#7 The Profits of Financial Engineering

Financial engineering is a symptom of soft money and cheap credit which often gets mis-attributed as a cause of inequality. In order to fully explain all the factors that go into making financial engineering possible, it would take a few more posts, but for now I want to lay the ground work on what exactly it is and how it’s profitable.

I recently read Rana Foroohar’s book “Maker’s and Taker’s” and while it provides an interesting commentary on the nature of financial engineering in the US markets, I find her conclusions to be ultimately lacking. We are told repeatedly by the entrenched financial academia that soft money and cheap credit are good things for our economy. They keep the money moving, encourage more participation in the economy, and force investment.

But as we know from our research into the macro phenomenons following 1971, incentives are everything. Rana writes in her book:

“How did finance a sector that makes up 7% of the economy and creates only 4% of all jobs, come to generate a third of all corporate profits in America, at the height of the housing boom, up from some 10% it was taking 25 years ago?”

And the answer is a roundabout one. Certainly regulations have changed quite a bit in the world of American business, one that immediately comes to mind is the repeal of Glass-Steagall following the 2008 financial crisis. There is no doubt these changes in regulation are partly to blame. But if we want to fully understand the implications of these shifts in corporate profit structures we must examine them from first principles.

In a free market economy the entrepreneur’s goal is to profitably satisfy human action. That is, he must provide a good or a service in an adequate enough supply to meet market demand with enough operational margin to profit from his undertakings. This is the building block of peaceful cooperation in human society. Nobody is better than this incentive of the coincidence of wants. I have money, you have shoes, I want shoes, you want money. Both parties willingly engage in this transaction and come away from it more satisfied than before (whether this satisfaction lasts is another story).

Disruption of credit cycles and money creation by intervention from central banks and governments, does more than just encourage investment, it disrupts the measuring stick of economic calculation. Imagine you are building a house, and the length of your tape measure is constantly changing. One moment a foot is 12 inches, the next its 9. Building that house suddenly becomes a much more difficult task, and building a proper house might be near impossible. More on the specifics of this in future newsletters.

We must remember, when trying to understand the why of the markets, everything must be reasoned from first principles. Profits are a market force of capital distribution that allocates resources to those who are best able to satisfy consumers. If the entrepreneur profits from more efficiently satisfying consumer demand  why then does Apple, a technology engineering company have lower R&D spending as a % of sales than ever before? And with a warchest of $145 billion in cash, choose to borrow $17 billion in 2013 (As asked in Rana’s book)?

The answer is because financial engineering in a society with chronic, artificially cheap credit has grown more profitable than entrepreneurship. The moneyness of assets has created an environment where equity is more directly rewarding (and often less risky) than currency. The answer is because the financial engineers of today are satisfying the market demand for sounder monies.

I will continue to expand on these principles in future newsletters.


Book of the Month:

The Dao of Capital: Austrian Investing in a Distorted World

“It was Böhm-Bawerk who defeated them so effectively with economic theories and critiques such that Marxism did not take root in economics to the degree that it has in other professions, such as sociology and history. Using impeccable logic, Böhm-Bawerk showed that the workers who are employed by the entrepreneur are paid immediately for the “full value” of their labor, so long as that value is correctly calculated by including the time element. After all, in most production processes the input of labor hours doesn’t immediately yield a finished good.”

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