There is an article in the latest issue of the New Yorker that poses two questions: 1] what does the financial sector do, really do for the economy?, and 2] is what the financial sector does so valuable as to justify its rewards [in general and for its executives]? I give the link to the article below and I also copy some opinions that give the gist of it so you don’t have to read to whole thing if you don’t want to. But before let me give you a couple of additional links to information sources mentioned in the article.
One is the Paul Woolley Centre for the Study of Financial Dysfunctionality, whose working papers are worth looking over: http://www.lse.ac.uk/collections/paulWoolleyCentre/
The other is The Epicurean Dealer Maker, a blog written by a mid-level investment banker whose insights are worth a fortune:
http://epicureandealmaker.blogspot.com/
And without further ado, let’s see what the New Yorker has to say:
http://www.newyorker.com/reporting/2010/11/29/101129fa_fact_cassidy?currentPage=all
In a recent article titled “What Do Banks Do?,” which appeared in a collection of essays devoted to the future of finance, Turner pointed out that although certain financial activities were genuinely valuable, others generated revenues and profits without delivering anything of real worth—payments that economists refer to as rents. “It is possible for financial activity to extract rents from the real economy rather than to deliver economic value,” Turner wrote. “Financial innovation . . . may in some ways and under some circumstances foster economic value creation, but that needs to be illustrated at the level of specific effects: it cannot be asserted a priori.”
Established international players, such as Citi, Goldman, and UBS, were getting bigger; new entrants, especially hedge funds and buyout (private equity) firms, were proliferating. Woolley’s firm did well, too, but a basic economic question niggled at him: Was the financial industry doing what it was supposed to be doing? Was it allocating capital to its most productive uses?
Financial markets, far from being efficient, as most economists and policymakers at the time believed, were grossly inefficient. “And once you recognize that markets are inefficient a lot of things change.”
Some kinds of trading serve a useful economic function. One is market-making, in which banks accumulate large inventories of securities in order to facilitate buying and selling on the part of their clients. Banks also engage in active trading to meet their clients’ wishes either to lay off risk or to take it on. American Airlines might pay Morgan Stanley a fee to guarantee that the price of its jet fuel won’t rise above a certain level for three years. The bank would then make a series of trades in the oil-futures markets designed to cover what it would have to pay American if the price of fuel rose.
However, the mere fact that a certain trade is client-driven doesn’t mean it is socially useful. Banks often design complicated trading strategies that help a customer, such as a pension fund or a wealthy individual, circumvent regulatory requirements or reduce tax liabilities. From the client’s viewpoint, these types of financial products can create value, but from society’s perspective they merely shift money around. “The usual economists’ argument for financial innovation is that it adds to the size of the pie,” Gerald Epstein, an economist at the University of Massachusetts, said. “But these types of things don’t add to the pie. They redistribute it—often from taxpayers to banks and other financial institutions.”
The Dodd-Frank bill also didn’t eliminate what Schlosstein describes as “a whole bunch of activities that fell into the category of speculation rather than effectively functioning capital markets.” Leading up to the collapse, the banks became heavily involved in facilitating speculation by other traders, particularly hedge funds, which buy and sell at a frenetic pace, generating big fees and commissions for Wall Street firms. Schlosstein picked out the growth of credit-default swaps, a type of derivative often used purely for speculative purposes. When an investor or financial institution buys this kind of swap, it doesn’t purchase a bond itself; it just places a bet on whether the bond will default.
At the height of the boom, for every dollar banks issued in bonds, they might issue twenty dollars in swaps. “If they did a hundred-million-dollar bond issue, two billion dollars of swaps would be created and traded,” Schlosstein said. “That’s insane.” From the banks’ perspective, creating this huge market in side bets was very profitable insanity. By late 2007, the notional value of outstanding credit-default swaps was about sixty trillion dollars—more than four times the size of the U.S. gross domestic product. Each time a financial institution issued a swap, it charged the customer a commission. But wagers on credit-default swaps are zero-sum games. For every winner, there is a loser. In the aggregate, little or no economic value is created.
… the history of Wall Street is a series of booms and busts. After each blowup, the firms that survive temporarily shy away from risky ventures and cut back on leverage. Over time, the markets recover their losses, memories fade, spirits revive, and the action starts up again, until, eventually, it goes too far. The mere fact that Wall Street poses less of an immediate threat to the rest of us doesn’t mean it has permanently mended its ways.
During the credit boom of 2005 to 2007, profits and pay reached unprecedented highs. It is now evident that the bankers were being rewarded largely for taking on unacknowledged risks: after the subprime market collapsed, bank shareholders and taxpayers were left to pick up the losses. From an economy-wide perspective, this experience suggests that at least some of the profits that Wall Street bankers claim to generate, and that they use to justify their big pay packages, are illusory.
Economic historians refer to a period of “financial repression,” during which regulators and policymakers, reflecting public suspicion of Wall Street, restrained the growth of the banking sector. They placed limits on interest rates, prohibited deposit-taking institutions from issuing securities, and, by preventing financial institutions from merging with one another, kept most of them relatively small. During this period, major financial crises were conspicuously absent, while capital investment, productivity, and wages grew at rates that lifted tens of millions of working Americans into the middle class.
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