Sep 22, 2011

The financial sector and allocating capital

Kevin Drum flags Ezra Klein talking about tech investment:
Eric Jackson, a former employee of PayPal and now the CEO of the online-investing platform CapLinked, worries that implementing the “Buffett rule” would hurt the pool of investment money available to tech start-ups. His logic on this point is unimpeachable: If the Buffett rule means taxing capital gains more like normal income, then it will, on the margin, hurt investment of all kinds, including investment in tech start-ups.
Drum has some good thoughts there, but this reminded me of something I read in 13 Bankers the other day.  I've often wondered why it is growth was so weak during the Aughts.  Interest rates were super-low for most of that period, and usually one would think that would light a fire under the economy's ass, so to speak.  If macroeconomics is to be believed, we should have had screaming growth, bordering on an inflationary spiral.  Why not?  In 13 Bankers, Kwak and Johnson argue, in a quick aside of sorts, that the reason we had such lame growth during the Aughts is that the financial sector was systematically misallocating capital:
The irony is that the flood of cheap money did not even have the healthy effect it should have had.  Ordinarily, businesses should take advantage of low interest rates to make capital investments, which contribute to overall economic growth.  In the 2000s, however, as Tim Duy notes, business investment in equipment and software grew more slowly than in the 1990s, despite the lower interest rates.  The problem was that the money was misallocated to the housing sector, resulting in anemic growth.
ECONned (which is that rarest of books about the financial crisis, an original) makes a similar argument at one point.  Ostensibly, the reason the financial sector exists is to allocate capital.  Whenever you ask Jamie Dimon or Lloyd Blankfein why their employees deserve umpteen zillion dollars in bonuses every year, that's the answer you'll get.  Gotta make sure America's throbbing entrepreneurial spirit isn't starved for cash.

Allocating capital is a critical function of the modern economy, it's true.  But if Johnson and Kwak (and Yves Smith) are right, not only is Wall Street mostly functioning as a giant casino, it is also actively hindering the economy where it is supposed to be performing its only key function.  This seems an under-discussed part of the financial crisis, or even things today.  Financial sector profits are back to stupendous heights—I see no reason not to assume they're not systematically misallocating capital again (and probably inflating the next bubble to boot).  Is anyone aware of research on this question?

Bringing it back to PayPal, I see no reason to worry all that much about raising capital gains taxes.  That part of the economy doesn't work anyway.

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