By Peter D. Schiff
Over the past half-century, the United States has seen its global dominance in dozens of industries slip away. One plum that we have maintained is our gargantuan financial-services industry, whose contribution to total gross domestic product (GDP) more than tripled between 1947 and 2005. However, as a result of the current global financial crisis – manufactured on Wall Street and exported to the entire world – the United States may well lose its financial-services crown, as well.
Once upon a time, America owned the automobile industry. But after several decades of excessive taxation, onerous government regulation, union extortion, and a crushing lack of foresight and innovation, we no longer dominate an industry that we practically invented. Just as Detroit no longer claims center stage in the world automobile marketplace, soon New York will lose its position at the center of global capital markets.
In the first place, the center of finance tends to go where the money is. Right now, all the money is coming from Asia and the Middle East – much of it from state-controlled investment pools known as "sovereign wealth funds." When the United States was the world's greatest creditor nation – and its largest supplier of capital – it made prefect sense for that capital to be allocated here. But why should the Chinese send their savings to New York only to have it re-invested back in China? Wouldn't it make more sense for the Chinese to allocate their capital locally, rather then out-sourcing the job to us?
In the second place, when the strength of the U.S. greenback was widely regarded, it made sense for global savers to allocate substantial percentages of their savings to dollar-denominated investments. This preference gave Wall Street a competitive advantage in attracting capital. However, now that confidence in the dollar has evaporated – perhaps permanently – this advantage has been lost.
First Detroit, Now New York …
It was once also true that investments in the United States were encouraged by America's respect for private property, low taxes, and minimal government regulation. But this advantage also has been lost as other nations have strengthened their private-property laws, deregulated their economies, and lowered their taxes – while we have done the opposite. As a result, the returns on U.S.-based investments so far this century have far underperformed those achieved in virtually every other major market.
Most importantly, Wall Street's reputation, once its greatest asset, is also in jeopardy. Just as Detroit lost its reputation for high-quality cars, bankrupted dot-coms and worthless subprime debt are creating similar problems for Wall Street. You can't expect to keep your customers if you continually sell them shoddy merchandise. Wall Street has spread hundreds of billions of dollars in losses around the world and, in so doing, shattered its reputation with some of its best customers.
It gets worse.
The Deal Wall Street Should NOT Have Made …
In the last few years, Wall Street not only cheated its customers, it cheated its shareholders, as well. At one time, all of our major investment banks – such as Goldman Sachs Group Inc. (GS), Lehman Brothers Holdings Inc. (LEH), Morgan Stanley Inc. (MS), The Bear Stearns Cos. Inc. (BSC), Smith Barney, Shearson, E.F. Hutton, Kidder Peabody and Salomon Brothers – were private partnerships. However, during the 1990s they all went public [Of course, many merged first, so they no longer exist as independent firms]. Goldman Sachs was the last to go public in 1999. The transition allowed longtime Wall Street partners to cash out, transferring future risks to new shareholders. In doing so, they were able to capitalize on bubble valuations, yet through lavish bonus compensation packages, were still able to keep the lion's share of the profits for themselves. In other words, they got to have their cake and eat it too.
As a result of this transfer of risks, the business models of America's leading financial institutions shifted, with profits coming from riskier sources, such as proprietary trading and structured finance. To line their own pockets, Wall Street firms willingly exposed their shareholders to risks that they never would have assumed when the companies were partnership-controlled and using their own capital.
This moral hazard set the stage for the enormous losses shareholders are now suffering: Those losses are a direct consequence of the phony profits booked in prior years. The former Wall Street partners-turned-employees have already walked away with huge IPO and stock-option windfalls – as well as lavish bonuses paid on those phantom profits. And shareholders are left holding the bag.
The coming crash will very clearly expose these conflicts of interest, and the reaction will be severe. In the end, finance and banking – like manufacturing – will stand as yet one more industry where U.S. dominance was ceded to foreign competition. The new financial capitals will likely be in Asia, the Middle East, and Europe.
New York will certainly still have a role to play. But much like Detroit, it will be a shadow of its former self.
[Editor's Note: Money Morning Guest Columnist Peter D. Schiff is president of Euro Pacific Capital Inc., a Darien, Conn.-based broker/dealer known for its foreign-market expertise. A well-known financial author and commentator, Schiff is a regular Money Morning contributor, and last wrote about soaring gold prices. In mid-August, when analysts were touting beaten-down financial shares, Schiff said the stocks were "toxic," were destined "to get hit hard," and advised investors to "stay away." Investors who heeded that advice, and avoided such shares as Merrill Lynch, also avoided some stressful, subprime-induced losses. Schiff's first book, " ," was published by Wiley & Sons in February 2007. To order the book, please click here].
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