was a young child, no more than three.

We focused on learning and knowledge.

He recently said (paraphrased): “Dad, that’s what we did — that’s all I knew — we learned.”

Today, he is a proactive, independent learner, who thrives on value added impact.

For several decades, societal values were severely misguided: placing an exceptionally high value on money and materialism at the expense of intellectual curiosity and the love of learning.

It seems the modern economists, who developed ill-conceived interpretations of reality, reflected the distorted value system that penetrated our society with pathological proportions.

When true individual purpose and self-actualization takes precedence, the creation of innovative services and products follow, and that generates earned income: not the reverse. The highly talented and famed fashion designer, Valentino, suggested his focus was on his creations; the money simply followed.

During the past few decades, the notion of unearned income (i.e., a return on an investment that doesn't require time and work) deeply took root. This philosophy generated an astronomical appetite for financial instruments that added little value in terms of product and service to our society: it merely transferred wealth.

Our education system enabled and reflected these values. My son introduced me to a recent documentary entitled, “Race to Nowhere,” which powerfully depicts this dynamic.

As society placed an inordinate emphasis on the possession of money, our education system developed the template to realize this objective. To earn large sums of money, one needed to attend the most prestigious universities; this invariably required performing exceptionally well on examinations, standardized and otherwise.

This precept eviscerates the love of learning, curiosity, innovation, creativity, and strategic/critical thinking: all vital to a well-functioning knowledge based economy. It seems the testing methodology devolved to accommodate lower skill levels to provide an illusion of progress. In fact, today, the graduates arriving in the workplace don't adequately possess the requisite skills, despite the fine educational pedigree.

In my previous piece, I indicated that I noted a marked and unwarranted market appreciation in 1993. More on that later in this entry.

The financialization of our economy was the market manifestation of these values: specifically, the excess creation of financial instruments, including equity, debt, and especially their derivatives.

Greta Krippner, from the University of California at Los Angeles, suggests financialization is a “pattern of accumulation in which profit-making occurs increasingly through financial channels rather than through trade and commodity production.”

In his 2006 book, “American Theocracy: The Peril and Politics of Radical Religion, Oil, and Borrowed Money in the 21st Century,” Kevin Phillips said financialization is “a process whereby financial services, broadly construed, take over the dominant economic, cultural, and political role in a national economy.”

He compares it to the pattern that marked the decline of Habsburg Spain in the 16th century, the Dutch trading empire in the 18th century, and the British Empire in the 19th century.

Brooks Adams wrote, “as societies consolidate, they pass through a profound intellectual change. Energy ceases to vent through the imagination and takes the form of capital.”

The Commodity Futures Trading Commission (CFTC) reported the number of future contracts traded in 1970 was comprised of agriculture (80 percent) and precious metals (20 percent). On Sept. 11, 1975, the CFTC approved the first futures contract on a financial instrument: the Chicago Board of Trade (CBOT) Government National Mortgage Association (Ginnie Mae) futures contract.

By 2004, 75 percent of all CFTC contracts were based on financial instruments (which were 0 percent in 1970). In 2009, the Financial Industry Association estimated nearly 6.5 billion futures and options contracts were traded that year. Moreover, the notional value of all derivates at that time was estimated at more than $500 trillion.

Government and industry data suggest the market value of financial instruments traded in 1956 was 1.25 times GDP. Fifty years later, this figure was 100 times GDP (an 80-fold increase).

Thomas Phillipon, finance professor with NYU Stern School of Business, estimates the GDP contribution of the financial industry quadrupled to 8 percent in 2010 from 2 percent in 1940. According to a 2009 Presidential Economics Report, financial industry profits in 2007 represented 33 percent of the total corporate profits, but employed only 5.6 percent of the working population.

As promised, rewind to 1993. Industry data suggest by mid-1993, the Chicago Mercantile Exchange (CME) began releasing the nominal value of contracts traded at the CME each month. In November 1993, it set a monthly record of 13.4666 million contracts traded, with a market value of $8.8 trillion. By late 1994, the monthly market value doubled, and total volume for the year increased 54 percent to 226.3 million contracts worth roughly $200 trillion. Shortly thereafter, the CME discontinued reporting the market value of contracts traded.

Why would CME cease reporting this statistic?

The empirical evidence strongly suggests there was good reason the financial markets seemed overvalued at that time: financialization created and perpetuated a significant increase in artificial demand. This caused financial instruments and their derivatives to appreciate substantially, albeit highly unwarranted.

The financial industry may not want to publicize that type of information.

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