Mistaking the Transmission for an Engine
The Times’ David Leonhardt had a long and thoughtful take on financial re-regulation Sunday, focusing mainly on the details and their larger implications. But he brushed past the real issue in a couple of places. Here’s the closest he gets:
What may be more worrisome than the size of any individual bank is the size of the entire sector. It accounted for about 30 percent of all corporate profits in the decade before the crisis, up from 16 percent in the 1970s and 1980s. Some of that growth no doubt reflected innovations that improved people’s lives, like the A.T.M. But a significant portion probably did not. It reflected, among other things, Wall Street’s ability to make huge profits in good times and to be bailed out in bad times. It was what some economists have called the privatization of profit and socialization of risk.
Similarly, Paul Krugman today accepts the premise that Too-Big-To-Fail is here to stay. It is a fait accompli to all future regulation, mooting the Republicans’ Frank Luntz-inspired attacks on re-regulation as a continuation of the bank bailout:
The only question is whether we’re going to regulate bankers so that they don’t abuse the privilege of government backing. And it’s that regulation—not future bailouts—that reform opponents are trying to block.
It’s fair enough to blast the mendacious Richard Shelby (R-Ala.), who is currently posing as some kind of populist, for his demented attacks on behalf of the richest of the crooks.
But how can anyone take seriously the notion that—regulations or not—bankers won’t “abuse the privilege of government backing?” Why can’t there be a dismantling of TBTF?
As Leonhardt notes, part of the problem is the size of the banking sector. But mainly it’s the misapprehension of the financial services industry’s economic role. You hear it said all the time that banking, insurance, the bond market are an “engine” of the economy.
Take it from someone who has worked on engines for 30 years: Finance is more like the transmission than the engine.
Confusion between the two is not academic. This error goes to the core of our current trouble. For those not versed in the mechanical trades, I’ll unpack this metaphor in detail.
First, imagine that money is power.
If you think of the U.S. economy as an automobile, the engine is manufacturing, which transmutes raw materials into money. Similarly, internal-combustion engines transform raw materials—gasoline or diesel fuel—into power to move the vehicle and its passengers. Internal-combustion engines are notoriously inefficient, transforming less than 30 percent of the energy stored in their fuel into torque (that’s twisting motion) to move the vehicle forward. In the same way, American manufacturing is (and has been) less efficient than many of its competitors, wasting a lot of its potential. But let’s set aside that detail for now.
In order for a car to get around efficiently, with decent acceleration and a reasonable top speed, the engine is bolted to a transmission. The lower gears—first and second, say—multiply the engine’s torque to make the car accelerate more quickly, overcoming the inertia of 3,000 or 4,000 pounds so that it can merge onto the highway or pull out of a driveway without stalling. The higher gears allow the heavy car to cruise at 70, 80, or even 90 miles an hour while getting much better mileage than an older car would get.
In general, the more gears a transmission has, the more drag it imposes on the engine it’s connected to. More gears mean more weight, and the inertia of those spinning gears tends to work against the engine. Still, improvements in transmission technology have contributed greatly to the better efficiency, quickness, and top speed of modern cars, compared to those made a few decades ago. My 1967 Chevrolet Nova came from the factory with just two forward gears. It topped out at about 90 mph and got about 17 mpg, even though it weighed less than 3,000 pounds. My fiance’s 2005 Toyota Corolla has four speeds, including overdrive. It’s much quicker off the line and (I’m sure) has a much higher top speed than my old Chevy, despite having about the same horsepower and weighing only a little less. It also gets about double the gas mileage.
So: Better transmissions make better lives.
Better banking systems make better lives, too, by multiplying the “torque” (money, or value) produced by the manufacturing sector and distributing its power most efficiently, to help people move forward and create new businesses.
Before the Great Depression, this country’s tremendous economic engine was stunted by its coupling to a relatively puny and unsophisticated financial-services industry. Depression era laws and regulations not only restored consumer confidence in the banking system, but also complicated that system in ways that allowed it to work better.
During the past 30 to 40 years, as the American economy’s engine has sputtered and become less powerful, leaders have tinkered with and expanded the financial sector—the transmission—in an attempt to make up for lost torque.
Amazingly, it seemed to work for a while—rather like bolting a semi-truck’s 18-speed transmission into a pickup truck instead of doing a needed tune-up.
Now, there’s a lot to know about big-rig transmissions, and there’s no need to get into all that here. Suffice it to say that they’re bigger and more complex than anything you’ll find in a passenger car or truck, and adapting one to fit, say, a Chevy C-10 would be a job for the Monster Garage. But something like this happened to our economy, and it did so because our nation produced a bumper crop of transmission specialists—or, to shift out of our metaphor for a moment—banking, insurance, and finance experts.
These whiz kids went to work on our economic transmission, removing the regulators that made it shift more smoothly, and then converting it into an automatic so your old mother could drive your laughably under-powered truck. They claimed they were making it safer and better, called this “financial innovation,” and for decades it allowed Americans almost not to notice that they were systematically becoming poorer (with less power and torque). With our huge fancy transmission, society continued to move forward. We could even get over some little hills.
Transmission experts grew in power and influence, gaining control over their own pay as well as most of ours. They paid themselves extravagantly, attracting more smart people into their ranks. The engine mechanics were fired, outsourced, and underpaid so that only folks bearing GEDs bothered applying for those jobs. The old V-8 engine in our truck developed a miss, burned oil, lost some of it’s power as it stopped firing on all cylinders, effectively becoming a six, then a four. Mechanics suggested engine fixes—new spark plugs, valve adjustments—and questioned the utility of the big transmission. The transmission guys told the mechanics to shut up, and added more gears to the transmission to keep our economic truck rolling. They awarded themselves bonuses.
In 2008, trying to get up a hill, our engine smoked and wheezed on its two or three remaining good cylinders, while the gears in our clownishly scaled transmission ground to a stop.
Now our engine is so weak and our transmission is so large and so few people remember what it’s like to have a good running engine, and those people are dropouts anyway who don’t know anything. All the important people know only transmissions, and those people are our best and brightest. We’ve mistaken our transmission for an engine.
All our resources are going to fix this outsized gearbox, which was never needed and should not have been installed but for someone’s decision, two or three generations ago, to concentrate only on making bigger and better transmissions and allow the economic engine to wear out.
Seen in this light, the financial-services reform proposals in congress make little sense, not because they’re a gift to the financiers or because they’d “stifle financial innovation,” but because they’re still concentrating effort on the wrong machinery.
Rebuilding our pickup truck would require dismantling the huge, heavy, drag-inducing transmission and replacing it with something appropriate to the vehicle—a modern six or seven-speed automatic, say, maybe with four wheel drive.
But the real job—which almost no one is talking about—involves rebuilding (or replacing) that sputtering old V-8 engine: the neglected and maligned manufacturing sector. And we can’t do that until we recognize that the engine is the primary thing and the transmission—the financial-services industry—is secondary.