In traditional terms (say when reading a textbook on the markets) you're always told that the social function of a financial system is to allocate money to productive investment efficiently. That's the justification one always hears for the existence of stock and bond markets - companies, businesses and people need to raise money, and the financial sector exists to allow them to do so. The rise of the stock corporation, where money can be raised from many many people not directly involved in running the company, is rightly celebrated as an invention which made much larger companies much more feasible than the older model where a company would be owned by one, or a few people, all of whom were directly liable for what the company did (and many have bewailed what ownership without responsibility has done, also correctly.)

Bill Moyers recently interviewed John Bogle, founder of the Vanguard Group, one of the world's largest mutual funds. Seems John isn't pleased with the rise of financialization (hat tip, the Consumerist):

JOHN BOGLE: Well, it's gotten misshapen because the financial side of the economy is dominating the productive side of the economy

BILL MOYERS: What do you mean?

JOHN BOGLE: Well, let me say it very simply. The rewards of the growth in our economy comes from corporate, largely - from corporations who are a very important measure, from corporations that are providing goods and services at a fair price innovating and bringing in new technology -- providing a higher quality of life for our society and they make money doing it. I mean, and the returns in business in the long run are 100 percent the dividends a corporation pays and the rate at which its earnings grow.

That still exists. But, it's been overwhelmed by a financial economy. The financial economy, which is the way you package all these ways of financing corporations, more and more complex, more and more expensive. The financial sector of our economy is the largest profit-making sector in America. Our financial services companies make more money than our energy companies -- no mean profitable business in this day and age. Plus, our healthcare companies. They make almost twice as much as our technology companies, twice as much as our manufacturing companies. We've become a financial economy which has overwhelmed the productive economy to the detriment of investors and the detriment ultimately of our society.

BILL MOYERS: By the financial sector, you mean?

JOHN BOGLE:Banks, money managers, insurance companies, certainly annuity providers. They're all subtracting value from the economy. They have to subtract. To be clear on this now -- I don't want to overstate it. To be clear on this, they have to subtract some value. But, the question is--

BILL MOYERS: What do you mean they subtract some value?

JOHN BOGLE:In other words, -- you've go to pay somebody something to provide a service. It's just gotten totally out of hand. My estimate is that the financial sector takes $560 billion a year out of society. Five hundred and sixty billion.

BILL MOYERS: Where does it go?

JOHN BOGLE:It goes into the pockets of hedge fund managers, mutual fund managers, bankers, insurance companies. Let me give you this just one little example. If you didn't make a $129 million last year -- I'm presuming that you didn't. You don't rank among the highest paid 25 hedge fund managers. A $129 million doesn't get you into the upper echelon.

As the Consumerist notes, half a billion dollars is one quarter of the entire federal budget. It's not a small amount of money.

And Bogle is, I suspect, only really talking about transaction costs, not about opportunity cost. Opportunity cost is generally defined as the amount of money you could make doing something else. If you work at a job that pays $5/hour when you could work at a job that pays ten, the $5 difference is the opportunity cost. In terms of an investment, if you invest in something with a 5% return, rather than something with a 10% return, the 5% difference is your opportunity cost (although if the second is more risky, it might be worth it.)

In terms of the economy right now, because financialization has created very high paper returns, investing in real production; hiring employees, and so on, often effectively has an opportunity cost. You're better off taking your money, using it to borrow from Japan, taking that money and using it to get another loan, then leveraging it probably winding up with twenty times the money you started with. (And sometimes as much as a hundred times, if you go through enough leverage stages). You then use that money to buy securities and your return on the amount of real money you put in is nothing. Assume you have on million upfront and you are able to turn it into 20 million with loans and leverage (a very, very conservative number). If you then make 5% returns on that - you've made a 100% in the year. Even with fees, interest charges (minimal, but they exist) and some marginal hedging, you're probably pulling in 50% returns - on your one million, making five hundred thousand. If you just give your money to a hedge fund, many of them easily make double digit returns. These sort of profits have been fairly routine in this decade.

Normal companies mostly can't compete. You can't make those sort of returns year in, year out. Companies that try to compete with the lower end, by going for 15% returns, say (what my last corporate employer aimed for) tend to do so by really strict cost controls and by ditching businesses which make less than that. As a result real economic activity actually decreases - businesses which can't make the cut struggle or go out of business; departments are closed down and people are laid off. Or, to make the vig, you outsource and offshore, paying 3rd world workers 50 cents an hour (and that's high) to do work once done for $20/hour in the first world.

So the economy doesn't get the growth in real productive enterprise. This doesn't show up in GDP numbers, which simply reflect "economic activity" as if it's all equal - as if buying and selling securities is the same thing as creating new goods. But nonetheless, large chunks of America don't have high speed internet. The best trains are built elsewhere. The best cars are built elsewhere. The best phones are built elsewhere. The best solar panels and windmills are built elsewhere.

This is the real opportunity cost of all those inflated dollars bought through leverage and debt gains - the decline of the real US economy.

Bogle has a lot more good things to say. For example:

BILL MOYERS: You said the other day to someone that we think we can fight the war in Iraq without paying for it.

JOHN BOGLE: Well, we borrow the money to fight the Iraq War by some estimates and they're not absurd estimates is running now towards a $1 trillion. We could be doing what the British empire did. We could be bankrupting ourselves in the long run. And--

BILL MOYERS: You see us as an empire?

JOHN BOGLE:Well, of course it's an empire. We reach all over the world. We thought of ourselves in many, many respects as the policemen of the world. God knows we know we're the policemen of the Middle East. And there are those say, even from Alan Greenspan on up or down, that oil is the root of that. I mean, these are great societal questions. Protecting oil, which is in turn polluting the atmosphere.

We have problems as a society. And we don't have to surrender to them. But, we have to have a little introspection about where we are in America today. We've go to think through these things. We've got to develop a political system that is not driven by money. I mean, these are societal problems for us that don't have any easy answers.

But you don't have to be an economist to know that a great deal of or a minimum in our economy is coming from borrowed money. People are spending at a higher rate than they're earning, and we're starting to pay a price for that now. Particularly in the mortgage side. But, eventually, that could easily spread and people won't be able to do that anymore. You can't keep spending money you don't have. It gets a lot of it, you know, and it wasn't that many years ago — maybe a couple of generations ago — that if you wanted something, you saved for it. And when you completed saving for it, you bought it. Imagine that. And that wasn't so bad. But, now, we know that we can have the instant gratification and pay for it with interest payments, of course, over time, which is not an unfair way to do it. We're going to pay a big price for the excessive debt we've accumulated in this society both in the public side and the private side.

And it's no secret that this lack of savings in our economy — just about zero — is putting us at the mercy of foreign countries. China owns — I don't know the exact number — but, let me say about 25 percent of our federal debt. China does. What happens when they start to buy our corporations with all those extra dollars they've got there? I mean, I think that's very-- these problems are long term, are very much worrisome and very much intractable.

The "growth" of the last decade, indeed of the last generation, has been bought by borrowing - borrowing from other countries and borrowing against the future - or to put it more crudely, against American's children's and grandchildren's credit. They are the ones, along with those of us who are young enough. And unless you're at least 60, preferably 70, you're young enough, the real victors in this game are mostly already dead, having won the "death bet" of "I'll be dead before this bill comes due. You suckers get to pay."

Go read the entire transcript, it's worth your time.

And in the meantime, remember, TANSTASFL

There Aint No Such Thing As A Free Lunch