March 19, 2012 Dylan Ratigan

From the Vault: Yves Smith on How Banks Extract from the Economy

This podcast was originally recorded in January 2012.

With Dylan off this week, we’re looking back at some of our favorite podcasts from the last few months that you might have missed. This one digs into a term that we talk about a lot in Dylan’s book Greedy Bastards — extractionism.

Joining us to discuss the concept of “extractionism” is Yves Smith of nakedcapitalism.com.  She is author of ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism.  She opened my eyes to some radical stuff going on in the capital markets.

Big Banks are extracting capital for themselves with such power that investors are actually afraid to go to the courts for redress — a perfect example of institutions that like to create one set of rules for themselves, while preferring that everyone else play by another set of rules, solidified and supported by a stunning lack of transparency in certain sectors of the markets.

The examples of that reveal themselves over and over.  But first, what is extraction, and how is it the opposite of capitalism?  How can extractionist systems have all the characteristics of capitalism, while hiding the elimination of productive resources over time?

Greedy Bastards like to call themselves capitalists, but what they’re actually doing is the exact opposite: it’s extractionism: taking money from others without creating anything of value; anything that produces economic growth or improves our lives.

Under an extractionist system, we find lose value at a faster rate over time, while we need to be creating it.  Instead of giving people incentives to make good deals where both sides can benefit, extractionist systems rewards those who take and take some more, and give nothing in return.  Sadly, extractionism has crept its way into every aspect of our economy — it’s everywhere, from trade to taxes to banking.

Let’s take a look at banking as an example.  As Yves Smith explains, financial firms do provide valuable services to our economy, like establishing stable and reliable methods of payment for goods and services, and selling bonds and stocks to help raise new money to fund big projects. There are more than that, of course, but those are two basic examples of valuable services that our banking and financial sector provides.

Now, let’s look at how they can also be extractive — almost always going back to the lack of transparency in the financial markets.

Yves identifies two main extractive techniques of our financial industry.  The first is charging too much for goods or services. “Even fairly sophisticated customers can’t know what the prices are of many of the products, so it’s difficult for them to do side-to-side comparisons,” says Yves.

The second method is producing products that are so complicated —like in the swaps market — that clients can’t see hidden risk in them.  “This has unfortunately become extremely common now that we have a lot more use of derivatives. Many of the formulas that are used they are disclosed by they are extremely complicated, and then on top of that, the risk models that are commonly used for evaluating the risk actually understate the risk,” says Yves.

So what is the Greedy Bastards Antidote to extractionism?  Here’s what Yves would like to see:

1. A small tax on all financial transactions.  This would “discourage customers from engaging in so many transactions.  And the reduction in the number of transactions would mean less opportunities for banks to trade the risk and lay-off the risk so quickly, so the fact that they would have trouble turning around and laying off risk would make them… more cautious because they would have more trouble with their own risk management and would have to be more conservative in their own strategies,” says Yves.

2. Give financial institutions a bigger financial responsibility when they knowingly recommending bad products or dubious strategies. Yves believes that we need to have a better way for customers to hold financial institutions accountable when they sell bad products. “The problem is that that’s in theory a good solution; in practice, a lot of these – and we see this in the mortgage crisis — that the customers are so afraid of the banks that they are not willing to sue them.  They are afraid of the power that  the big banks have, they are afraid that either the banks will cut them off directly and that the banks have so much  power that the government would go after them… If you can’t use courts for redress, you kind of have a problem because then it means it falls to regulators and we have a very weakened regulatory apparatus, too,” says Yves.

And that brings us to the next point.

3. We need increased political pressure for an effective and robust Securities and Exchange Commission.  
Yves believes we need “the sort of SEC that was actually feared in the 1970s. People seem to forget that.  When they had an effective enforcement director, Stanley Sporkin, who really did – and he was not only willing to try cases, he was willing to lose cases.  You have to be willing to lose a few to perfect theories.  The SEC has become so risk averse it’s not even willing to lose cases, which means it’s only going to do ones that are slum dunks like insider trading cases,” explains Yves.

4. More inspection of what the banks are doing in their over-the-counter businesses.  “Particularly in terms of disclosure,” says Yves.  “One of the classic examples is infrastructure deals.  You will have a government that owns some sort of asset — the classic example was the Chicago parking meter deals, where they get revenues from it and because they are a bit broke, they decide that they are going to sell the family china when they are still going to have to rent it back and use it.  And what happens is that these investors will have so many fees in these deals, there are multiple fees. Not only do the investors want to earn a return in the 15% to 20% range, but then you also have a lot of fees in putting together the deals because they are extremely complicated. And there is a fee for managing the asset on top of that… Literally in the case of the Chicago meter deal, they marketed to investors at twice the price they paid the city because they knew they are going to ramp – they planned to ramp their fees aggressively,” says Yves.

Meg Robertson is a digital producer for DylanRatigan.com.

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