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.