Death Knell for a Great Region

The Bacon’s Rebellion theory of economic development (“Economy 4.0”) is about to undergo an important real-world test in New York.

The theory says that financial capital and human capital gravitates to where it generates the highest return on investment. All other things being equal, states and regions with lower taxes, fewer regulations and a less heavy-handed government will enjoy superior economic performance over the long run. Things aren’t always equal, of course. One of the major countervailing forces is the existence of world-class industry clusters where a critical mass of human capital can generate enough innovation and productivity to offset the disadvantages of obtrusive government. Silicon Valley is such a place. Hollywood is such a place. Manhattan was such a place, defying economic gravity for years. But it may be no longer.

Wall Street stood at the center of one of the greatest wealth-producing machines in American history. For decades, the phenomenal profits of the investment bankers, mortgage bankers and hedge fund managers fueled economic prosperity in New York City (and environs, particularly the Connecticut suburbs where the hedge fund managers dwell) despite an otherwise inhospitable business climate. Through their ability to borrow extraordinary amounts of money, leverage their capital and seemingly dish off risk through opaque and often incomprehensible derivatives, Wall Street financiers generated unconscionable salaries, bonuses and corporate profits.

Kenneth Rogoff, former chief economist with the International Monetary Fund, says that profitability will never return. As quoted by Spiegel Online, he said:

The US financial system was bloated and overgrown and reckless to some extent. Now it is being reigned in. … In 2006, the financial sector accounted for a third of corporate profits in the US, although it only represents 2 or 3 percent of total gross domestic product. Goldman Sachs alone distributed $16.5 billion in bonuses to its 26,000 employees. I’m sorry, I think it’s unbelievable. You can’t just make money out of thin air like this, and underlaying this there were enormous risks being taken.

What we’re seeing is a shrinking industry — perhaps by 20 or 25 percent and in some segments perhaps as much as 50 percent. But these finance products based on fancy rocket science and derivatives just aren’t coming back, and that’s very painful. The industry is not going to make the same profits in the future as it did in the past. And this isn’t just about subprime and mortgage losses. Investors are starting to realize that the profit model these investment banks were running on has been trimmed.

Wall Street financiers amassed incredible fortunes (contributing to the much-talked-about disparity in wealth in the United States, incidentally) while shoveling off risks that Rogoff says could explode into $1 trillion in liabilities to U.S. taxpayers. You and I will be paying for New Yorkers’ yachts, estates and country club memberships for a very long time.

But Wall Street’s melt-down will be felt most acutely in New York itself. Nationally, financial services accounted for 8.3 percent of the U.S. economy, the highest level in its history. That industry is super-concentrated in the New York New Urban Region (extending into New Jersey and Connecticut). According to the Wall Street Journal, about five percent of New York City’s jobs are in financial services, but they account for a quarter of the city’s wages, or about $60 billion in 2006. That’s about to change. Even before the disastrous events of the past few days, New York had shed 11,000 jobs. Wall Street has been through downturns before, but this one is different. As the financial industry de-leverages, profit margins, stock prices, bonuses and employment will shrink permanently. And that shrinkage will run the economic gears in reverse. As the Journal notes, each financial services job generates three positions in other sectors. “The financial services industry won’t be the same economic engine it has been in recent years.”

Now New York will have to come to grips with the fact that, outside of a handful of industries, such as media, advertising, fashion and tourism, high taxes and a high cost of business make the region hideously uncompetitive. The question is, can New York reinvent itself?

Bacon’s Rebellion’s “Economy 4.0” theory suggests an answer: not bloody likely. Carrying the weight of high taxes, regulations, labor unions and other high business costs, new industries will find it difficult to take root, much less to grow enough to offset the shrinkage of the financial sector.

I do confess to experiencing schadenfreude in seeing the Wall Street “masters of the universe” knocked down a few pegs. I have no respect for people whose greed created immense wealth for themselves and destroyed it for others. But Gotham is a magnificent city, and it is populated by many people who never benefited from the excesses of the money mavens. I pity them for what awaits the city when its employment base and tax base shrivels. I will take little pleasure in having my hypothesis confirmed. But, for now, I am very glad I make my living in Virginia.

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16 responses to “Death Knell for a Great Region”

  1. rightwingliberal Avatar

    If Ireland can do it, anyone can do it.

  2. Anonymous Avatar

    I suppose that when New York implodes, the fragments will land where? Tysons’s?

    Or maybe they will try to find some place a little more attractive to live in or look at.


  3. Darrell -- Chesapeake Avatar
    Darrell — Chesapeake

    What you don’t seem to realize is we aren’t in a meltdown yet. Yes, it all looks really bad and scary, but we haven’t even begun. I see what’s happening so far as a dropped rod nuclear event. In economic parlance, it means the Fed is attempting containment without the ability to cool a global economy.

    First we saw housing problems, followed by tax and credit problems. Agencies were running into bonding issues, and somewhere back in the miriad threads I asked when would pension funds and the general economy take a hit. Well with AIG we see that insurance companies are vulnerable. It is merely the point man of companies whose heavy investors are pension funds and governmental agency cash accounts. Investments that are subject to laws of mandatory redemption based on quality or international entities who have no desire to be partners in an inferno.

    It would be prudent to ask which investors are going to be next to fall off a cliff. Those are the ones that will really force our economy into meltdown. State and local government will soon realize that all the social programs in the world are worthless if there is no money to pay for them.

    You ain’t seen nothing yet.

  4. Anonymous Avatar

    It is way too soon, and a bit silly, to write New York’s obituary.
    The city has been through a lot worse and it’s still the most important city in America. I believe it still will be years form now.

    Peter Galuszka

  5. Anonymous Avatar

    I know a fellow who likes to beat up on what he calls government bailouts. Still, he bought a thousand shares of AIG yesterday, at $2.15.


  6. Anonymous Avatar

    “dropped rod nuclear event”

    I like it.

    Nice Analogy

    Nice Hyperbole, too.


  7. The events of the last few weeks put a whole new spin on the word “protectionism”.

    It’s NOT OK to protect folks from payday lenders, low-ball ARM mortgages and outsourcing their jobs, losing their health insurance, etc … but it’s a “must” that we “protect” Fannie, Freddie, Bear Sterns, and AIG and whatever corporate sloths can manage to belly up to the trough.

    Business as usual folks.

    and .. our big “threat”?

    why.. we’re going to have a 9-11-like commission to “figure this out”.


  8. Anonymous Avatar

    Hey Larry:

    In a down market, is a short seller a speculator?


  9. Anonymous Avatar

    “Russian markets stopped trading for a second day after emergency funding measures by the government failed to halt the biggest stock rout since the country’s debt default and currency devaluation a decade ago.”

    The Russian market is down 57%.

    “The government yesterday injected $20 billion into the interbank lending market via central bank and Finance Ministry auctions in a bid to contain soaring borrowing rates as credit dried up in the wake of the Lehman Brothers Holdings Inc. bankruptcy.”

    “Here in the US, we may be well meaning interventionists Socialists — but at least our markets are open!”


  10. E M Risse Avatar

    Jim Bacon:

    You did not mention that the New York / New Jersey / Conn. / Etc. New Urban Region has wildly dysfunctional settlement patterns at the Alpha Community scale.

    These patterns will make obtaining a sustainable trajectory very difficult, but not impossible if they start to change now.

    Having higher intensity in some places and a shared-vehicle system that carries more people than any other is not enough, in fact it contributes to the problem. It allows many to avoid the need to achieve Balance.


  11. re: “In a down market, is a short seller a speculator?”

    as long as it is his own money and he is not being essentially financed by Government insured entities and securities – he can speculate all she wants.

    We need to have people and entities willing to take risks but you’re not taking a risk if your actions have a government security net …..

    this is really simple.

    We turned over the Government to those who would use it to finance/insure whatever risky activities they chose to engage in…

    .. and the rest of us are little more than chickens in the henhouse cheap seats….

  12. E M Risse Avatar

    OOPS, forgot:

    Great to see a Region-centric post!!!


  13. The numbers are a bit misleading. Wall street (broadly speaking) provides maybe 25% of the New York metro area’s economy.* Remove that 25% and you have a pretty thriving city still.

    What you will miss is the high end entertainments (restaurants, shops, galleries, amusements) that feed on the fat of Wall Street. What makes Tysons different than NY (or DC different) — more free money floating around.

    Of course, this is all a bit of hysteria. New York is not going the way of Philadelphia for some time. Remember, whenever someone on Wall Street posts a loss, someone else makes a profit. So don’t pay too much attention to the smoke, look for the fire.

    * law is related directly to Wall Street as well — but although it is large, I don’t have any idea of the numbers. REmove wall street, remove the lawyers in 10 years.

  14. like Darrell has intimated…

    we’re about to find out whose pension funds invested conservatively and whose did not.

    Unless mistaken – the Virginia Pension fund has steadfastly refused to invest in mortgage securities that were not adequately securitized.

    My own has already dropped by about 3 percent – not counting today’s meltdown…

    and I hear some of the CEOs have taken huge hits.. some of them have lost more than half of their 30 million dollar stakes….

    it’s a tragedy .. it is….

  15. Darrell -- Chesapeake Avatar
    Darrell — Chesapeake

    Unfortunately it isn’t a factor of being conservative. Pension funds are generally limited by law from overinvesting in toxic securities. So they invest in safe insurance companies and banks. Much of the same stuff that the average joe invests in. But what happens when those safe investments crash? According to Virginia’s state pension fund, it’s Lehman losses were a “drop in the bucket”. A measley 125 million. But those drops get bigger as more and more companies are forced to liquidate their holdings.

    That’s the situation we are seeing with the unprecedented bailout of AIG and the scramble for merger partners by the likes of Morgan and Wachovia. In the 1930s the average joe ran on the banks, hoping to save their investments. Today we saw the heavy hitters doing the same thing, using a strategy of better safe than sorry.

    With the mergers we are seeing cash short companies trying to save their butt by grabbing the ready cash of depositors. Our checking and savings accounts are now casino chips in this mad dash for cash. Some will say it’s no big deal if Wachovia folds, everyone is covered by FDIC. It’s a nice thought, but that insurance is close to being tapped out as well, adding even more Main Street risk in an environment where the Fed is covering Wall Street’s current losses with Joe’s future income.

  16. “But what happens when those safe investments crash? “

    “safe investments” based on securities – bundled or otherwise that are themselves, in fact sub-prime, ARM and ninja loans are NOT “safe investments”.

    What is killing all these companies right now is – how much exposure do they have in securities consist of sub-prime, ARMs, etc because it’s the VALUE of those that now has to be written down – which then means more reserve capital is needed to offset that loss.

    But where would you get that additional capital from if you don’t have any surplus access to back it up?

    Why did ALL of these companies get involved with securities that were not adequately capitalized – you ask?

    …because .. it was believed – and rightly so – that the Feds would stand behind these ninja loans… was like a virtual guarantee that you could – essentially print money.. on Uncle Sam’s dime….

    If the Feds stuck to their original policy of NOT buying nor guaranteeing ANY loan that was not adequately collatoralized …then the so-called investors would not have made loans like that – for fear that they would eat them if they went bad.

    I don’t dispute that the mess we have now.. threatens a whole bunch of people and companies and that the solution may well be taxpayer bailouts…

    but I don’t think understanding what happened is that difficult despite all the hand waving going on…

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