Financial Innovation vs. Technological Innovation

For the past three years we’ve been wondering: How is it we can have an impending currency crisis and have new paradigm shifting technology breakthroughs at the same time?

To that end, we’ve redoubled our investigation into major technological advancements — particularly in the life sciences — and their impact on your wallet and the way you work, live and play. On the flipside of those breakthrough innovations, however, has been a pernicious force called “financialization”.

Financialization, related our co-founders Addison Wiggin and Bill Bonner in Empire of Debt, is when “a man can get rich without actually working or coming up with an insight or an invention by careful study or dumb luck. All he has to do is put his money ‘in the market’ and poof! — by some magic never fully described, it comes back to him 10-fold.”

It’s a phenomenon, as David Stockman has been explaining this week, that has quashed the real wealth creating activities of entrepreneurs by diverting resources away from productive uses and into the pockets of financiers.

In an effort to glean the difference between building a more efficient industrial process or finding a cure for cancer… and building a collateralized debt obligation… we spoke with Charles Hugh Smith, publisher of www.oftwominds.com. He explains what financialization has wrought and how innovation can overcome it, below…

Peter Coyne: Charles, I’m a fan of your work and try to read everything you publish on your blog, www.oftwominds.com. I encourage all of our readers to visit your site and do the same. You also have a new book, Get a Job, Build a Real Career and Defy a Bewildering Economy which they should find on Amazon and read.

Welcome to the Daily Reckoning.

Charles Hugh Smith: That’s a very big compliment, thank you. I’ve been a Daily Reckoning reader for at least a decade now.

Peter Coyne: Great. We’ve been discussing innovation in these pages, lately. And I’d like to discuss two types of innovation in particular with you today. One’s productive and the other is unproductive. The unproductive kind I’m talking about has been going on for decades in the financial services sector. It’s called “financialization.”

Can you describe what financialization is?

Charles Hugh Smith: Sure. Financialization is a phrase we use to describe two aspects of our economy. One is the securitization of assets that were once stable and decentralized. This would include home mortgages, for example.

Home mortgages used to be quite a stable asset class. They were very boring… they paid interest… and banks would hold them for years or even decades. The forces of financialization, however, took this stable asset and securitized it.

In other words, it was turned it into a financial security that could be sliced and diced into tranches, sold globally and then leveraged with derivatives. You can think of the whole thing as an inverted pyramid of financial assets that were all resting on a relatively small base of an actual mortgage.

The second aspect of financialization generates profits without generating more productivity or goods or services. In other words, it’s detached from the real economy.

The real economy is totally based on increasing productivity, which is the only force that raises all boats, if you will, in an economy.

Financialization doesn’t generate any new goods and services.

The home mortgage debacle that brought down the economy in 2008 was a classic example in which no new goods and services were created by securitizing, tranching or generating a lot of financial profit for those doing the financialization. It didn’t really boost the productivity of the economy or generate any more goods and services.

Peter Coyne: Correct me if I’m wrong on the stats, here, but I believe since the late ‘70s, the financial services industry has doubled as its share of GDP. Likewise the number of workers employed by the financial services industry has grown by a similar amount.

What have been the missed opportunities due to the financialization that’s been going on since at least the 1980’s — in terms of lost growth, productivity and standard of living?

Charles Hugh Smith: Very few analysts ever look at the opportunity costs. Opportunity cost, by the way, is a phrase we use to describe what else we didn’t invest in, because we invested in financialization.

And when I say investment, I’m not just talking just about money and financial assets. I’m talking about human capital and social capital. For example, what are we devoting all of our best minds to pursuing?

And so obviously, when you have a financial sector that’s paying a third of a million dollars, half a million, up to even one hundred million dollars in annual earnings, you’re creating a huge incentive structure to suck in the most ambitious minds.

That means, instead of creating innovation in goods and services, they’re creating so-called financial innovations, which don’t really aid the productivity of the whole economy. So, there is a gigantic opportunity cost to creating huge incentives for the financial sector.

Why is the financial sector able to suck off so many talented people and keep growing? As you pointed out, it’s immensely profitable. I believe the statistics are that financial sector used to generate about 10% of the S&P 500’s total corporate profits, and now it’s on the order of 30%.

Peter Coyne: How has that affected the relationship between government and the financial sector?

Charles Hugh Smith: Well, that profitability has enabled the financial sector to buy a lot of political influence. This is something that readers of the Daily Reckoning are well aware of, but the average American may not realize that it’s not just profit that flows into the hands of a few, it’s profit that enables the purchase of political influence on a vast scale, too.

Peter Coyne: Once the process of financialization starts, it seems to take on a life of it’s own. But what was the root cause of financialization in the U.S. and across the globe?

Charles Hugh Smith: I think that we really can’t understand our economy and this slow movement from producing goods and services to financialization without understanding how we create and issue money.

Again, this is a topic that’s well known to long-time readers of Daily Reckoning, but the average American might not understand it. Money is created and distributed into the hands of the few.

It’s not like everybody gets a check for $1,000 every time the Federal Reserve creates money. It flows into the hands of the few who then lend it to the rest of us at interest. This dynamic of creating a lot of debt and leverage with debt instruments, erodes the underlying economy, because people are spending more and more of their income on paying interest and servicing debt. That means there’s less money left over to invest in productive assets.

I think one other point we have to stress here is that, when financialization is so immensely more profitable than producing goods and services — due to tax law and the structure of our economy and political system — then corporations are almost duty bound to pursue financialization techniques to boost their profits. Otherwise, they won’t be as profitable as their competitors and the people running the corporations will be fired.

That is a hidden dynamic that we see in stock buybacks, for instance. We know that trillions of dollars have been borrowed and then used to buy back the shares of existing companies. This is another classic example of financialization generating immense wealth for the owners of those shares that have been boosted by buybacks.

But it didn’t really impact productivity or create any new goods and services; it just enriched a few at the top who own most of the shares.

Peter Coyne: Right. There’s a great chart I like to publish that illustrates this trend we’re discussing. It shows income gains between World War II and 1971. And before we went on a paper dollar standard, the bottom 90 percent of income earners, not the top 1%, made big income gains.

REC_06-03-15_Income

Post 1971, the top 1 percent was making all of the gains. Again, I think that illustrates when the U.S. economy switched from investing resources into innovations in producing material things, to financial innovation.

But this is pretty abstract stuff to the individual investor. For example, if I read an article that claims, “The income gap widened in the U.S. by 1% in 2014” it would make for a good political debate, but it’s an abstraction that has little direct impact on my wealth.

Why is this topic important for the everyday investor to understand?

Charles Hugh Smith: That’s an excellent question that I don’t think very many people ask. It allows us to tie in global trends to our decisions as individual investors.

Let’s talk briefly about these really large, really long-term trends that have helped fuel this income disparity. That includes globalization, and we have to recall that, after World War II ended in 1945, the U.S. was basically supreme in the world in terms of having its factories intact and its financial system intact, and an educated workforce.

We sort of had the whole global economy in our hands for probably about 15 years. And then, as Germany, Japan, and other countries rebuilt and became highly competitive and their currencies were extremely weak compared to the dollar, then we lost a lot of advantages that we had held for almost two decades.

Even if we had strict trade laws and a lot of other things that people have often promoted as saving us from globalization, just the fact that the rest of the world became much more competitive with us was something we can never escape. It was just the reality of it.

And so, globalization is one driver. Now, every American worker is, to some degree, competing with other people around the world because many of the tasks, products and services can be done anywhere on Earth.

To say that we can keep wages rising at the bottom when there’s a lot cheaper labor sources elsewhere is just not realistic for the enterprise that has to constantly look at costs and profitability. Those trends are something we have to be aware of.

But how does that relate to being an individual investor, as you asked?

Well, obviously, investors want to look at diversifying their portfolios and keeping a sharp eye on currencies. I’ve been a dollar bull for many years. That’s one of the things that I think any investor has to keep in mind. Trade and profitability are intimately bound up with the value of the currency that the profit is being generated in.

For example, if a country’s currency is declining in value compared to the dollar, then the profitability of any company with sales in that currency is going to be declining as well. The reverse is true, too. If you’re earning a profit in dollars, and the dollar is rising in its purchasing power, then you’re making a lot more money than what it would appear just as a profit margin.

Peter Coyne:  If it’s ok, I’d like to move onto another question I have for you. In the past, we’ve written about innovation cycles in the DR. Specifically, technological innovation cycles like the Kondratiev Wave.

But I wonder if there are also cycles of financialization? And if so, where are we in the cycle and how does it end?

Charles Hugh Smith: That’s another great question. We can refer first back to the business cycle. That term “business cycle” is bandied about often. What it really means is the expansion and contraction of credit. When people are able to borrow more money for whatever reason — their income can have risen so they can afford to service more debt, interest rates might have declined, the economy might be expanding — they can use that to invest and buy more goods and services That then puts the economy in expansion mode.

Then, after people have over borrowed, and banks have lent too much money to marginal borrowers and companies have invested in marginal investments, which are not paying off, then a lot of credit has to be wiped out.

In other words, there’s a credit contraction. That’s basically an analogy for recession. In other words, people cut back because they can’t borrow any more. Bad investments are written off and bad debt is written down.

That’s a key part of financialization. You see, the vested interests in financialization would suffer tremendous losses if bad debt was written down. So, financialization is basically the process by which we never allow any credit contraction.

That’s because, if credit contracts, then these highly leveraged corporations and banks, which are using financialization to make immense profits, go bust. This is why the 2008-2009 financial meltdown was so dangerous to the too big to fail banks. They were so highly leveraged that the loss of 1 percent of their capital would basically render them insolvent.

This is part of why financialization is so corrupting, if you will. It never allows a normal business cycle to play out. And so what we’re now seeing is, financialization is getting to the point of diminishing returns.

The Federal Reserve keeps adding liquidity and credit to the economy, but they can’t create more qualified buyers or good, solid investments. They can’t just create them out of thin air like they create credit. That’s why we’re seeing less and less positive results from the expansion of credit.

Peter Coyne: You mentioned why vested interests in financialization won’t let the credit expansion end. But you also mentioned diminishing marginal returns to credit creation. That implies that though big banks and the Fed will do what they can to keep the cycle from ending, it will end anyway.

In your opinion does that spell deflation or inflation, ahead?

Charles Hugh Smith: That is the trillion-dollar question.  Clearly, for deep, long cycle reasons, deflation still has more to room play out. By long cycle trends, I’m referring first to demographics, in that, as the population ages, people spend less money, they have less need to buy things, and their earning power goes down. Then they’re starting to sell assets to pay for their health care and they’re selling their large homes to downsize.

All of the economic impacts of an aging population are deflationary. Then we also have technology, which is also deflationary in terms of producing goods and services faster, better, cheaper.

Peter Coyne: Globalization, like you mentioned, too. That’s deflationary.

Charles Hugh Smith: Yes, so, those are long-term, multi-decade trends that are not going to be stymied or overcome easily. The caveat to that, of course, is that a central government and a central bank can destroy their currency. Once the currency’s been destroyed and its credibility has been lost then you can get hyperinflation because people are desperate to turn that money into something that will hold its value longer than a few hours or days.

So, there are two competing forces and I, myself, don’t feel that there’s any clarity on which one’s going to win in the long term. But in the short term, there are huge deflationary forces are that will be very hard to overcome.

Peter Coyne: The world’s financial system is more connected than ever before and central banks are all printing in concert. Because of that, do you think that the credit expansion could go on for much longer than anyone expects because the risks are spread across the globe?

Charles Hugh Smith: That’s an excellent observation that the scale has a lot to do with the end result. It works both ways, I think.

As you say, the fact that there are now multiple large central banks that are capable of issuing enough new currency to reflate an asset bubble on their own certainly distributes the risk, if you will, to a number of central banks.

In other words, if there is a global recession, any one central bank has the power to generate enough new money and credit that it can soften that global recession.

But, on the other side, what we see is a very high correlation of policies. All central banks believe Keynesianism, which is the philosophy of running huge government deficits on a permanent basis to boost demand and creating new money by lowering interest rates and liquidity issuance, is going to solve all economic and financial problems.

Keynesianism is the dominant ideology of all central banks. They’re all pursuing the same policy. In that regard, we actually are seeing a heightening of risk because everyone’s doing the exact same thing to keep financialization going. That actually increases the risk.

Peter Coyne: Right. That’s something Jim Rickards has seared into my mind — that the risk in the financial system grows exponentially as the scale of the system increases. Meanwhile, what do you think the knock-off effects on society are? Do you think financialization makes people shortsighted and tempted to be unethical?

Charles Hugh Smith: That’s an excellent topic, which, again, is underrepresented, in our financial media and our mainstream media.

As you suggest, a focus on short term profits as the only metric that matters pushes people to ignore the longer-term consequences of their actions and choices. It more or less forces them to engage in whatever it takes to reap the profit that will keep them their job.

These kind of incentive structures that we’ve created as defaults lead to exploitation of anything that’s ethically ambiguous. By that I mean, if there’s some loophole that can be exploited then there’s a desperate drive to find and exploit it while retaining a veil of legality.

I don’t want to take an overly political example, but I think the Clinton Foundation is offering us many, many examples of exactly this kind of behavior. The sort of letter of the law has been followed, but it’s been distorted and exploited for the personal gain of a handful of people.

I think that describes a lot of the actions of the too big to fail banks and/or people within those banks, too.

Peter Coyne: That’s a good point. I wonder if, on the flip side of this financialization discussion, you think that productive innovation offers a way out of this situation. Do you believe that there’s an innovation cycle counterbalancing the financialization cycle?

Charles Hugh Smith: I am absolutely positive about innovation as a way out of the financialization trap. As you say, I think it could create a sustainable, fairer economy once financialization either implodes or is eroded by more positive trends.

I believe there are several kinds of innovation. We’re very familiar with technological innovation—smartphones, apps and so on. But there’s also social innovation, and that’s a slower process. Social innovation requires changing people’s value systems and how they perceive problems.

I see a great opportunity to use technology to implement broad social innovations. The primary example is peer-to-peer businesses like Airbnb and Uber. These businesses are changing the way we do things not just technologically, but the way we organize our cities, organize our lives, organize our work.

These are really broad based changes, and I think it’s all for the better. But the other side of technology is that there’s always going to be an industry that has vested interests. This can include the government sector, not just the private sector. Public unions are a good example of a vested interest that will fight tooth and nail to resist any technology that disrupts their slice of the pie.

What’s interesting about that is, economies that are mostly controlled by vested interests — like Third World kleptocracies or former colonies that are ruled by a very small elite — do very poorly. That’s because those vested interests are so powerful and wealthy that they can stymie or co-opt or get control of any technology that could disrupt them. But those economies are also stagnant. The only thing that’s widely distributed in those economies is poverty.

Peter Coyne: How do we avoid that extreme?

Charles Hugh Smith: As consumers, investors, and citizens, we have to insist that vested interests are stripped of the power to stop technology from disrupting their piece of the pie.

When I look at, say, the U.S. economy from a 30,000-foot view, I see some very, very large industries, which are always private sector-government partnership cartels, if you will. They’re always industries that are controlled by a few government agencies and a few really large corporate players.

I’m thinking of healthcare and national defense, specifically. Each of those is about $700 to $800 billion in terms of the federal budget. They are overwhelmingly the largest part of the government’s expenditures, and they’re also extremely large in terms of the overall economy. Health care is roughly 18% of the whole gross domestic product.

These are industries, which are completely ripe for disruption, but it’s very difficult to get innovation into these sectors. That’s because the vested interests have so much political power.

I see that as something that we have to chip away at.

Innovation is allowed to blossom in our economy when there are no existing vested interests and nobody to fight it. The personal computer was the ideal example of that. There wasn’t really an industry that profited from no one getting his or her hands on a personal computer. And so, the personal computer was allowed to expand into this new territory.

Innovation is really our only hope to boost productivity, which is the only tide that can raise all ships. But vested interests are going to fight tooth and nail to suppress it or marginalize it. And I think the healthcare sector is an excellent example of that dynamic.

Peter Coyne: That’s interesting. I think we’ve bit off enough to think about for one reckoning. I’d like to have you back to continue you this conversation, though. You have a great book out called Get a Job, Build a Real Career and Defy a Bewildering Economy. I recommend that readers grab a copy on Amazon. It brings this discussion of innovation and it’s impact on how innovation and financialization affect how our readers’ work, play, raise their children and much more.

We’ll have to have you back very soon to flesh that topic out some more.

Charles Hugh Smith: That would be great. I appreciate you asking such terrific questions. These are large, complex topics.

Peter Coyne: Yes, and I want to thank you for your time, Charles, I appreciate it. It’s been thought provoking. We’ll talk with you again soon. Again, the books called Get a Job, Build a Real Career and Defy a Bewildering Economy. You can grab your copy on Amazon now.

Regards,

Peter Coyne
forThe Daily Reckoning

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