The Value of Finance
You sometimes hear people question the value of the financial sector. Indeed, sometimes you’ll hear me doubt it. The doubting claim would be that it doesn’t appear to be the case that “financial innovation” has created the kind of economic benefits that you associate with, say, the technical innovations that have given us faster laptops, better cell phones, and more fuel efficient cars or the kind of business process innovations that have helped bring us lower retail prices for many kinds of everyday consumer goods.
To this one typical argumentative move in reply is to simply make the case that if there were no finance at all the world as a whole would be a much worse place. Household savings needs to be aggregated and channeled to people who have potentially profitable investments they would like to undertake. But I think that’s not really the issue. Rather, as Brad DeLong says, the issue is whether the sharp pre-crisis rise in the profitability of the financial sector had any relationship to the creation of real value:
I find the plea on the second charge unconvincing too. The rise in profits from 20% to 40% would have been justified had finance produced (a) better corporate governnance and thus better management, or (b) more successful diversification and thus a lowered risk-adjusted cost of and a higher risk-adjusted return to capital. There is no evidence that a sector that could not provide good corporate governance to itself was successful at providing good corporate governance to its clients. And the claim that modern financial markets provided successful diversification is to laugh: if it had we would not be here now, would we? Guilty as well.
I think the sources of finance’s outsized payrolls are to be found: (a) in the naivete of investors who are not able to calculate what they are paying people who are essentially gambling with their chips in the casino–investor who should be entrusting their money to Vanguard and PIMCO but cannot figure that out–(b) in the naivete of corporate CFOs who overpay for financial products so that they can tell their CEOs “yes, we are hedged”; and (c) in the naivete of the stockholders of financial services corporations who did not insist that the traders they hired keep all their money in the firm in order to give everybody an incentive not to take equity-destroying risks. And none of these three are reasons to believe that the payrolls ever corresponded to the effect of their actions on social welfare.
Could it really be the case that so many people were naive enough to trust their monies to institutions that were only claiming to have brilliant investment models? Well, it seems to me that it could. And that this would explain why it might make sense for a firm financial firm to pay Larry Summers $5 million a year for a one-day-a-week job. When your company’s underlying product isn’t necessarily sound, it’s important to invest a lot in marketing. Summers is like a celebrity endorsement. This is also a reason, I think, why having gone to a fancy college seems to have been very helpful for getting a job in finance. The firms’ business models very much depend on putting a certain image of themselves forward.
30 Responses to “The Value of Finance”
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April 12th, 2009 at 9:10 am
The finance industry grew faster than the economy as a whole by creating a lot of paper assets. As per the ideas of Frederick Soddy, Nobel Laureate chemist turned political economist,
http://www.nytimes.com/2009/04/12/opinion/12zencey.html
that will inevitably lead to crashes.
“Debt, for its part, is a claim on the economy’s ability to generate wealth in the future. “The ruling passion of the age,” Soddy said, “is to convert wealth into debt” — to exchange a thing with present-day real value (a thing that could be stolen, or broken, or rust or rot before you can manage to use it) for something immutable and unchanging, a claim on wealth that has yet to be made…..when there is no inflation, an economy with overgrown claims on future wealth will experience regular crises of debt repudiation — stock market crashes, bankruptcies and foreclosures, defaults on bonds or loans or pension promises, the disappearance of paper assets…It’s like musical chairs — in the wake of some shock (say, the run-up of the price of gas to $4 a gallon), holders of abstract debt suddenly want to hold money or real wealth instead. But not all of them can. One person’s loss causes another’s, and the whole system cascades into crisis.”
It sounds very plausible to me and it means that in our current circumstances, the very success of financial sector (in the recent past) is the cause of our current woes. The sharp pre-crisis rise in the profitability of the financial sector was a necessary precursor to crisis.
April 12th, 2009 at 9:29 am
it might make sense for a firm financial firm to pay Larry Summers $5 million a year for a one-day-a-week job.
Well, it might make sense for a firm financial firm. A shaky financial firm might want to pursue other options.
April 12th, 2009 at 9:37 am
Of course, when members of the permanent governing class make ‘celebrity endorsements’ in exchange for money, it’s called corruption.
April 12th, 2009 at 9:55 am
“I think the sources of finance’s outsized payrolls are to be found: (a) in the naivete of investors who are not able to calculate what they are paying people who are essentially gambling with their chips in the casino..”
It is well known that the average money manager does not even manage to beat market averages over the long term- a chimp throwing darts at a target of stock listings would do just as well or better. Yet the hope that these managers might do so keeps people paying their outrageous management fees.
Galbraith’s observation that “financial genius is a rising market”, really is true, yet people refuse to see it.
April 12th, 2009 at 10:12 am
From a World Trade Organization “Trade Policy Review” of the United States, 1996:
We’ve been hearing this “financial innovation” mantra nonsense for several decades now. It got them what they wanted. We’re paying the price, but it was a pretty damn useful schtick for a while.
April 12th, 2009 at 10:39 am
Uh, DTM, maybe — maybe — Matt should have narrowed his brush to have said that we can all agree that the “top executives” at the big firms are bad people.
It sure looks like the top types looted the system in S&L days, and Enron and Worldcom days, and Madoff SEC days, and, yeah, we all know it, in Harken Oil days. And that they did it again this time around, times about 100. And those who weren’t outright looting have been going along, not raising the red flag, not riding through town on a horse to warn fellow citizens, “The Bankers are Coming! The Bankers are Coming!” Too cowardly and unpatriotic to even say, “OK, boss, you’ve got us all over a barrel, but I’m not taking this filthy bonus check.” And, I’m willing to bet big that not one in a thousand quietly took the bonus check, so as not to make waves, but then turned around and gave it to charity.
April 12th, 2009 at 11:02 am
And, DTM, look at how the poorest of our people live. Millions of Americans of all ages and races, huddled down and suffering, with rotting teeth, scrambling for shelter, hungry, desperate and afraid.
That’s deliberate neglect, pal. Far worse leadership than given by the African chief who drives his Rolls Royce past his desperate tribe.
April 12th, 2009 at 11:06 am
I believe it was Murry Kempton who said “Finance is the art of passing money from hand to hand until it disappear”. Not very fair really but tell that to the millions who have lost trillions.
Finance however is principally involved not in making money but in inflating the prices of the paper assets of its own invention. People with vast fortunes have very little money at all. They have portfolios of financial assets; stocks, bonds, options etc. Their wealth is measured in the theoretical price which could be had if they sold it all one day.
The principal and vital systematic function of finance is to provide credit to business. To create the instruments of credit and to facilitate their trade. Credit is the lifeblood of business and capitalism itself. Credit is capital put into the hands of business. Stocks are a sideshow which only put capital into business once when they are issued. In most cases the money thus raised has nothing to do with funding the business so it can grow. The function of the stock sales is to capitalize the companies owners.
Google did not have to sell stocks to raise money. It did have to sell stock to make all its owners billionaires. They had to sell the stock so as to actualize their wealth. Until they went public their only way to grasping their wealth was to sell the company outright or to pay themselves as lavishly as the cash flow or its creditors would allow. In neither case would that have equaled the wealth they gained from going public.
While inflating stock prices is what we see mostly it was the inflation of what amounted to fictitious financial instruments which have lead to the collapse. Now tens if not hundereds of trillions of dollars are being spent to reinflate the now deflated assets. None of which goes into the economy of transactions for products and services. The money supplied not by the markets but by governments. The crisis has not wounded finance. It is making it stronger.
April 12th, 2009 at 11:16 am
Anybody that was long cash before this crash is now in position to outbid and control going forward. Unless, via government of the people, we re-inflate and restore something like the pre-crash status quo.
April 12th, 2009 at 11:29 am
Credit is the lifeblood of business and capitalism itself.
But debt is a slow death. And there’s the paradox.
While Daniel Davies is talking in parables right now, his 2003 post on Pound’s Canto 45 is pretty good on this.
April 12th, 2009 at 11:33 am
Unfortunately, Larry Summers is a poor example for your case (which is plausible enough in the main), given that the firm (DE Shaw) that Summers worked for has done rather well for itself during the recession. So perhaps, in this case, his pay was warranted. At the very least you should find an instance that is not an exception.
April 12th, 2009 at 11:35 am
Wall Street fears a brain drain of financial innovator talent.
April 12th, 2009 at 11:56 am
@ DTM: you criticize MY for his characterization of executives at large financial institutions as being, ultimately, bad people, but MY’s point is richer than you recognize.
In line with Krugman’s recent point that banking, in the sense of pooling and mobilizing capital, should really be a boring, moderately profitable business in a healthy economy, MY’s point is that in contrast to ideal, boring, pre-repeal-of-Glass-Seagall banking, the people running large financial institutions really behaved in objectively bad ways.
Note that he’s not attacking every employee on the trading floor, but the executives: the ones who systematically chose to take their companies into high-risk gambling while simultaneously initiating the systematic looting of their companies by the executive cadre in the form of disproportionate executive compensation. MY’s point, if I understood it, is twofold:
1) The behavior of large fiscal institution executives was objectively bad: it hurt not only their customers and the whole economy, it ultimately destroyed or severely weakened the companies themselves.
2) It was sufficiently clear by the late ’90s that a career in high finance (not in regional banking, not in traditional insurance, but exactly in the go-go investment banking that swept up legions of recent Ivy grads as their marketers) meant behaving in profoundly anti-social and corrupt ways that only those who were themselves narcissistic and corrupt would enter the business and rise to the top.
Anyone who’s studied a little history knows there are plenty of such people among the human race, of course: this is not an attack on Ivy grads (I’m as guilty as MY) or even finance industry employees. Rather, the point is that since at least the late 80s, and particularly since the late 90s, investment banking systematically drew in such people, and they did the best and rose to the top of their companies, where they were in a position to wreak havoc on all of us while enriching themselves obscenely.
A healthy institution does not hand over control so systematically to the worst among us: as we all know, healthy and stable institutions include checks and balances, and have pathways to prominence that weed out pathological narcissists, because pathological narcissists are not good leaders for institutions. The investment banking industry notably failed to demonstrate such constraints, with the results we now see.
April 12th, 2009 at 12:30 pm
An interesting convergence here between MY’s other recent theme of “The New Economics of Valuelessness”. If the finance industry was actually efficient their profits would be very thin. They are just moving bits around in databases, the products can be standardized, there are lots of competitors, etc. Efficient finance would converge on the zero profits limit of other pure information industries.
The converse demonstration of inefficiency is that Madoff got “sophisticated” investors to put $50 Billion into a investment with absolutely no real economic value. Less explicitly, Enron, AIG, etc. have demonstrated the same thing.
The key link here is opacity. Madoff famously used total opacity as a marketing tool — “Nobody knows how he does it!” the marks would whisper excitedly. Enron, AIG etc. used opacity more defensively, using a screen of impenetrable complexity, “trade secrets”, offshore entities in venues that sell secrecy, etc.
If we destroy opacity we would create an actually efficient finance industry. That would take care of driving down profits, compensation, etc. without any special regulation. Plus it would make Madoffs and AIGs impossible.
But to destroy opacity we have to be ruthless and comprehensive. The wails of outraged propriety will be deafening, but there really is no social justification for keeping secrets. Of course hedge fund trading strategies will be revealed and they will lose their competitive edge (which in many cases is similar to Bernie Madoff’s competitive edge). So what?
The only information that probably should remain undisclosed is personal identification of individual investors. Everything else should be public, maybe with a delay of six months. Let the information economy do its work.
April 12th, 2009 at 1:14 pm
Afterthought: In my imagined transparent world there’s still lots of money moving around, and surely some people have to be well paid to take care of it?
Yes, but what jobs does that justify? The information security people and the risk managers. They would get the big bucks in a sufficiently transparent system. Of course now they are entirely subordinate to the traders and machers and consequently get pushed around and prevented from doing their jobs.
I’m pretty sure all the traders could be replaced by players on the internet with no loss of effectiveness, no bonuses due, and nothing too big to fail. Let’s find out.
April 12th, 2009 at 2:11 pm
Massive fragility of the economy is a small price to pay for installing 10,000 granite counter-tops in kitchens in Westchester.
April 12th, 2009 at 2:21 pm
@21: “the very success of financial sector (in the recent past) is the cause of our current woes. The sharp pre-crisis rise in the profitability of the financial sector was a necessary precursor to crisis.”
Yep. Sums it up perfectly. Thanks for the link as well.
April 12th, 2009 at 2:31 pm
Hmm…
Is all your money in US dollars, Matthew? I, and any other educated person, could give you ten reasons why that’s a bad idea — massive debts, an uneducated population, capture of the economy and politics by the plutocracy etc etc.
OK. So let’s put the money in what?
Yen? Japan has been standing still for 20 years and doesn’t seem able to change that?
Yuan? Well, apart from the fact that it doesn’t seem possible for little investors, who knows what the probability is of chaos in China ten years from now. Civil war seems not unlikely, or just economic collapse from the pollution plus broken financial system as everyone stops believing.
Pounds? Turns out Britain emulates the US in bad financial ideas as much as in bad political ideas.
Euros? Turns out they were prime buyers of the crud the US was shoveling.
In other words, it’s easy after the fact to see that something was a bad idea. It’s not so easy at the time. I’m sure, ten years from now, it will be just as obvious that, in 2009, the smart move was put your money in South America…
So criticizing people for the specific sin you attack is, I think, foolish. I think a better line of attack is to criticize the get-rich-quick culture, the idea that it makes sense to treat your savings as a lottery. If anything, it is THAT that is the defining sin of the US in our age, the hope that we don’t actually need to give up any consumption today because some magic will make our paltry savings grow at 15%, thereby building up our retirement savings. And this particular myth permeated every aspect of our society, from pension funds to politicians.
Heck, how many TV shows or movies have you see where the hero/heroine state “we are NOT going to have an insane wedding/holiday in Hawaii/buy the house we love” because we need to save for the future, as opposed to how many where such a short-sighted and impulsive act is portrayed as true love, knowing how to live your life well, seizing the day etc etc?
April 12th, 2009 at 3:16 pm
Was the rapid rise i investor pay out of proportion with the rapid rise in movie producer pay? software CEO pay? with the general rise in global trade?
DeLong and Yglesias have to make the case that finance executives were more or less out of line with other executives.
April 12th, 2009 at 3:32 pm
Even if the current captains of Big Finance are dead or dying, the next generation is sprouting into existence:
Crisis Altering Wall St. As Stars Begin to Scatter
http://www.nytimes.com/2009/04/12/business/12wall.html?_r=1&ref=business
We’re still bailing out all these zombie banks and financial institutions, and the old top dogs are fleeing to new firms, trying to recreate their past success. God forbid if we let these assholes rob us again in the future!
April 12th, 2009 at 3:55 pm
From a Machiavellian pov, it doesn’t matter if the rich hedge fund managers are “bad” or not, what matters is stripping them of as much moral prestige as possible, just as the right stripped the “welfare mother” of prestige before they brought down welfare.
Otherwise, they will use their prestige to preserve the current system, to the detriment of us all. That system has to be changed in many ways – watered stock laws have to be reinstated, interstate companies have to be re-incorporated at the federal level, the OTC peer to peer pseudo-market in securitized instruments has to be abolished and transferred to an open, institutionally visible trading venue, like the NYSE – the last of which is the reform suggested by Myron Scholes. Gretchen Morgenson’s story about Bogle today suggests reforms on the institutional investor end.
In a world of wars, poverty, malaria, etc., the use of a couple trillion dollars to prop up the wealthiest people in the world has been a major, major crime against humanity. It shouldn’t have to happen again. It will if the financial sector isn’t majorly controlled.
April 12th, 2009 at 4:14 pm
What interests me about this whole mess is that this whole generation of finance has been built around the notion of the control of risk based on a model of how things work which everybody knows to be incorrect.
Black-Scholes is built on the idea that the distribution of financial returns follows the distribution identified by the Central Limit Theorem.
This is incorrect in somewhat the same way as it would be incorrect to say that planets are spherical. The sphere, like the witches’ curve of the Central Limit Theorem, is an ideal invention of the human mind, and corresponds to nothing found in nature.
Financial returns are not even ideally modelled by the witches’ curve. If there is an ideal mathematical form to which they fit, is would be that family of heteroskadastic curves identified by Mandelbrot and all the other chaos folks.
The financial industry fell apart because it was doing things wrong — and everybody who had the first clue knew all along that they were doing it all wrong.
April 12th, 2009 at 5:57 pm
“The financial industry fell apart because it was doing things wrong — and everybody who had the first clue knew all along that they were doing it all wrong.” But why were they doing it at all? There is a use for a certain spectrum of derivatives, but they become more and more useless as the ratios they are composed of become more and more baroque. In the end, the “insurance” AIG was selling, the cds that were being built in the infamous financial unit in London, had absolutely no productive economic function. Which goes along with there being no real market. The weak defense is that these kinds of exchanges “freed up” credit, but what did it free it up for? To invest in ever more lethal financial shenanigans. Even before the fall, nobody outside somme maid services and jewelry stores benefited from CDSes, except those in the financial industry.
Mobuto stealing foreign aid and salting it away for himself had a more beneficial economic effect than those banksters.
April 12th, 2009 at 6:48 pm
No one’s pay has ever reflected their effect on social welfare. What one is paid is determined by how much money one makes for someone else.
This is why public school teachers, like employees of other non-profits, make very little, while baseball players can make $20m a year if they put butts in the seats.
April 13th, 2009 at 12:07 am
It is funny – the neoclassical school of economics has rejected the labor theory of value except when it comes to CEOS – who are regarded, and regard themselves, as these multi-talented players, like baseball players, who “make” the money for the corporation.
While they aren’t at all like baseball players in that sense, in another sense, I like your comparison. It is standard biz claptrap, but the analogy points us towards a utopian truth. Baseball teams, basketball, football – the compensation is very, very egalitarian. If a baseball pitcher gets some amazing contract, the contract will still be compensation that is no more than nine times the catcher – and hardly 300 times.
So I think corporations should definitely pay like baseball teams. And in fact at one time they did. Let’s get back to that time. Leonart’s column on making another tax bracket for those making a million or more per year is right on. We need high taxes, we need to penalize corporations severely that pay ridiculous ratios to the upper management – Boeing, for instance, should have to pay a surcharge equal to the price they are paying for the lardhead that heads them up – and so on. It is true that pay doesn’t reflect social welfare, but it is also true that it doesn’t have to reflect an entrenched and evil oligarchy, either.
April 13th, 2009 at 2:05 am
It’s worth remembering that it wasn’t always like this. There are a number of regional investment banks in this country that most people have never heard of, that have taken pride in helping to build their communities: floating muni bond offerings that paid for the local hospital, IPOs that helped local businesses expand, etc. That’s work that benefits society, and that’s what finance should do. Many of these firms never took the risks that the biggest investment banks took because most of these regional investment banks remained partnerships, where the capital at stake was that of the employees and family members, and not that of public shareholders.
“The doubting claim would be that it doesn’t appear to be the case that “financial innovation” has created the kind of economic benefits that you associate with, say, the technical innovations that have given us faster laptops, better cell phones, and more fuel efficient cars or the kind of business process innovations that have helped bring us lower retail prices for many kinds of everyday consumer goods.”
Remember where the money for these technical innovations came from though. In many cases, it came from capital raised from investors by the financial sector.
April 13th, 2009 at 3:00 am
“It is standard biz claptrap, but the analogy points us towards a utopian truth. Baseball teams, basketball, football – the compensation is very, very egalitarian. If a baseball pitcher gets some amazing contract, the contract will still be compensation that is no more than nine times the catcher – and hardly 300 times.”
Compensation isn’t as egalitarian in pro sports as your example suggests. The highest paid player in the NFL last year made almost 100x the rookie league minimum. That’s just limiting the comparison to players, who represent the meritocratic tip of the spear of the larger organizations that comprise pro sports teams. The star quarterback might make 30-50 times what the late draft pick rookie makes, but an NFL team also employs trainers, accountants, secretaries, security guards, etc. The difference in pay between the top players and the lowest paid employees in the organization are as great or greater than those between the CEOs at large publicly traded firms and their line employees.
Worth noting, though, that CEO pay tends to be a lot lower in small cap companies.
April 13th, 2009 at 1:29 pm
The logic of the analogy is about a baseball or basketball team, not a comparison over all all teams, nor the whole of a team organization. So, I’ll stick with my point. The team is basically a pretty egalitarian unit. Once a baseball player goes from the minors to the majors, he goes to a level on which his compensation is not 100x less than his teammates.
The team analogy points to the dispensibility of any particular player, and the need for them to all work as a team. So, if the CEO can use the company jet to go to some golf course to play a round, I’d say the same perk should be extended to the guy riveting wings on the boeing jet.
In fact, of course, there have been studies made connecting the profusion of CEO perks, paid for by the company, with declining performance. See David Yermack’s paper, Flights of Fancy.
Bringing a halt to the increase in wealth inequality in the U.S. is the best way to save the republican form under which the nation is, theoretically, governed. Othwerwise, we have the pissant feudalism we suffer under today.
April 14th, 2009 at 8:12 am
Financial returns are not even ideally modelled by the witches curve.If there is an ideal mathematical form to which they fit,is would be that family of heteroskadastic curves identified by Mandelbrot and all the other chaos folks.
The financial industry fell apart because it was doing things wrong — and everybody who had the first clue knew all along that they were doing it all wrong.
April 19th, 2009 at 12:11 pm
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