The contemporary context of investment in the United States, part 2: definitions

This post is second in a series on the contemporary state of investment in the US. The first is here. The purpose of this post is to provide some definitions and context. There are three questions: first, what processes does “investment” refer to; second, who invests; and third, what patterns should interest us? To define and identify what investment activity matters (for economic growth and development in the US for the next decade or so), I rely mainly on some of the writings of critical/heterodox economists Hyman Minsky and John Kenneth Galbraith.

What is investment?

There are two common usages of the term “investment”. The first is the buying and selling of shares of companies that are publicly listed on stock exchanges. This set of activities is not the sort of investment I’m talking about in this post. No doubt, the stock market can be a source of capital for companies, which can then be deployed for investment. More often than not, however, the stock market functions as a market for corporate discipline and control (mergers, acquisitions, takeovers). The investment I refer to here is the accumulation of fixed assets (such as capital goods [like machinery], inventory, property, physical structures) for the purposes of generating income.

Let me offer a short digression here. Many would say that the two definitions above reflect a financial definition and then an economic definition of investment. In casual, daily conversation, that might be acceptable. However, if you have read Hyman Minsky then you would be aware that both processes are actually interlinked and co-constitutive. That is, the accumulation of fixed assets happens very much according to what is happening in capital markets (of which stock markets are a sub-set). More specifically, Minsky argues that the financing (particularly when financed through debt) and pricing of capital goods occurs in capital markets. The point is that the capital goods and fixed assets that are used for investment are also financial assets. And because these financial assets are accompanied by ownership claims and are financed, this implies that there are cash flow obligations: the debts that were used to finance capital goods accumulation must be validated. Those obligations are met by splitting off part of the income produced by those assets, either as dividends, interest payments, or perhaps (in dire situations) from the sale of capital goods. To make a long story short, Minsky demonstrates that these arrangements can precipitate a depression in the event that financial asset prices collapse, which he argues is possible if capital goods accumulation is financed in too speculative a manner. Otherwise stated, the capitalist system itself sows the seeds of its own crises. I suggest you read this or this.

Where does this leave our definition of investment? There are at least six elements: it refers to a (1) process of accumulating (2) capital goods, which are simultaneously (3) financial assets that are (4) owned by capitalists/entrepreneurs and (5) might be financed through debt, for the purposes of (6) generating income.

In the next section, I’m briefly going to discuss why (5) and (6) do not always apply but rather depend on who is doing the investing. Nonetheless, I think that the definition here is workable and sufficiently distinguishes this set of activities from the “investing” (asset trading) that commences every day with the ringing of the bell at the New York Stock Exchange.

There are a couple of other points I’d like to add here concerning how investment might influence the larger political-economy. Recently a book was released that contained a number of previously (I believe) unpublished essays by Hyman Minsky (they may have been published in a few academic journals) on the topic of jobs, employment, and welfare. I recommend this one, too, for a general introduction to Minsky’s thought and its application to employment. In the introduction and throughout that book, the reader might notice that the US economy is characterized as observing a “private, high-investment strategy”. I think there are two very important points in that phrase. First, investment is private: it is subject to ownership by individuals, not the state. This point should interest anyone who conducts cross-national comparative research: you cannot compare the investment process in a country like the US, where investment happens by entrepreneurs and households, with a country like China, where capital expenditures are determined largely by committees in state-owned businesses appointed by the (Communist authoritarian) state. It may be a minor point, but I think it is worth bringing up.

The second point is much more important: “high-investment strategy.” What does that imply exactly? The idea is that the US economy in particular generates growth by stimulating investment. That is, more private ownership of capital goods. Such a strategy is executed, in the US at least, by various policies: a tax code that favors capital goods accumulation (incentives for depreciation, tax credits); a favorable business environment (low regulation of business, which decreases the cost of doing business generally); and government contracts that partly underwrite profits in select industries, typically those that require high capital goods consumption (armaments, construction, airlines). Thus “growth” in the US economy is primarily pursued by creating favorable conditions for income generation by businesses.

There are number of problems associated with such a strategy, and I’ll quote the four that are mentioned in that volume on employment by Minsky. These can be found in a summary around kindle location 358-382.

First, a tax code that is geared towards more investment will increase inequality between the owners of capital and labor. For what it is worth, inequality on its own does not necessarily spell economic disaster. For instance, if you have read Thomas Piketty’s book, you’ll know that countries can endure long periods (centuries) of inequality without encountering, say, collapse and ruin. Certainly, there are issues of justice and quality of life that arise from high inequality, but the evidence that inequality might lead to economic and financial crisis is wanting. Politically, I don’t worry about inequality because the President and most American political leaders are not Rockefellers, Morgans, Vanderbilts, Carnegies, Fords, or Hearsts. In other words, the money eventually runs out.

[An aside: one of my favorite economists (Deirdre McCloskey) has recently written a review of Piketty that I suggest everyone read. It’s there on the home page in pdf form.]

Second, the income that accrues to owners of capital can lead to opulent consumption by them and emulative consumption by the masses, leading to inflation. There is a natural experiment here in the period 1964 to 1974 in the US, as employment tightened, defense spending escalated with the War in Vietnam, and the economy enjoyed an investment boom (initiated, by the way, with tax cuts passed during the Kennedy and Johnson administrations).

Third, government spending on defense (contracts to specialized and sophisticated high-technology industries) creates demand for high-skilled, high-wage labor. In turn, this widens the inequality among workers. Again, we can observe the effects of growth in high-technology sectors on wages and skills across occupations by observing the period from 1994 onwards, when the revolution in computer chips and the internet began. This was not totally the result of government spending (in fact, US defense spending dropped off after 1990, leading in part to the recession of 1991), although much of the US advanced technology industry grew out of companies that received defense contracts. Nonetheless, this is a serious problem for worker quality of life and, I would argue, for growth prospects between regions and metropolitan areas.

The final problem Minsky describes of a high private investment strategy is that if the tax code and business environment privilege capital spending, then rising business confidence hence banker optimism will erode lending standards while also increasing the riskiness and speculative nature of investment. The result can be a financial crisis and recession. It is worth noting that the 2008 crisis was not the result of excessive optimism by corporate businesses. Rather, the 2008 crisis was the result of a housing boom and a highly leveraged household and and highly leveraged, speculative, and corrupt financial sector.

At this point, I’ve elaborated enough on what I mean by investment. Now I’m briefly going to outline some key differences between the sources of investment.

Who invests?

I mentioned earlier in my definition of investment that it might be financed through debt and that the purpose of investment is to generate income. I’d like to add some caveats to that with the help of John Kenneth Galbraith.

In a previous post containing links, I had one from the St. Louis Federal Reserve documenting that credit to non-corporate non-financial sectors has remained low following the crisis. That to me was a key indicator of who is able and willing to invest in the current economy. We have at least three major groups here: the corporate sector (AT&T, Wal-Mart, ExxonMobil, DuPont, Microsoft); the household sector (you and me); and the financial sector (banks and lenders big and small). Each of these sectors have very different sources of capital and ways of generating income. The corporate sector, which as you can tell is populated by very large companies that are often structured in what economists would call an oligopolistic market (where they can influence prices of inputs and outputs), gets most of its capital (for the purposes of future investment) from retained earnings. In other words, expansion programs, research and development, development of new products are financed from last year’s profits. These business do not typically take out loans from banks to finance their activities, although they certainly float bonds and stocks as part of their complex capital structures. The main point is that these companies seek to make the supply of capital (like they do for all other strategic costs) a “wholly internal decision” (Galbraith, 2007, 34). Chapters Three and Four in The New Industrial State are the relevant backgrounds for this interpretation.

As such, investment is not necessarily financed through debt. In addition, investment may not happen with the aim of producing income. Galbraith describes that in these large corporate enterprises, the managerial hierarchy is responsible for long-term planning; this includes when and whether to make capital expenditures. The ultimate goal of the corporation, then, is not income or profit generation, but rather the elimination of uncertainty. The corporation seeks stability. The process of investment, we can deduce, will fall in line with how corporate managers attempt to achieve that stability. An oligopolistic market structure allows companies to pursue goals other than the relentless pursuit of profit, contra the neoclassical economics dicta.

In contrast, when American entrepreneurs attempt to launch a business, the financing usually comes from residential mortgages and the purpose is the generation of income (they do not exercise oligopolistic power). A home is an individual’s greatest potential source of capital, save inheritances. Consider how easy it is (excuse me, how easy it used to be) for most people to get a mortgage or to refinance their home; this, too, surely was a reflection of the high private investment strategy (or at least should be treated in policy as such).

Obviously, between the individual entrepreneur and the oligopolistic corporation, there are a lot of businesses that do not have pricing power and that have access to various forms of financing that are not restricted to home mortgages or inheritances. These businesses, which could be termed ‘mid-sized’ and have several hundred employees (let’s say, fewer than 500), and which are typically in manufacturing, transportation, utilities, and related industrial sectors, do enter into debt contracts with banks and other lenders. However, I think that our focus should really fall to entrepreneurs and large corporations. For the former, the reason is that small businesses create a tremendous amount of activity, in terms of jobs and sales. Most small business also fail, so this is a tremendously inefficient set of activities. In the short-term, however, small businesses drive quite a bit of local economic activity while providing a lot of people (not just the small business owners themselves but also the people they hire) with an outlet for social and economic advancement.

In the case of large corporations, the interests of these entities set much of the industrial and social policy in the US, and they are responsible for the bulk of exports and income. Furthermore, municipal and state governments compete quite vigorously over corporations. Local governments offer tax incentives, provide physical infrastructure, train the workforce, etc., partly with the aim of attracting business activity, and therefore tax revenue.

What I’m getting at here is that there is a geography of investment, and two very important features of that geography will be households and large corporations. The financial system is also important in this geography, but these days it is less about the location and activities of banks and more about the location, organization, and prerogatives of special investment funds, like pension or hedge funds. With that, I’ll move on to the final question.

Measuring investment and identifying patterns

I won’t dwell on this point much because instead of telling you what I’m going to do, I may as well just do it. In the next posts in this series, I’m going to present the data I stumbled upon from the Bureau of Labor Statistics for output, savings, and investment. The data is organized by sector, that is, industrial sector following the NAICS codes and also by the divisions suggested above (household, financial, corporate, and others).

The most basic pattern to identify is change over time: which areas demonstrate growth and which demonstrate contraction? There are roughly seven years of annual data, which is not a large sample by any means. There will be some noise.

A subsidiary pattern is relative change. The 2008 crisis marks a point where we can evaluate how credit distress during and after the crisis was distributed between sectors and, consequently, what have been and will be the prospects for investment and therefore economic growth. In other words, we can determine to an extent what sectors are “holding back” growth. Recall that this endeavor was largely touched off by the New York Times article that asked that very question (see previous post). My goal is to further investigate that question.


The contemporary context of investment in the United States, part 1: introduction

The Great Recession (2007-2009) changed the context for investment in the United States in several ways. First, it created imbalances in the economy, in terms of losses and gains between economic (businesses, households, government) as well as industrial (agriculture, manufacturing, services) sectors. These losses and gains can be measured in terms of lost output, including employment. These are imbalances to the extent that contractions in output were unevenly shared across sectors.

Second, the political environment changed as new constituencies and alliances were formed, while others were made more obvious. An example of such a long-standing alliance that became stronger was the relationship between the Federal Reserve and large, globally-competitive financial companies. This relationship was codified in the emergency recapitalization (the TARP) and in the Dodd-Frank law. New constituencies emerged or became more pronounced, for instance as unemployment and homelessness rose, and they reflected a regional character (for the reason that the financial crisis and recession were, in fact, regional crises). These new constituencies and alliances generated pressures for different kinds of policy intervention, with varying success.

And finally, the macroeconomic context changed, given changes or stickiness in the informal rules of investment (such as tax rates, interest rates, the supply of credit). Similarly, economic development through the application of new technologies, discovery and extraction of fossil fuels, and global capital flows also have shaped the macroeconomic context.

Over the next several posts, I’m going to outline the context of investment in the US immediately before and since the financial crash in 2008. I will describe the nature of investment since the crash, with a focus on the distribution of investment activity between sectors (economic and industrial) as well as the nature of investment (private fixed assets: structures, equipment, intellectual property). Finally, I’ll briefly describe the kinds of companies and regions that were poised to reap the benefits of this changing context, and contrast them against those entities that have borne the greatest burden.

The next posts will frame investment in the US with the following specific questions. First, what do I mean when I talk about investment in the United States? I will outline that question by referencing JK Galbraith’s new book (The End of Normal) as well as borrowing some insights from Hyman Minsky. Let me add that I do not mean to advance any kind of coherent theory; that is way beyond my remit at the moment. Rather, I find it useful to identify useful metrics and relationships in the data that can eventually be situated within a wider theory, or can be used to advance or refute other ones.

Second, what are the current obstacles at the geopolitical and national levels to growth in investment within the United States? Off the top of my head, I can think of several important “obstacles”: the process of domestic credit allocation (including interest rates, integrity of too-big-to-fail banks, property development); the cost of raw materials (especially oil and gas); and, military commitments and the general financing of national security. Readers of Galbraith’s book will notice these topics are quite prominent in his account, while I have spent most of my very short academic career focused on the first.

Third, what is the current progress or state of the economic recovery since 2009? There are some subsidiary descriptive questions that point to my thinking here. Which economic sectors have returned to pre-crisis trends in output growth (contribution to GDP) and which remain stalled? Which industrial sectors? How did investment in private fixed assets respond to the crisis and aftermath? What about for investment in structures, equipment, and intellectual property? (If readers want to see what I’m getting at with these questions, take a look at this article from the NYT back in April:; I am essentially expanding this kind of inquiry, which has been, incidentally, the empirical base upon which most of research has been conducted).

My doctoral dissertation advisor liked to say that a solid way to organize an argument follows the formula: what; why; and, so what. The what component here is really, where is investment happening in the USA (both in sector and locational terms). The why seeks to explain the relevant processes that propel the investment we see or hinder the investment we hope for (particularly, why it should be the case that despite there being a real recovery in material terms, there should be such a slow expansion in quality employment opportunities). The so what for me really comes down to distributional fairness. In other words, something that has been on my mind the last few years is whether the parties responsible for the financial crisis and disappointing recovery were the same parties that amortized its costs, or whether there has been a systemic and successful effort to push those costs onto other parts of society. Additionally, I want to explore the durability/sustainability of the investment that is happening. At the end of the day, we all want to be a part of a successful collective endeavor–the US economy. Hopefully I’ll find much to be proud and excited about as I dig through the data. Alternatively, hopefully I can provide some insight into how to rectify the processes that point to the contrary.

Minor point on interest rates

I am currently writing a post that uses cluster analytical techniques to identify different economic structures at the county level in Texas, which I hope to complete soon. The point is to demonstrate the utility of a common but underutilized tool in economic-geography and also to continue my case study on the economic success story of Texas.

In the meantime, I just wanted to make a point about low interest rates. Quite frequently in the business press, one will stumble across a phrase like “in today’s low interest rate environment…” and it is typically quickly followed by a reference to our “accommodative” or “activist” Federal Reserve. Many would have us believe that low interest rates are somehow “unnatural,” which is an attractive idea because interest rates are in fact set by a committee, for all intents and purposes. The article that set me off today in a waiting room referred to the growth of fracking, and the whole thing was prefaced by the boilerplate statement about low interest rates.

But the United States is a country full of risk-hungry women and men. Do commentators truly expect us to believe that if interest rates were, say, five percent instead of near zero, high-risk endeavors and investments would not be undertaken? The causal effect of interest rates, I think, are totally overblown with respect to operational decisions of businesses and entrepreneurs to pursue high-risk projects or investors to purchase high-yielding securities whose underlying assets are less stable and cash flows less predictable. The while thing sounds like a lazy cop out.

People don’t make investment decisions exclusively on the basis of the Fed’s monetary policy. It is certainly one factor, but not the only one and an over-emphasized one at that. Entrepreneurs and corporate decision-makers don’t go into hibernation when interest rates rise or rev up when they drop. They make their decisions after careful consideration of risk, expected return, current capabilities, and a host of market factors.

Wouldn’t it be more interesting to know who (which entities/organizations, what sort of investors) make high-risk investments? And where those investments are located? Using what kind of evaluative technologies? What sort of collateral they put up, how they finance their investments? These are processes that depend on the structure of markets and organizations, and these in turn do not flow from the Fed’s interest rate dicta.

Databases of financial crises

On the economic history of financial crises

In my dissertation defense, my examiners and I spent a great deal of time talking about what kind of economic history emerges from the variable-based approach that is employed by economists such as Carmen Reinhart and Ken Rogoff. I’m not trained as an economist, but economic history is an important part of my discipline as well. The variable-based approach refers to long-term databases of dummies that indicate the presence of absence of a variety of financial crises. For example, Reinhart and Rogoff have a book called This Time is Different ( where they describe a variety of crises (banking, stock market, inflation, sovereign debt default, currency) for the last 800 years, in a large sample of countries.

I wrote a chapter on my dissertation on their dataset, and I used their sample of crises on a dataset of employment in nine economic sectors. In brief, however, such work contains serious problems with defining and determining thresholds for financial crises. One problem is that, in Reinhart and Rogoff’s book, a banking crises involves state intervention into the banking sector. Obviously, this makes a banking crisis as political as they are financial. Collecting the data is another problem, as it demands reviewing quite a bit of history.

The Wall Street Journal last week had a post on its MoneyBeat blog ( about a new database documenting financial distress on an index for a sample of advanced countries from 1967 and 2007, by Christina Romer and David Romer. Christina Romer previously served on Pres. Obama’s Council of Economic Advisers, and she recommended the President support and execute a spending program, which she helped to put together, in early 2009. That alone should suggest that the Romers take very different stances—in wider political circles but also within the discipline of economists—than do Reinhart and Rogoff, who, by the way, advocated for austerity measures and produced research (now determined to suffer from debilitating flaws in their data collection and analysis) to support their reasoning. I am very glad that we have this new dataset, because it is based on a very different method than the financial crisis dataset of Reinhart and Rogoff.

I’ll be writing up analysis in the coming days, as I fiddle with the Romer dataset. I need to read the paper that accompanies the dataset and also construct some databases.

Should Lehman Brothers have been allowed to fail?

On the question, briefly

I was recently asked the question: “Should the investment bank Lehman Brothers have been allowed to fail in the summer of 2008”? I’d like to sketch out a couple of points about the question and its answer, mainly to make myself feel better after realizing I did not have an answer ready and responded so inarticulately.


For a more thorough introduction to Lehman Brothers, I suggest scanning this post at Investopedia ( and the Wikipedia entry entitled ‘Bankruptcy of Lehman Brothers’ ( A search for ‘Lehman Brothers’ on Amazon reveals a number of books about the firm, none of which I have read. Here are some key points.

  • Lehman Brothers was an American, New York-headquartered investment bank–fourth largest in the States–with global operations. It had been part of American Express until that company decided to divest its banking and brokerage operations in 1994. The new entity, Lehman Brothers Holdings, Inc. was listed on the New York Stock Exchange. The company operated in three segments: capital markets; investment banking; and investment management.
  • In 2003 and 2004, the firm acquired mortgage lenders that were engaged in high-risk practices, namely subprime lending. The source of growing revenues in its capital markets division was securitization techniques, and revenues in this division surpassed other areas in the company shortly after acquisition. Record profits were reported from 2005 to 2007. Incidentally, rapid growth in profits is a tell-tale sign of an accounting control fraud.
  • Defaults on subprime mortgages began to increase over late 2006-early 2007. By August 2007, Lehman stock dropped substantially following the failure of two hedge funds associated with investment bank Bear Stearns. Lehman began shuttering its mortgage businesses, but continued to underwrite mortgage-backed securities. Global equities and fixed-income markets brushed off the hesitations earlier that year that profitability would suffer as mortgage and housing markets registered rising defaults.
  • Bear Stearns collapsed in March of 2008, and Lehman’s stock price dropped by almost 50 percent. Lehman was able to raise capital through preferred stock, however. In June, the company announced a loss of $2.8 billion but continued to raise capital from investors. It further announced it had increased liquidity, decreased assets, lowered exposure to mortgages, and decreased leverage. The stock price continued to drop over the summer and investors spurned management.
  • In September, the collapse in talks between Lehman and Korea Development Bank precipitated a new drop in the stock price as investors (hedge funds and short-term creditors) began to withdraw funds and limit exposure. The stock continued to drop as its cash reserves dwindled, losses and write-downs were reported, and restructuring programs were announced. A final attempt at a rescue by Barclays and Bank of America failed over the weekend of September 13 and on that Monday, the company declared bankruptcy.
  • Bear Stearns was in a similar position to Lehman Brothers, in that it was not a chartered institution, was publicly-listed, was an investment bank, and faced financial distress from its risky positions and unsound management practices. It was, however, the recipient of an emergency Federal Reserve loan via JP Morgan, earlier in the summer. The reasons for this, contrasted against the lack of such a loan to Lehman, are discussed below.

Is the question relevant?

My first comment is that the phrasing of the question “should Lehman have been allowed to fail” is actually quite misleading. A more pertinent question is “Could Lehman have been saved?” The answer, I think, is no. Recall that the rescue of Long-Term Capital Management in 1998 was orchestrated by the Federal Reserve of New York, but involved no public funds. That is, the Fed compelled creditors of Long-Term to recapitalize the firm. There were several attempts at a private sector recapitalization of Lehman Brothers; there was simply no appetite by its creditors or competitors to intervene.

Why is it the case that after the inability to recapitalize privately there was no recourse to a public recapitalization or any other preventative action by a government agency? Just as was the situation with Long-Term, Lehman was not a chartered bank. It’s primary regulator was the Securities Exchange Commission (SEC); the FDIC and (New York) Federal Reserve were not its supervisors. The SEC has no powers like the FDIC or Fed, and can really only intervene through review of a company’s risk management and investor protection policies. It can also levy fines on its supervised entities. In other words, it probably would have been illegal for the FDIC or the Fed to have used public funds to support Lehman Brothers. Furthermore, the SEC and the New York Fed have a long and combative history. Again, even though the Fed could not have provided any kind of balance sheet support, we should at least recognize that these turf wars prevented a lot of meaningful interagency communication.

In the absence of any consensus by private companies to support the bank, there was very little the state could do within the parameters of existing banking and macroprudential law to prevent the bankruptcy of Lehman. Specifically, with no chartered bank, the FDIC could not intervene by seizing the bank and its assets. The US Treasury could not have organized a direct loan nor could it have offered funds under various emergency programs related to the preserving the integrity of the dollar. And the SEC has no such powers in any event.

The exception is Section 13(3) of the Federal Reserve Act, which authorizes the Federal Reserve Board to permit a Federal Reserve Bank to extend loans under exigent and unusual circumstances. So essentially the question is really why Lehman Brothers was not offered an emergency loan as was Bear Stearns. What explains this discrepancy? In the words of Fed Chairman Ben Bernanke:

A public-sector solution for Lehman proved infeasible, as the firm could not post sufficient collateral to provide reasonable assurance that a loan from the Federal Reserve would be repaid, and the Treasury did not have the authority to absorb billions of dollars of expected losses to facilitate Lehman’s acquisition by another firm. Consequently, little could be done except to attempt to ameliorate the effects of Lehman’s failure on the financial system (underline mine).

The underlined portion is actually very important. Pursuant to Section 13(3) of the above stated Act, the Fed cannot extend a loan with the knowledge that the loan cannot be repaid. The perception on Wall Street prior to Lehman’s bankruptcy was that it was insolvent; it could not repay any loans extended to it. Certainly, this does not explain why the Fed did not extend such a loan many months before, but then hindsight is twenty-twenty, and there are limits to what these regulators know (especially in light of the turf wars just mentioned). So, the state was effectively unable to save Lehman Brothers.

So what?

The next pertinent question is, what does it matter that Lehman Brothers failed? Many would stipulate that its bankruptcy was the triggering mechanism of the banking panic that fall. I suggest this is wrong. There are several relevant points here.

First, housing markets began to buckle in late 2006 and early 2007. This manifested in liquidity problems at a host of non-bank financial institutions, including two hedge funds associated with Brazilian firm BNP Paribas in 2007 and Bear Stearns as mentioned. Saving Lehman would not have prevented housing markets from tanking or prevented the liquidity problems associated with the failure of mortgage markets and products. The Lehman bankruptcy was only one event in a long series of events that dried up credit and lending. Interbank lending in particular had already seized up.

Second, it is arguable that US financial markets were already in a state of panic before the weekend that Lehman failed. Again, note the experience of Bear Stearns. There are other examples: Countrywide Financial experienced a run in August 2007 before being acquired by Bank of America; IndyMac Bank suffered a run in July 2008 after Senator Charles Schumer stated to the media that he believed the bank was unstable; Washington Mutual witnessed massive withdrawals by its retail customers beginning on the same day as Lehman announced its bankruptcy. The financial panic, not only in the ‘shadow’ financial sector as well as in retail, therefore, was already underway when Lehman failed.

And finally, the stock markets “crashed” beginning on September 16, 2008, the day after Lehman declared bankruptcy. Indeed, during several trading sessions in September and October of 2008, US stock markets lost two to five percent of their value. However, again, equity markets had begun to decline beginning in 2007. If Lehman Brothers had not failed, then stock markets likely would have responded to similar triggering mechanisms, of which there were many.

These points support the conclusion that at a certain stage in the financial evolution of the US economy between 2003 and 2006, a financial crisis became inevitable. This was due to the construction of balance sheets, the dependencies erected between sectors of the economy, the rampant fraud and corruption in markets, etc. Lehman stands out principally due to, I suspect, the animus held by many on Wall Street for state regulation and action that doesn’t suit their wishes. The Lehman Brothers bankruptcy is partly an instance of scapegoating–‘the government failed to act’ narrative–and a failure of imagination, specifically the failure to grasp the roots of financial crises as endogenous and nonrandom.

The loan to deposit ratio and the trouble with US finance

 The three problems in US finance revisited

In an earlier post, I suggested there were three core problems with US finance: tendency towards dysfunction; uneven cost and access to financial services; and, waste, redundancy, and fraud. I was just browsing through blogs and saw a post at zerohedge ( It is entitled ‘All that is broken with the US financial system in one chart’ and shows the loan to deposit ratio at JP Morgan from 2008 to now. The question I’m asking myself is: does JPM’s loan to deposit ratio really tell us everything wrong with US finance? Does it reveal the US tendency to undermine profitability and stability by way of incentives to misallocate credit? Does it reveal the uneven ability for consumers to access credit on good terms? Does it reveal the wastefulness of the US system, the high incidence of consumer fraud, and the high incidence of white-collar fraud?

The first thing I note is that I don’t think the 2008 to 2014 period is satisfactory for answering these questions. Furthermore, there is no comparison to other large banks, even though JPM on its own has market power and can be considered a special case worthy of analysis. I don’t post comments on that blog, but I did notice in the comments section someone asking if there was a chart for the whole financial system. The implicit criticism, I think, was that JPM is not indicative of the rest of the banking system, even though it is the largest bank in terms of deposits, or at least in the top four. I think a better starting point is asking whether or not the loan to deposit ratio can capture the problems in US finance, and then proceeding with individual banks to understand how the ratio is constructed organizationally and geographically.

I’ve attached below a chart created using FRED (, showing the ratio of loans & leases to deposits at US commercial banks. It begins in 1973 and continues monthly to the start of October 2014.

Loan to deposit ratio, US commercial banks

It seems to me this is another important institutional relationship in US finance. Some notable features include: (1) the ratio currently stands at its lowest level since the late 1970s; (2) it peaked during the bubble, and even the mortgage lending boom could not raise the ratio to its previous peak (which suggests some interesting limits to leverage); (3) it increased rapidly starting in the mid-1990s economic boom; and, (4) it had been in decline from the panic in 2008 until earlier this year.

There are a number of different behaviors that affect the ratio. First is clearly the demand for credit, which is structured by access and cost. Demand, by this token, is affected by the organization of credit allocation, that is the specific institutions responsible for providing it (too-big-to-fail banks, savings associations, credit unions, payday lending). Second is the effect of interest rates, which affect willingness to take on risk by banks. Third is capital and other regulatory requirements.

So, does this institutional relationship reveal the problems in US finance? This question assumes that the three-problems are valid; they may not be, and this is a good exercise to work that issue out.

1. Tendency towards dysfunction

The ratio tends to drop around US recessions, but it is interesting to note that it did not drop as much during the S&L debacle. Leverage actually appears to have increased from 1985 onwards, even through 1987 when there was a sharp drop in profitability of US banks. Even during a banking crisis, leverage continued to grow. It did, however, respond dramatically to the latest recession and banking crisis, however it is hard to separate out those effects. Did leverage decline after 2008 because of demand or because of supply side factors? I don’t know. At the least, the ratio might anticipate collapses, in that periods of expansion in leverage are followed by contractions, which is to be expected based on periods of credit expansion.

2. Cost and access is uneven

In order for us to determine whether or not the ratio can reveal the problem of access, it would probably be best to disaggregate the ratio between types of organizations. First would be sector (commercial banks, savings associations, credit unions, non-regulated intermediaries); second would be size of organization; and third would be the region of operations. It would be great if there were data on the average ratio by banking markets served (which could then be related to other demographic features of those markets, such as income, population, etc), but that would be quite an undertaking. At least in general terms, the ratio suggests that there has been a significant pullback in leverage; as we cannot quantify the factors that contributed to that (it could be demand, regulation, and supply), it is difficult to know whether or not the pullback reflects lower willingness by consumers to take on debt or greater risk aversion by banks. The post at zerohedge argues that the flatlining in amount of loans outstanding indicates a conscious decision by the bank not to extend loans; I think we would need more data on the volume of loan applications as well as the rate at which applications are accepted. The Federal Reserve has survey data from banks, which speaks in a way to sentiment, but hard data would be more useful.

Another important point that comes to mind, and which returns to the issue of access and organization type, is that using commercial banks to determine lending might actually be misleading. As I’ve posted before, regulated banks are actually performing less lending. The ‘shadow’ financial sector has been encroaching on traditional lending markets for decades. It may be the case that the growth of shadow activities in financial markets has lowered the share of commercial banks in lending. To develop this line of inquiry further, one would need to explain that this pattern accelerated after 2008.

3. Waste and fraud

On the whole, the ratio really seems to be an indicator of system-wide leverage. It does not seem capable of tackling issues of consumer fraud, white-collar crime, etc.


I am weary of these reductionist articles that pop up on so many blogs and online news sites. The problems in the US financial system cannot be boiled down to any one factor. The sector is too heterogeneous for there to be even one set of factors. Clearly, there are more than three problems as well, but I’ve tried to make it so that other “sub-problems” can be filed under those categories. Again, the endeavor to determine just exactly what is wrong with US finance has to take place on a lot of levels–regional, sectoral, historical, institutional, etc. The key may be to generate case studies that are regionally and institutionally specific and see what kinds of patterns and differences can be identified. That said, I’m glad to add the ratio to the list of relevant institutions of finance.

Too-big-to-fail profitability

This is a short post, comparing basic financial information of the too-big-to-fail banks (these are: Bank of New York Mellon, Bank of America, Citigroup, Goldman Sachs, JP Morgan, Morgan Stanley, State Street, and Wells Fargo). Of these organizations, three are not headquartered in New York (BOA in Charlotte; State Street in Boston; WFC in San Francisco/Minneapolis).

The information I have included is the change in stock price over the 2008 crisis and price performance since the trough up to now; return on assets; a liquidity ratio (from the balance sheet, cash as a ratio to total current liabilities); and, profit as a share of total revenue. All this information can be collected from the balance sheets and income statements of the banks, which I retrieved using Google. The figure below contains the information.

Stock price change ROA Liquidity (Cash/Current liabilities) Profit/Revenue
2007-2009 2009-2014 June2014 June2013 avg 2013 avg 2012 avg 2013
BNYM -63% 58% 0.74% 0.56% 0.5 0.49 0.137
BOA -94% 129% 0.37% 0.30% 0.39 0.4 0.112
Citi -95% 42% 0.52% 0.51% 0.35 0.32 0.180
Goldman -77% 71% 0.87% 0.91% 0.29 0.285 0.235
JPM -70% 267% 0.66% 1.03% 0.35 0.275 0.188
MS -83% 70% 0.53% 0.19% 0.3 0.51 0.090
State Street -75% 74% 0.85% 1.02% 0.88 0.93 0.216
WFC -77% 563% 1.50% 1.48% 0.44 0.42 0.265
Average -80% 181% 0.82% 0.86% 0.44 0.46 0.196

There are a few points I see as especially relevant. First, almost none of the banks have restored the price of their stock to levels seen around 2007, the stock market peak. Not all of the banks, it should be said, were trading at historical peaks in 2007; nonetheless, they all responded to the crash in 2008. Bank of New York Mellon, State Street, JP Morgan, and Wells Fargo had below-average declines, but only JP Morgan and Wells had recovered their losses. The worst-performer has been Citigroup, which comes as no surprise seeing as it is easily the worst-run organization on the planet.

Second, the range in ROA is quite large. I’ve spent a lot of time looking at ROA at lots of other banks of various sizes and specialization; a previous post here put US total average bank profitability currently at around 1%. Wells is the only company reporting an ROA greater than the US average (in 2014; many more were closer to the average about a year ago). I’m not sure what the patterns are–perhaps there are regional trends, but I suspect they have much more to do with target deposit markets and product lines, etc–but this variability in ROA encourages further analysis.

Third, it is illuminating to see the liquidity ratio comparison if only because it introduces the challenge faced by regulators and supervisors on macro-prudential matters. Current liabilities consist of accounts payable, short-term/current long-term debt, and ‘other current liabilities.’ Each of the banks, in turn, have different concentrations in each of these areas. The amount of cash (and current liabilities) also differs substantially between companies. Obviously, one of the more quiet fights by regulators over the last few years has been to raise capital ratios (one way to ensure that costs of crisis resolution fall as much on the private sector as possible). Some of these businesses simply operate in riskier markets; this may explain why there is such variation in liquidity ratios. I wonder how this unevenness is looked at by the regulators themselves?

Finally, the profit as a share of revenues for all too-big-to-fail banks is close to 20 cents on the dollar. I’m not sure what this number is for all Fortune 500 companies, but I remember hearing an interview with the CEO of ExxonMobil some years ago where he said that Exxon’s profit per revenue was 10 cents on the dollar, and that this put Exxon ‘right in the middle’ of the Fortune 500. If you look at the most recent Fortune 500 list, the top four companies (oil majors and conglomerates) are all less than 10%, but then Apple is at 21.6%. What this all suggests to me is that financial conglomerates enjoy profit margins that are much higher than capital goods producers and energy companies, but then there remains quite a bit of difference. Again, I suspect this has to do with product and market specializations but also company structure.

It is easy to clump the too-big-to-fail firms together, but in fact they serve quite different markets. When we devise strategies and policies to control them, we need to take into account this heterogeneity and plan accordingly.