Does finance deserve its earnings?

Many economists (even some relatively free market economists) have begun to question the high returns flowing to the financial industry in recent years.  It’s not that people don’t understand that finance is important, or that it plays a critical role in our economy, but rather the claim is that finance is much more generously rewarded than in the past, and that those extra earnings are at least partly unmerited. 

Today I’d like to defend finance.  Not the role it played in the housing debacle (in that specific case I agree with the critics.)  Instead I’ll try to show that even in the absence of policies such as Too Big To Fail, you would expect the share of income going to finance to be rising sharply, as compared to earlier decades. 

Let’s start with a simple economy that produces lots of wheat and a little bit of iron.  The income distribution in society mostly reflects differences in productivity in farming.  Stronger farmers can produce somewhat more than weaker farmers, but not a lot more.  Hence income is distributed fairly equally.  

Suppose productivity in the mining industry mostly depends on skill at noticing iron deposits.  Let’s also assume that this skill is distributed very unequally–some people are much better at spotting iron deposits than others.  The next assumption is crucial.  Once iron is found, it can be mined very easily.  The hard part is finding the iron in the first place.  In that sort of economy, income will become less and less equally distributed as iron becomes a larger and larger share of GDP. 

In the 1950s and 1960s it wasn’t that hard to figure out where capital needed to be allocated.  Capital was allocated to produce steel, and the steel was used to produce cars and washing machines.  Capital was allocated to the production of aluminum, and the aluminum was used to make airplanes. The most productive members of society were those who made things, and Michigan was near the top in per capita income.

Today the most productive members of society are not those who produce things, they are those who discover the things that need to be produced.  Once you have the blueprint, it is easy to produce many types of software and pharmaceuticals.  The big money goes to those who figure out the blueprint, but also to those who allocate capital to the guy who has the idea for a Google, or Facebook, or Twitter.  In contrast, the technicians who actually implement the vision often earn modest salaries.  Thus companies are “discovered” in much the same way as an iron deposit is discovered by a skilled geologist. 

And then there’s globalization, which means decisions about allocating capital can vastly improve productivity even in the old-line industries that were dominant in the 1960s, when the rest of the world hardly mattered.  Finance is not that important in an agricultural economy or even in an economy where the mass production of goods can be done with almost military precision.  It becomes extremely important in an economy where it is not at all clear what should be produced, or on what continent that production should take place.

I’m not sure if I’m saying anything new—this analysis is sort of related to the ”economics of superstars.” But if it is well-understood, why do people seem so perplexed by the fact that finance earns much bigger incomes than in the 1960s?  Finance now plays a much more important role than in the 1960s.

Perhaps people are drawing the wrong conclusions from the housing fiasco.  Finance made a serious mistake in allocating so much capital to housing, but that’s not what caused the recession.  In a country with 100 million houses, the damage from adding two million a year for a couple years instead of one million a year for a couple years is modest.  The reason we have a severe recession is because of tight money, not too many houses.  Otherwise we would have had a severe recession in 2006-08, when housing construction collapsed, rather than 2008-09, when we actually had a big downturn.  And of course much of the sub-prime mortgage fiasco had nothing to do with housing construction, it was refinancing. 

As long as we have an economy that is increasingly dominated by “idea companies,” where the idea is really, really hard to discover and really easy to implement once discovered, finance will earn huge gains.  In my model economy the iron spotters were highly productive and the iron miners had a relatively low marginal productivity. 

Right now, those who develop new ideas are being highly rewarded.  More importantly, those who spot good ideas developed by others, and allocate capital to implement those ideas, are also highly rewarded.  Get used to finance earning obscene profits, it isn’t going away.  But if it makes you feel any better, they are producing something of great value (except when they screw up and allocate money to sub-prime mortgage borrowers.)

Some might point to the fact that finance also earned high incomes in the years right before the Great Depression.  And yet we obviously did not yet have high tech economy.   But those high incomes merely reflected the extraordinary bull market.  Today finance earns large incomes even during years where stock prices are not soaring.  In others posts I’ve argued that income is a pretty meaningless metric, as it is distorted by the mixing wage income and capital gains.  Whenever stock prices soar income will temporarily look much less equal.  But our recent move toward greater inequality is not just driven by stock gains during bull markets; it’s a secular trend that isn’t going away anytime soon.


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86 Responses to “Does finance deserve its earnings?”

  1. Gravatar of JTapp JTapp
    2. January 2011 at 14:09

    Since you’re a defender of EMH, it makes sense that you’d argue that the “price is right” in regards to earnings in finance (or any field). It seems most economists I read only have a problem with people at the very top of these firms getting paid so much. Classical theory says that earnings should equal the marginal product of labor, which it doesn’t always (although in an area like finance it’s very difficult to measure that marginal product). So, we have “tournament theory” and various other attempts to explain why a CEO gets paid so much more than his VP, etc. Those are all similar attempts to argue that the “price is right.” There is definitely “rent” collected by these agents that cause their earnings to be much higher than their marginal product.

    My problem is that the earnings > MPL problem doesn’t seem as big in finance as it is in professional sports– yet you never hear criticism of professional athletes. Someone who works in finance to allocate capital more efficiently helps create future wealth. This is much better for society than someone who scores 6 points which will be erased once the football game is over.

  2. Gravatar of JoePisarcik JoePisarcik
    2. January 2011 at 14:34

    This is a thought-provoking post. But I have a question –yes, it is logical that those financiers who discover the next Google earn outsized rewards. And maybe there are some less obvious discoveries that also lead logically to big paydays. But what about the vast numbers of traders who make hundreds of thousands of dollars a years flipping securities? Or, like the “heroes” of Michael Lewis’s The Big Short, making risky bets that everybody else is wrong? What precious things are these people discovering? What explains salaries that, even by the standards of well-trained professionals in pretty much every other field, to say nothing of the average middle class, are massive?

  3. Gravatar of Jon Jon
    2. January 2011 at 14:51

    Its not clear the construction boom was even a mis-allocation–having recently see this:

    http://innovationandgrowth.wordpress.com/2010/12/14/our-aging-capital-stock/

    The mistake was probably who and where: desert locations far from infrastructure or jobs, sold to people who could only afford it if someone else would come along in a few years in buy it out.

    Why the big mistakes? Fraud.

    There is more to this ugly situation. New research by Edward Pinto, a former chief credit officer for Fannie Mae and a housing expert, has found that from the time Fannie and Freddie began buying risky loans as early as 1993, they routinely misrepresented the mortgages they were acquiring, reporting them as prime when they had characteristics that made them clearly subprime or Alt-A.

    Smells like fraud.

    Market observers, rating agencies and investors were unaware of the number of subprime and Alt-A mortgages infecting the financial system in late 2006 and early 2007. Of the 26 million subprime and Alt-A loans outstanding in 2008, 10 million were held or guaranteed by Fannie and Freddie, 5.2 million by other government agencies, and 1.4 million were on the books of the four largest U.S. banks.

    So the government was backing half of the subprime market–something to keep in mind when people claim Freddie and Fannie had nothing to do with subprime. Only 1.4M were held by the banks. Something to think about in the context of TARP–the banks weren’t collapsing from subprime, they were collapsing from the general deterioration of their loan book due to tight monetary policy.

    In addition, about 7.7 million subprime and Alt-A housing loans were in mortgage pools supporting MBS issued by Wall Street banks—which had long before been driven out of the prime market by Fannie and Freddie’s government-backed, low-cost funding. The vast majority of these MBS were rated AAA, because the rating agencies’ models assumed that the losses that are incurred by subprime and Alt-A loans would be within the historical range for the number of high-risk loans known to be outstanding.

    So the number of subprime loans outstanding was a component of the rating models…

    But because of Fannie and Freddie’s mislabeling, there were millions more high-risk loans outstanding. That meant default rates as well as the actual losses after foreclosure were going to be outside all prior experience. When these rates began to show up early in 2007, it was apparent something was seriously wrong with assumptions on which AAA ratings had been based.

    So the big reason models went so wrong: Fraud.

  4. Gravatar of Morgan Warstler Morgan Warstler
    2. January 2011 at 14:54

    Nope. Not even close.

    Until the entire net is taken out from under bankers / traders, what you do to abuse them with regs / taxes is virtually meaningless. Molest them for fun!

    It is a sad state of affairs, but unless they can be gutted, and their hard assets sold off in liquidation events, unless they live in fear of losing everything – we need to treat them as second class citizens.

    Meanwhile SMB owners should be able to aggressively move profits from one SMB venture to another without seeing any taxable events take place.

    As to your example, the reality is most innovation is happening sans real investment dollars. VC is an incredibly small asset class.

  5. Gravatar of JL JL
    2. January 2011 at 14:54

    Sorry Scott, but you totally missed the Tyler’s central thesis.
    Where finance is productive then there is no problem.

    The problem is that finance of the “going short on volatility” has become a legal form of theft: profits are cashed in privately, while losses are covered by taxpayers. It’s robbing the poor to pay the rich, the wrong kind of wealth transfer.

    No one has a problem with Warren Buffet and the billions he earned fair and square.

    We do have a problem with the hedge fund managers and their quants who took off with millions and then left governments worldwide to pay out insured deposits.

  6. Gravatar of scott sumner scott sumner
    2. January 2011 at 15:03

    JTapp, I’m afraid that I don’t agree. Some who scores 6 points has a huge effect on aggregate utility, there MP is very high.

    Joe Pisarcik, You said;

    “But what about the vast numbers of traders who make hundreds of thousands of dollars a years flipping securities?”

    If the flipping is merely random, then it’s a zero sum game. For every trader making money another is loosing money. I am trying to explain why the total income earned by the finance sector is so high. I don’t think your example is what is driving the growing share of income to finance. I’ve read that it is huge earnings going to people running hedge funds, etc.

    You asked:

    “Or, like the “heroes” of Michael Lewis’s The Big Short, making risky bets that everybody else is wrong? What precious things are these people discovering?”

    If they profit from their short positions, then they are presumably preventing capital from going to wasteful areas.

    You asked:

    “What explains salaries that, even by the standards of well-trained professionals in pretty much every other field, to say nothing of the average middle class, are massive?”

    Obviously talented people are free to go into whatever field they wish to. I could have worked on Wall Street, but choose teaching. I presume the high incomes represent one of two factors:

    a. A high disutility of labor–the jobs are very undesirable.
    b. A high level of skill at allocating capital (which I may not have.)

    I find that many people are very resistant to both these hypotheses, but I can’t see any other plausible hypothesis that fits the facts. The Wall Street types who I have met seem very talented. And again, I am pretty sure the very high returns that make finance so profitable go to a relatively few individuals.

  7. Gravatar of scott sumner scott sumner
    2. January 2011 at 15:17

    Jon, Isn’t your argument that it was mis-allocation, but that the reason was F&F, not the failure of the free market? (I blame both.)

    Morgan, I think there is lots of real investment.

    JL, It is you who don’t understand. The government has not been bailing out hedge funds. Their huge earnings do not come from taxpayers. In any case, government subsidies don’t cause huge incomes, because of competition. The government subsidizes agriculture more than hedge funds, for instance, but I don’t see farmers earning billions.

    Taxpayers have contributed to compensating depositors in failed banks and S&Ls. But the amounts are far too small to plausibly explain the huge returns earned in finance.

  8. Gravatar of JL JL
    2. January 2011 at 15:44

    Sorry, Scott, but please read Tyler’s article better.

    “In essence, we’re allowing banks to earn their way back by arbitraging interest rate spreads against the U.S. government.”
    How is that not a subsidy?

    Or when Icelandic banks collapsed and the Dutch and British central banks were left to reimburse the insured deposits.

    You have burned a strawman and have not discussed the real issues that Tyler brings up.

    Tyler isn’t criticizing massive fortunes in finance, only the “going short on volatility” schemes that implode after their creators have cashed in.

  9. Gravatar of Jon Jon
    2. January 2011 at 15:50

    Scott: The volume of investment was not a mis-allocation–which is what I gather from the age of the residential capital stock, but the prices were. F&F were responsible for the pricing problem–first by enabling demand growth and second by subsidizing loan-rates and loan-terms and distorting the publicly available information in way that induced others to do the same. So, yes.

    You blame the market, but why? Its important to remember that this episode does not contradict the the EMH. The fraudulent aspects of F&F, surely wasn’t a fact universally known at the time. Therefore, its not obvious on what basis one should complain that the market should have priced in more risk.

    The crux in the story is that F&F concealed information regarding how much of the market was being supported by subprime lending. One individual taking a subprime mortgage but believing everyone else is prime is not making an irrational choice. The level of demand is firm and sustainable. Then one day we woke up and realized all of our neighbors were subprime and could barely pay their bills. So much for our prior rational expectations of future demand.

    That’s my position.

    So what’s your proof of market failure other than wanting some measure of comity with the rabid anti-EMH crowd? Perhaps you are in David Henderson’s camp:

    I told Sam about a case where a proposal had good and bad aspects and the crude cost-benefit analysis I could do made it come about even. Ditto the pro- and de-regulatory parts of it. Sam said that in such a case, rather than flipping a coin, you figure out who your current and future allies are likely to be and take their position.

    When the evidence is equivocal, make allies? I guess we cannot know for sure.

  10. Gravatar of ssumner ssumner
    2. January 2011 at 15:51

    Jl, You said;

    “We do have a problem with the hedge fund managers and their quants who took off with millions and then left governments worldwide to pay out insured deposits.”

    I showed you that you were wrong. Then you said:

    “Sorry, Scott, but please read Tyler’s article better.

    “In essence, we’re allowing banks to earn their way back by arbitraging interest rate spreads against the U.S. government.”
    How is that not a subsidy?”

    Maybe you should read your own previous comment again before you assume I can’t read. Now if you want to make this argument that’s fine, but I already addressed it in my previous answer. I agree that deposit insurance is a subsidy to banking, just as we have farm subsidies. But these subsidies aren’t large enough to explain the high returns to finance, which are concentrated in unsubsidized areas such as hedge funds.

  11. Gravatar of Declan Trott Declan Trott
    2. January 2011 at 15:52

    Scott – Always fun to read you defending the “indefensible” (EMH, monetary policy not impotent at the zero lower bound), but how do you know that “those who spot good ideas developed by others, and allocate capital to implement those ideas” are the ones getting most of the money? A lot of the public anger is because so much of what finance does seems to be totally unrelated to this. Of course this might be uninformed prejudice, but then again it might not be. (Interesting that this trend is so much stronger in the US than elsewhere – of course this might just be a market size effect.)

    JTapp – I think you are right that earnings > MPL can occur in tournament theory – you pay the top guy more than he is worth to motivate those below. But I’m not sure about this applying to sports or finance. And it is not a necessary or sufficient condition for there to be rent (which is about earnings vs reservation wage – e.g. if someone is paid $2 for a job they would do for $1, they are getting $1 rent, even if their MPL>=2).

    Actually the MPL itself is not a simple concept in these situations. Considering CEO pay, the counterfactual of the firm having no CEO is not really relevant. The question is how much value hiring a CEO for an absolutely obscene salary adds to the firm, relative to hiring one for a less obscene salary. (You could also argue about value to the firm vs “social value”, but that’s a whole other story.) E.g. Gabaix and Landier argued that as firms get bigger, having a better CEO will have a bigger absolute impact on profits, so they will tend to get paid more.

    This is a coherent argument for why superstars might be “worth” their pay, but it is more complicated than the the “marginal product of labour” as we usually think of it – how much an extra worker will add to output, holding other things constant. The MPL of the CEO cannot be defined independently of the “supply” of alternative CEO’s. (There seems to be an analogy here with hedonic pricing, which I don’t know enough about – any suggestions?)

  12. Gravatar of Declan Trott Declan Trott
    2. January 2011 at 16:04

    Scott – sorry for doubling up – spent too long thinking about the MPL before posting!

    Would like to see the source for “I don’t think your example is what is driving the growing share of income to finance. I’ve read that it is huge earnings going to people running hedge funds, etc.” Your hypothesis vs Tyler’s is really the big question here (I guess I don’t have to point out that yours has the burden of proof on it at the moment!)

  13. Gravatar of ssumner ssumner
    2. January 2011 at 16:31

    Jon, I think too many houses were built, it wasn’t just in the wrong places.

    You said;

    “You blame the market, but why? Its important to remember that this episode does not contradict the the EMH.”

    I agree it doesn’t contradict the EMH, but I think that even given the distortions of FDIC, TBTF, etc, banks made some poor choices, as did investors in MBSs. I am not arguing it shows the free market doesn’t work, rather I am arguing that even with a perfect free market firms would sometimes make mistakes. And as you say it was far from being a perfect free market, the government has massively distorted housing and finance. So I don’t think we are far apart. I support a truly free market in banking and housing. But I also think that markets sometime screw up and make mistakes. I also regard the tech bubble as something of a mistake, and the government interference in that case was rather small.

    Having said all this, I agree with Russ Roberts that the government is mostly to blame. So I am probably with you on the policy questions.

  14. Gravatar of Doc Merlin Doc Merlin
    2. January 2011 at 16:31

    In my opinion, the earnings in finance exist because of regulatory arbitrage.

    Without the regulatory environment we are in, finance couldn’t make nearly as high earnings. Its like a less intense version of the war on drugs, which had made the drug lords rich.

  15. Gravatar of JL JL
    2. January 2011 at 16:35

    Perhaps hedge funds were a bad example, I don’t know enough details about the finance industry. If they are a bad example of “going short on volatility”, then my apologies.

    Farm subsidies are also a red herring. The government also subsidizes third world countries through aid and those countries aren’t rich. Whoop-di-doo, totally irrelevant.

    My main beef, is that you have not addressed the argument Tyler makes in his article. And you are only trying to sidestep it again with irrelevant discussions on hedge funds and farm subsidies.

    Some in the finance industry are making huge profits without creating wealth by exploiting the system (i.e. government schemes). That is unacceptable. Period.

    That others in the finance industry profit by actually creating wealth is irrelevant to this issue.

  16. Gravatar of ssumner ssumner
    2. January 2011 at 16:39

    Declan, You asked;

    Would like to see the source for “I don’t think your example is what is driving the growing share of income to finance. I’ve read that it is huge earnings going to people running hedge funds, etc.” Your hypothesis vs Tyler’s is really the big question here (I guess I don’t have to point out that yours has the burden of proof on it at the moment!)

    Here’s what I read:

    “For instance, for 2004, nonfinancial executives of publicly traded companies accounted for less than 6 percent of the top 0.01 percent income bracket. In that same year, the top 25 hedge fund managers combined appear to have earned more than all of the CEOs from the entire S&P 500.”

    My source? The very same Tyler Cowen article I linked to.

    So it looks like Tyler agrees with me. :)

  17. Gravatar of Ashwin Ashwin
    2. January 2011 at 16:39

    Scott – I’ll have to disagree with you. Tyler Cowen’s story is not the entire story but it is a large chunk of it. The rationale for why bankers earn so much is separate from, although connected to, the rationale for why hedge fund managers earn so much.

    All the growth in investment banking revenues over the last decade and a significant part of the growth even before that since the 80s has come not from capital allocation activities such as IPOs, debt placement etc but from secondary market trading and OTC derivatives. As an example, take a look at Goldman Sachs’ revenue split here http://www2.goldmansachs.com/our-firm/investors/financials/current/10q/BNY86940BNY020_BITS_N_1856_Goldman_As_Filed.pdf . Almost 70% of revenues come from trading.

    Some of the profitability in this business comes from the oligopolistic structure of the OTC derivatives business – an advantage which the banks are quite keen to maintain even in the post-clearinghouse environment. The rest comes from the tail risk seeking that Tyler Cowen’s article talks about. The source of rents here is simply the lower credit spreads at which banks can finance due to the explicit and implicit backing of the state. The product that caused the most losses in the investment banks and AIG was the super-senior CDO tranche which is as negatively skewed and tail-risk heavy a payoff as there is. If you want a detailed and jargon-heavy explanation of this with UBS as an example, try my post here http://www.macroresilience.com/2009/11/06/a-rational-explanation-of-the-financial-crisis/ or for a summary here http://www.macroresilience.com/2010/01/06/implications-of-moral-hazard-in-banking/ . Its worth noting that this does not involve a necessary loss for the central bank or state which can keep insuring the system till of course the day that it no longer can insure the system and the loss is catastrophic.

    On how this means that hedge funds also made money, I explained it in a post here http://www.macroresilience.com/2010/09/23/inequality-and-moral-hazard-rents-in-the-financial-sector/ . The key point being that the ultimate beneficiary of any economic rent may be far removed from its initial beneficiary. The final distribution of rents is determined by many factors, most critically the competitive dynamics of the industry in question. Taking the example of Magnetar HF, I noted that the “alpha” that Magnetar generated would likely not have existed if it were not for the skewed incentives faced by bankers which in turn were driven by the rents they could extract from the state guarantees provided to them.

  18. Gravatar of ssumner ssumner
    2. January 2011 at 16:43

    Doc Merlin, The Drug War analogy is a bad one. They’re being compensated for taking on a risk of death, and perhaps for monopoly profits (cartels). Banks and hedge funds aren’t risking death, and they aren’t monopolies. Only high productivity can explain their high earnings. Or else some hybrid argument that they are really good at producing something of no social value, that other people are not good at producing, but aren’t good at producing capital allocation that has positive social value. That’s a possible explanation, but Occam’s Razor says mine is better.

  19. Gravatar of ssumner ssumner
    2. January 2011 at 16:49

    JL, If you are arguing against government subsidies to finance, I totally agree with you. That wasn’t the point of my post. I was trying to show that even if there were no government subsidies to finance you’d expect profits in the financial sector to be skyrocketing upward in recent decades. No one has even tried to refute that argument.

    I think agriculture is very relevant. Here’s why farm subsidies don’t make farmers rich. They lead to more food output, which drives down food prices until farmers just earn a competitive rate of return. The same is true of banking. All banks benefit for the FDIC subsidy, although only some benefit from TBTF. But in both cases this subsidy should be passed on to borrowers in the form of lower rates on loans. That’s how competitive industries work. I’m not the first person to make this argument.

  20. Gravatar of JL JL
    2. January 2011 at 17:21

    What does it even matter if the finance industry is large or small? Nothing.
    If money is to be made in finance, the market will allocate labor and capital to finance.
    No one has tried to refute your argument, because it’s as meaningless as arguing against the EMH.

    The real interesting thing, deserving of our attention, is the rigged system.

    Finance is not a free competitive market like framing.
    Anyone can be a farmer, but only a few can start a bank. There are high barriers to entry.

    And financial subsidies are highly complex, not straightforward like farm subsidies.
    For a large part they consist of privileges not available to mere mortals: banks can create money, they get IOR and arbitrage opportunities, they get FDIC and bailouts, QE profits them directly by buying up their junk.

    So the fact that the finance industry can create wealth (your argument) is irrelevant to the fact that many financial actors are exploiting the system.

    We need to stop this ASAP.

  21. Gravatar of Doc Merlin Doc Merlin
    2. January 2011 at 17:23

    @JL:

    Ditto, I absolutely agree with what you just said.

  22. Gravatar of Richard W Richard W
    2. January 2011 at 17:25

    As one can see in this chart the share of the financial sector in GDP has been rising in lots of different countries for quite some time.

    http://2.bp.blogspot.com/_tvshDVnXSLc/TGMgs2BpWDI/AAAAAAAADY8/AkTeaa87_LM/s1600/share+of+fin+sector+gdp.jpg

    However, profits and compensation did takeoff after regulatory changes in the 1990s

    http://3.bp.blogspot.com/_tvshDVnXSLc/TGLN5KFi5GI/AAAAAAAADY0/O5jeJif0KwM/s1600/us+fin+sector+%25+corp+profits.gif

    http://2.bp.blogspot.com/_tvshDVnXSLc/THTMCxlo7KI/AAAAAAAADbk/yd283spGpzA/s1600/bonus+profits.jpg

    http://3.bp.blogspot.com/_tvshDVnXSLc/THPQ4WyUgnI/AAAAAAAADZM/Qy521RD7EnI/s1600/bonuses-NYC.png

    http://2.bp.blogspot.com/_tvshDVnXSLc/THPxcuACiWI/AAAAAAAADaM/IezTgIfmwLk/s1600/bonus+boom.jpg

    Was this divergence in profits sustainable?
    http://4.bp.blogspot.com/_tvshDVnXSLc/THPlG5cH-4I/AAAAAAAADZs/fnegeCXesLQ/s1600/profitsbanks.png

    This is an interesting image that charts relative education and the relative wage in UK finance over the last century. Did the higher wages attract graduates or did the presence of graduates drive the wages higher?
    http://4.bp.blogspot.com/_tvshDVnXSLc/THPVN-2vqeI/AAAAAAAADZU/xhZg3RcxRVM/s1600/bank+bonus+humancap.jpg

    There is a lot I agree with in this post. However, the last decade has also been about unsustainable profits generated through leverage.

  23. Gravatar of scott sumner scott sumner
    2. January 2011 at 17:30

    Ashwin, You said,

    “All the growth in investment banking revenues over the last decade and a significant part of the growth even before that since the 80s has come not from capital allocation activities such as IPOs, debt placement etc but from secondary market trading and OTC derivatives. As an example, take a look at Goldman Sachs’ revenue split here http://www2.goldmansachs.com/our-firm/investors/financials/current/10q/BNY86940BNY020_BITS_N_1856_Goldman_As_Filed.pdf . Almost 70% of revenues come from trading.”

    I thought “trading” was capital allocation. I’m not trying to be sarcastic here, because it’s obvious you know more about this than me. But are you referring solely to HFT here?

    I simply don’t buy the argument that the rents are as big as people assume. This once in a century banking crisis results in loans of several hundred billion to big banks, but many of the loans weren’t even needed or wanted by banks. The banks then repaid the loans. Meanwhile the bank shareholders absorbed huge PRIVATE losses, which were not compensated by taxpayers. What sort of catastrophe would be required before the big banks actually were net recipients of government funds? Was that sort of catastrophe really considered something investors had to factor in, if even this disaster didn’t trigger a net flow of funds to big banks?

    The biggest distortion is the smaller banks, which have repeatedly received major transfusions of funds from taxpayers (1980s, and the recent crisis.) But they don’t earn massive profits.

    The the best argument your side has is not the small banks, which have actually received lots of taxpayer subsidies, and not the hedge funds where the truly spectacular income gains have occurred, but the big banks. And I just don’t see the argument there being persuasive. Lehman was allowed to fail, so TBTF was certainly not an ironclad guarantee. And big banking may not be as competitive as small banking, but it is global and there are quite a few big banks around the world. I think my explanation is much more robust.

    And remember, I’m not really denying that government subsidies might play a small role in finance earning more, I’m arguing that even in a free market you’d expect the share of income going to finance to have been rising very rapidly in recently decades. No one is addressing that argument, instead they are making criticisms of government policies, and I entirely agree with those criticisms.

    Regarding your final point about Magnatar, the more complicated an economic argument the more hard to refute on purely logical grounds. Suppose I argued that hedge funds were getting rich by investing in farm commodities, and this was an implicit subsidy by the government because the government subsidized farming. I’d say approximately zero economists would find that argument persuasive, even though it would be hard to refute on purely logical grounds, as in economics once you move away from the Arrow-Debreu perfect competition equilibrium almost anything is possible in principle. I’m not saying the hypothetical you offer regarding Magnetar is nearly as implausible as my farming hypothetical, but I guess I still don’t see it as a particularly plausible explanation of the huge profits earned by hedge funds. In contrast, my hypothesis that is based on the changing structure of the economy (moving away from General Motors-type companies toward Google/Genzyme-type companies.) I think it is a more plausible explanation for the increased share of income going to finance. My prediction is that even with TBTF and FDIC, hedge funds would have earned huge and rapidly growing profits in recent decades. And I don’t see why my explanation is not plausible.

  24. Gravatar of Dave Dave
    2. January 2011 at 17:36

    Scott,

    I’m wondering whether there is any evidence that skill level at allocating capital is really that unevenly distributed across the population. I ask because the thrust of your explanation in the post makes sense (i.e. that financing a project/business which creates a lot of value for the economy is itself a high value activity and would therefore be expected to be highly compensated).

    I’m not aware of much evidence that professionals within the finance industry demonstrate any higher level of success picking “winners” as it were than any reasonably intelligent person with the proper training would – although I concede that finding evidence for this kind of thing would be tough. Perhaps hedge fund dollars allocated to business development as a percentage of GDP growth?

    I worry that it makes me sound like a conspiracy theorist, but I tend to agree with ashwin’s assessment that industry dynamics and oligopolistic industry structures are falsely inflating salaries for individuals in some fields. (finance and some government sectors come to mind)…

    Thanks for the thought provoking post.

  25. Gravatar of Nick Rowe Nick Rowe
    2. January 2011 at 17:38

    JL: “Anyone can be a farmer, but only a few can start a bank. There are high barriers to entry.”

    I used to know dozens of farmers. I can only think of one who was not himself the son of a farmer. (Not hobby farmers.) I doubt that is true of people who start banks.

  26. Gravatar of Declan Trott Declan Trott
    2. January 2011 at 17:38

    “In that same year, the top 25 hedge fund managers combined appear to have earned more than all of the CEOs from the entire S&P 500.”

    But this seems only vaguely related to your argument – that the higher incomes within the financial sector are not going mostly to people who are shorting volatility a with direct or indirect govt backstop. Even if we say hedge funds are not doing this (contra LTCM; also players without a direct govt guarantee can benefit from other players getting bailed out like with AIG), hedge fund managers vs the CEOs of publicy traded companies is not the relevant comparison. It would have to be hedge funds vs the “bad” insured financial institutions, including traders as well as managers (I would assume the people at the big banks who could be running hedge funds are not all CEOs.)

    On social vs private returns, I don’t think Occam’s Razor is going to be enough to shift people’s priors from e.g. the story Tyler tells about first movers. You have a nice just so story, but “The big money goes to those who figure out the blueprint, but also to those who allocate capital to the guy who has the idea for a Google, or Facebook, or Twitter.” (i.e. venture capital) seems completely disconnected from where financial profits have been coming from.

  27. Gravatar of scott sumner scott sumner
    2. January 2011 at 17:42

    JL, You said;

    “Anyone can be a farmer, but only a few can start a bank. There are high barriers to entry.”

    I can’t understand this assertion at all. There are thousands of banks in the US, it’s a highly competitive industry. Maybe not as competitive as farming, but extremely competitive. Where do the monopoly profits come from?

    As far as the system being “rigged,” almost all industries are rigged. You need a government license to be a hairdresser, or undertaker, or doctor, or lawyer, or taxi driver. I’m trying to explain why finance is earning far more money than in the past, and why the US distribution of income is getting more unequal. If you consider those questions uninteresting, then you should read a blog that you find more interesting. I believe many of my readers do find this issue to be interesting. Indeed much more interesting than I do. (I didn’t anticipate this post would get more comments then my other post listed at the same time.)

    All I agree with you on is that “we need to stop this as soon as possible,” if by “this” you mean the rigged system. If by this you mean big profits, then we should not stop it.

    Doc Merlin, See my previous answer.

  28. Gravatar of Doc Merlin Doc Merlin
    2. January 2011 at 17:46

    “Doc Merlin, The Drug War analogy is a bad one. They’re being compensated for taking on a risk of death, and perhaps for monopoly profits (cartels). Banks and hedge funds aren’t risking death, and they aren’t monopolies.”

    1. The drug “ca,brtels” aren’t actually cartels, and competition is fierce between them; this is why there is risk of death.

    2. You have the causality backwards, profits aren’t there because of high risk of death… the high risk of death is there because of the profits. The profits are so high and property rights so poorly enforced that you are likely to get killed by competitors.

    3. High productivity is not enough to explain those profits, because in competition, over the long run, high profits get demolished. In order to consistently make profits, you have to have some barriers to entry or product differentiation. Modern banking has very, very, very poor product differentiation, so the only explanation that works is high barriers to entry.

    Here is a good example, of just one part of how our financial system has massive barriers to entry. I will provide the example of an ETF.
    Lets say, I want to start a publicly traded commodity ETF, I would have to ask the SEC for permission. Its very likely I would get denied or the approval would take years and cost millions (like it did for GLD) also every time I wished to substantially increase my shares (in response to high demand), I have to apply for permission from the SEC to do so.
    For every single substancial change I make, I have to ask the SEC.

    Here is another example. Lets say that my friend wanted to start a business, and I wanted to give him a few grand to start out in exchange for a small percent of the business. That would be a crime, if he didn’t ask permission from SEC first and then wait 6 months for their reply. Furthermore, even if he got permission, it would still be illegal for me to do so, if I wasn’t already rich (legally a qualified investor).

    And lastly, to see how important regulatory rent seeking is, look at the profits made by congressmen versus business insiders. Businesses insiders beat the market by about 7.4 percentage points… senators beat the market average by about 12.3 percentage points. [1] I don’t think you can argue that this is because senators are just that much more productive, than business insiders.

    [1] http://insidertrading.procon.org/view.answers.php?questionID=001034

  29. Gravatar of steve steve
    2. January 2011 at 18:02

    1) Can bankers salaries be justified if risks cannot be matched with rewards?

    2) After reading you all of this time, I am still inclined to believe that tight money is a separate issue from the subprime causing markets to crash. Loosening the money supply in RESPONSE seems credible.

    3) When bankers make lots of money, it does not seem to benefit the economy as much as when other capitalists make lots of money, ie, fewer new companies and fewer jobs are created? Is that observational bias or just unique to the two times we have seen this happen (ie not enough data)?

    Steve

  30. Gravatar of scott sumner scott sumner
    2. January 2011 at 18:07

    Dave, Thanks. I find Ashwin’s idea’s possible, but I think my theory is simpler and more straightforward and more plausible and more robust.

    You ask why they earn so much. Consider the following:

    1. Lots of people would like to be filthy rich.
    2. Only a few people succeed.
    3. There is no quota on people going into finance.
    4. I know highly skilled people who work on Wall Street, and find it highly plausible that they have skills that I and other people lack. For instance I know someone who has a degree from Princeton in biochemistry, has worked in biotech, and then got a Harvard MBA and now helps spot promising biotech companies on Wall Street. How many people do you know who have that skill set, plus lots of common sense?

    But I’d never deny that some people just get lucky, indeed lots of people. But doesn’t it make sense that only a few people have the ability to evaluate complex investment proposals? It’s not at all easy to figure out where capital should be allocated, indeed it’s very difficult. Only a few people can play NBA level basketball, why is it implausible that only a few can do elite level capital allocation?

    Nick, Yeah, I also think I’d have an easier time starting a small bank than becoming a farmer.

    Declan, You said;

    “But this seems only vaguely related to your argument”

    First I said the big money goes to hedge funds. You are skeptical and ask for proof. You say it is what distinguishes my argument form Tyler’s. Then I provide proof and you say it is unimportant. If it’s so unimportant than why did you ask me for proof than the huge gains are going to hedge funds? I feel like someone trying to nail jello to the wall–each argument I refute just leads to another.
    As far as the rest of that paragraph, see my reply to Ashwin.

    You said;

    “On social vs private returns, I don’t think Occam’s Razor is going to be enough to shift people’s priors from e.g. the story Tyler tells about first movers. You have a nice just so story, but “The big money goes to those who figure out the blueprint, but also to those who allocate capital to the guy who has the idea for a Google, or Facebook, or Twitter.” (i.e. venture capital) seems completely disconnected from where financial profits have been coming from.”

    What you call people’s “priors” I call people’s prejudices. Everyone hates finance, or else hates the fact that government subsidizes finance. But I don’t see a shred of evidence that the big profits to finance are coming from government subsidies. FDIC means that banks have had access to funds at the T-bill rate since 1934, but finance only recently earned the huge profits. And the biggest profits go the to relatively unregulated hedge fund industry. Often to smaller hedge funds engaged in activities that would not plausible trigger a TBTF bailout. I just don’t see the facts fitting the theory.

    Yes, I have a just so story, as does everyone else. Where are the predictions from the theory that the big profits come from the fact that bank deposits are federally guaranteed? And where have the big hedge fund profits come from? I was under the impression that much of the profits were from investing in stocks and corporate bonds. Is that wrong? They certainly haven’t gotten rich investing in General Motors stock over the past 30 years. And don’t forget I didn’t just mention high tech, I mentioned that even old line companies could make gains through globalization, which makes decision-making much more complex. You buy a rust belt company, put in new management, and ship jobs to Mexico, for instance.

  31. Gravatar of scott sumner scott sumner
    2. January 2011 at 18:22

    Doc Merlin, You said;

    “2. You have the causality backwards, profits aren’t there because of high risk of death… the high risk of death is there because of the profits.”

    I don’t agree. If drug smugglers were not violent people, so many would enter the industry that the profits would disappear. The profits are not something that is just “there” waiting to be allocated. They compensate for risk of death. And even so the average smuggler doesn’t make all that much.

    You said;

    “3. High productivity is not enough to explain those profits, because in competition, over the long run, high profits get demolished. In order to consistently make profits, you have to have some barriers to entry or product differentiation. Modern banking has very, very, very poor product differentiation, so the only explanation that works is high barriers to entry.”

    This is completely wrong. Economic theory says that if profits exceed the MPL, they get competed away, if they’re simply are a return to talent, the don’t get competed away. Don’t hold your breath for NBA salaries to fall to $50,000 a year due to “competition.” The same hold for hedge fund superstars.

    Sure there are lots of barriers that we both think are silly. I’d abolish the SEC if I could. But lots of other industries have similar barriers to entry, and they haven’t seen profits soar since the 1960s.

    Congressman are exempt from insider trading laws, and they have tons of insider information. That may explain their high earnings. But that’s small potatoes compared to the earnings of hedge funds. This phenomenon is not caused by insider trading suddenly getting much worse.

    Steve,

    1. Bankers may make too much money, but that doesn’t explain the big gains going to finance in recent years.

    2. Let’s address that in another thread.

    3. Not enough data. In recent years factory labor has done relatively poorly due to factors like the move to high tech industries, replacement of factory jobs with machines, immigration, trade, etc. And finance has done well for some of these reasons, but not others. Immigration has not helped finance very much, nor has automation of factory jobs. But high tech and globalization may have helped finance.

  32. Gravatar of scott sumner scott sumner
    2. January 2011 at 18:30

    Richard, Thanks for all those charts. I see them as supportive of my theory, but also perhaps various “deregulation” theories. Does the deregulation theory apply to hedge funds?

    Only time will tell if the increased share going to finance is permanent. My hunch is that it is, although perhaps not at the levels seen in the over-leveraged 2000s.

  33. Gravatar of Doc Merlin Doc Merlin
    2. January 2011 at 18:51

    @Scott
    “That may explain their high earnings. But that’s small potatoes compared to the earnings of hedge funds.”

    The hedge fund average wasn’t about 30% annualized returns during the 90′s. There were a few hedge funds that managed that, but very few.

  34. Gravatar of Doc Merlin Doc Merlin
    2. January 2011 at 19:08

    @Scott
    ‘I don’t agree. If drug smugglers were not violent people, so many would enter the industry that the profits would disappear. The profits are not something that is just “there” waiting to be allocated. They compensate for risk of death. And even so the average smuggler doesn’t make all that much.’

    I’ll split this up.
    1. “If drug smugglers were not violent people, so many would enter the industry that the profits would disappear.”

    Not really, the governments keeps other people out of the industry for the drug dealers, by being violent towards them, as well. The drug dealers have to be violent because they don’t have well enforced property rights over their contraband.

    2. ‘The profits are not something that is just “there” waiting to be allocated. They compensate for risk of death. ‘

    I never said that profits were just “there” waiting to be allocated, I said they are there because the government forces the supply of drugs artificially low, which keeps equilibrium prices much higher than costs.

    “This is completely wrong. Economic theory says that if profits exceed the MPL, they get competed away, if they’re simply are a return to talent, the don’t get competed away. Don’t hold your breath for NBA salaries to fall to $50,000 a year due to “competition.” The same hold for hedge fund superstars.”

    You misunderstand what I am saying. I am not saying that hedge funds superstars aren’t good at making money. I am saying they are good at making money /because/ they are good at regulatory arbitrage. If the regulation wasn’t there for them to arbitrage around, they wouldn’t be making that money. The entire reason a hedge fund exists, is because banks, and many other institutions are not legally allowed to do what hedge funds do (this is why Goldman Sachs top earner left them to start a hedge fund when they converted to a Bank Holding Company).

  35. Gravatar of Doc Merlin Doc Merlin
    2. January 2011 at 19:21

    @Scott:
    “Richard, Thanks for all those charts. I see them as supportive of my theory, but also perhaps various “deregulation” theories. Does the deregulation theory apply to hedge funds?”

    Hedge funds aren’t really very regulated, this is the entire reason they exist, and why people who aren’t rich are legally forbidden from investing in them. They have always been this way, the state doesn’t backstop them, they don’t sell to anyone who isn’t already rich, and in exchange they don’t get regulated.

  36. Gravatar of redonkulus476 redonkulus476
    2. January 2011 at 20:00

    Scott,
    Great post!

    I know very little about finance, so maybe this is a dumb question. Assuming the EMH to be true (and I think I do believe in some version of it or something like it), what does it mean to say that hedge fund managers are good at allocating capital? Shouldn’t they just invest in a fund indexed to the S&P 500 or something like that? If hedge fund’s have a higher return on invest than, say, Vanguard’s mutual funds, is this merely/mostly due to their higher level of risk?

  37. Gravatar of Declan Trott Declan Trott
    2. January 2011 at 22:27

    “I feel like someone trying to nail jello to the wall–each argument I refute just leads to another. . . What you call people’s “priors” I call people’s prejudices. . . Yes, I have a just so story, as does everyone else.”

    Absolutely. My point is, most people’s prejudices are against your argument here, so if you want to change their minds (like you have with me and I suspect many readers of this blog on monetary policy) you will have to do a lot more.

    I still think the hedge fund vs S&P 500 numbers are of dubious relevance to your argument, but I already spelled out why. In the Kaplan and Rauh paper Cowen cited (http://rfs.oxfordjournals.org/content/23/3/1004.full.pdf+html) table 15 indicates that hedge funds are a pretty small part of the story overall. However they do argue that technology and scale explain most of the rise in incomes overall – “What has changed is the amount of money managed and
    the concomitant amount of pay.” (But if the industry was truly competitive, shouldn’t the traditional 2%/20% margins have come down as technology and scale increased?)

    Richard, the numbers on your graph http://2.bp.blogspot.com/_tvshDVnXSLc/TGMgs2BpWDI/AAAAAAAADY8/AkTeaa87_LM/s1600/share+of+fin+sector+gdp.jpg look way too big – a financial share of 20-30% of GDP, and France bigger than the UK and US most of the time? Are you sure this doesn’t include plain vanilla house rent?

  38. Gravatar of Ashwin Ashwin
    3. January 2011 at 02:30

    Scott – “Trading” in an investment banking context refers primarily to secondary and OTC market-making on equities/fixed income and proprietary trading. To give you an example of the market making, a municipality wants to enter into an interest-rate swap and goes to Wall Street which does the trade and takes a bid-offer spread of say 0.50%. The profitability of this business depends upon its competitiveness and atleast in the United States, it is not competitive. My point is simply that this is not like figuring out where to allocate equity capital to (which is more the domain of venture capital).

    Just to be clear, I’m not talking about the small banks. I’m not disagreeing with anything you say – I’m just doubtful that small banks have much to do with this rise in inequality. Small banking is competitive which means that rents flow out to the consumers. This is similar to the case in Germany where rents to banking get almost completely translated into lower funding costs for their SME sector due to competition.

    On why the govt/Fed hasn’t lost money, two points: One, we need to incorporate the eventual bill on AIG + Fannie/Freddie + all of the Fed’s “liquidity” programs. Two, central banks with the ability to issue fiat currency can almost always postpone the losses at the cost of eventually bearing a much bigger loss – think the magnification of losses in the S&L crisis by delaying the day of reckoning from the mid-80s to 1990.

    On Lehman, the damage done by Lehman was so great precisely because the market expected a bailout post the Bear Stearns bailout and was surprised when Lehman was allowed to go under. The market action especially in Lehman bonds and CDS proves this http://online.wsj.com/article/SB121331446000169869.html . Lehman 5y CDS was below 300 right until September when it exploded to 800 or so. Even then, 700-800 on the Thursday before the weekend it went bust still imputes a pretty significant probability of bailout. As you said, the only stock/CDS that followed Bear Stearns in March was Lehman so the only new piece of information that fooled the market was the possibility of a bailout. And right after the Lehman collapse, spreads of the entire sector exploded. ( If you need more data/links on these let me know)

    On Magnetar, I accept the criticism that its difficult to understand – primarily due to my rather poor skills at translating financial jargon into plainspeak. Let me try a simpler explanation – big banks are implicitly protected in scenarios of significant systemic risk. This incentivises them to seek out bets which explode in such scenarios but provide them with small premiums in more normal times (negatively skewed tail bets). Hedge funds such as Paulson, Magnetar etc take the other side of this bet which is a positive NPV trade. Again, atleast in the cases of UBS and Magnetar this is not conjecture but based on publicly available information.

    Finally, let me take you up on refuting your hypothesis on the changing structure. Firstly, as I mentioned before, none of these excess profits come from equity allocation, IPOs or even equities trading which is much smaller than fixed income trading. Secondly, if your argument is correct, we’d see excess profits flow much more to venture capital, seed investing etc than to hedge funds. In fact, returns in venture capital have been negative over the last decade – Paul Kedrosky is usually excellent on this topic http://paul.kedrosky.com/archives/2010/12/vc_rumors_of_it.html .

  39. Gravatar of Shane Shane
    3. January 2011 at 03:04

    Google, Facebook, and Twitter were far from original ideas. They just represented technical improvements on things like Yahoo, Friendster, and Myspace. If anything, this represents the triumph of the technician–those extracting the ore, not those discovering it. The profits go to those who control the extraction techniques, not to those who own the mine.

    High returns don’t accrue to these endeavors because they are so crucial to the economy; rather, high returns make these companies seem as if they are crucial to the economy, when they are just elaborate rent-seeking schemes. These companies are nothing more than marketing schemes and manipulators of intellectual property right laws. Facebook lowers productivity, if anything, so why exactly should it be profitable to come up with the next version of this thing?

  40. Gravatar of DanC DanC
    3. January 2011 at 03:59

    I think Doc Merlin’s view has much more merit then Scott is admitting.

    Buffett makes a great deal of money for the reasons that Scott argues (superior skills), but he also has superior access to capital markets. Capital markets are inefficient, do in large part to government regulations, and superior skill in manipulating those political markets are rewarded.

    For example, Mr Buffett was able to get a very profitable deal with Goldman during the height of the financial crisis. Mr Buffet’s opportunity was uniquely available to him because of his wealth. Goldman was able to extend the offer, in part, because of their superior access to Federal agencies and political actors.

    Simply, capital markets are not as efficient as the Sumner model implies. It is as much a super connected system as it is a super star system.

    Or for example, look at Robert Rubin and his ability to influence the regulation of derivatives. Derivatives became a way to transfer significant risk to taxpayers while “financial” experts collected hefty incomes. Incomes that were often based on their political connections and the ability to manipulate the regulatory structure.

    NBA salaries are as high as they are because NBA owners are very good at manipulating tax codes and getting public subsidies. Absent the skill of NBA owners at acquiring public financing for their enterprises NBA salaries would be lower regardless of how short the supply of basketball talent.

    Prohibition showed that regulating a substance can lead to the creation of shadow markets. In the case of prohibition, high potential profits attracted people who were able to manipulate markets (often local monopolies) with superior skills. Those skills included a willingness to commit violent acts and the ability to manipulate public officials. The modern financial gangs don’t need to be violent.

  41. Gravatar of JL JL
    3. January 2011 at 05:34

    But Scott, which is it?

    Do you agree that the system is rigged to such a degree that something needs to be done soon, or not?

    Because this post, and your comments, read like an apology for the financial industry, it sends this message: “No Tyler, there are no big problems in the financial industry, it’s mostly just a secular trend. So we don’t need a major overhaul of the system”.

    Obviously we are all in agreement that “rigged system”=”bad” and “honest (big) profits”=”good”.

    Were we are in disagreement is the scale of the matter.
    You think the riggedness is a small matter, akin to licences for hairdressers or subsidies for farmers.

    Whereas I see a system that has corrupted politicians and has become a large parasitic drag on society.

    Like criminals who also operate legitimate businesses as a cover for their illegal activities, the financial industry also does worthwhile work, which you like to point to in defense of said industry.

    Anyway, this will be my last post where I criticize you for being a rationalizing tool for the financial industry.
    I’ll let you have the last word if you want.

  42. Gravatar of DanC DanC
    3. January 2011 at 06:36

    While I think Scott may place too much faith in the current structure of the financial markets people like JL are too far the other way.

    Government regulations are often the root cause of many of the problems in the current system. Increased micro management of the industry only creates more unintended consequences.

    We are not crony capitalism on the scale of Russia nor do we have the open competitive markets that Libertarians might desire.

    Labor markets and capital markets are imperfect in our economy. The labor market in our financial markets seem to be rewarding behavior that is detrimental to the general economy and all too often based on an ability to manipulate the power structure.

    Many bubbles in history seem to follow financial innovations. That does not mean that financial innovations are bad, just that they carry risks. However when players are able to transfer the costs of those risks to the government something is breaking down.

    Moreover, government interventions in the labor and capital markets are rarely helpful beyond some minimal level.

  43. Gravatar of scott sumner scott sumner
    3. January 2011 at 08:21

    Doc, Merlin, You are confusing total earnings and rate of return. I think it’s obvious that my post was directed at trying to explain total earnings by individuals. Nobody is jealous of someone who invests 10 cents and gets back 30 cents a year later.

    Regarding government, you are just adding one more risk factor–risk of going to jail, It doesn’t address my argument at all (which is the mainstream view in econ, BTW.)

    Your view at arbitrage skill makes no sense to me. Why wouldn’t others do the same thing? Presumably because they aren’t as good at spotting good investment opportunities as the hedge fund guys. But that’s exactly my point!!!

    Your argument is like someone denying that LeBron James is good as basketball, by pointing to the fact that he is also good at football. But that would actually strengthen the argument that he is good at basketball, not weaken it. If hedge fund managers are good at spotting regulatory arbitrage, and mere mortals are not, then that suggests that investment skills are allocated very unevenly among the population, which is exactly my point.

    I agree that hedge funds aren’t very regulated, which was exactly my point.

    redonkulus476, Thanks. I’ve always argued the EMH is true for government regulators, academics, and ordinary investors. But someone has to do the work of making markets efficient, and I assume that those people are compensated for their efforts. I’m saying their skills are very unevenly allocated. I’m no expert on the EMH, I suppose this is an argument for one of the weaker versions of the EMH.

    Declan, You said;

    “Absolutely. My point is, most people’s prejudices are against your argument here, so if you want to change their minds (like you have with me and I suspect many readers of this blog on monetary policy) you will have to do a lot more.”

    This was merely a blog post I tossed off with what I thought was a plausible alternative take on finance. I don’t expect it to convince people, merely start a conversation, which it’s done. I could do another post just on all the arguments I’ve presented in response to comments here. But I’m not seeing persuasive arguments against my theory, just good arguments that finance also makes some money from regulatory arbitrage, which I never denied.

    A few comments on hedge fund managers.

    1. I think people are misinterpreting may argument, viewing it as narrower than it really is. All sorts of people allocate capital, not just hedge fund managers. But the growth is hedge fund incomes has been very rapid, and is one of the factors that explains recent trends. Another is growth of CEO compensation, and of course CEOs also allocate capital, so this is also consistent with my model. Obviously CEOs do other things as well, so they are not as “pure” finance as hedge fund managers, but allocating capital is surely an important part of their jobs.

    Ashwin, You said;

    “Scott – “Trading” in an investment banking context refers primarily to secondary and OTC market-making on equities/fixed income and proprietary trading. To give you an example of the market making, a municipality wants to enter into an interest-rate swap and goes to Wall Street which does the trade and takes a bid-offer spread of say 0.50%. The profitability of this business depends upon its competitiveness and at least in the United States, it is not competitive. My point is simply that this is not like figuring out where to allocate equity capital to (which is more the domain of venture capital).”

    First of all, trading in secondary markets is very much a part of what I have in mind by the allocation of capital. it sends signals as to where real investments should occur, and if the signals are accurate the buyers of stocks (or short sellers) are rewarded. Second, I’d like to know how much of GDP goes toward market making. Much hunch is that it is quite low, and doesn’t explain the sharp rise in the share of GDP going to finance. But I may be wrong, as this isn’t my area.

    You said;

    “On why the govt/Fed hasn’t lost money, two points: One, we need to incorporate the eventual bill on AIG + Fannie/Freddie + all of the Fed’s “liquidity” programs. Two, central banks with the ability to issue fiat currency can almost always postpone the losses at the cost of eventually bearing a much bigger loss – think the magnification of losses in the S&L crisis by delaying the day of reckoning from the mid-80s to 1990.”

    I’ve been a critic of F&F for decades, and expect them to lose lots of money. But I see that as a separate issue, similar to FDIC, which will also lose a similar amount. That’s subsidy to finance in general. AIG will probably not lose, even in the long run, and I’d say the same about the Fed, although I might be wrong in both cases. In any case, I don’t disagree with the entire moral hazard/FDIC/TBTF arguments, they are bad public policies and a subsidy to finance. I just don’t see them as plausibly explaining the sharp rise in income going to finance. Competition should push most of those subsidies into lower consumer prices. You know more about finance than I do, and there may be some monopoly power in specialized trading at big banks, but how has that changed since the 1960s? And I don’t consider oligopolies to be all that monopolistic. Boeing and Airbus are arguably the most oligopolistic industry in the world, and they compete fiercely on price. In contrast, there are dozens of big banks that compete in a global marketplace. Some like Lehman go bankrupt. Others, like Bear Stearns are forced into mergers and their stockholder lose almost everything. Yes, the creditors at Bear Stearns were saved, and I don’t dispute your rebuttal to my point about Lehman, but I do think these failures show a fairly competitive industry, even if your data also shows it was a highly subsidized fairly competitive industry. Those are two logically distinct points. I’ve often made the same arguments against TBTF that you are making, so I don’t want you to think I don’t agree on the public policy question. But I see my theory that the titans of finance have special skills as being more plausible than the oligopoly story for high profits.

    I won’t say anymore about Magnatar, as I don’t know enough to comment on that specific example. But again, I think it all comes down to a debate over competition vs. subsidy. You say the subsidies are the key, I say there’s enough competition in finance that specialized skills are the key. As I said to Declan, If hedge funds really have the specialized skills to take advantage of regulations in the way you guys are assuming, and if us mere mortals are not able to make the big bucks doing the same thing, doesn’t that suggest they have very rare and valuable investing skills? And would they also be expected to use those skills to make money in an economy that is structually changing in such a way as to make the skills much more valuable?

    You said:

    “Finally, let me take you up on refuting your hypothesis on the changing structure. Firstly, as I mentioned before, none of these excess profits come from equity allocation, IPOs or even equities trading which is much smaller than fixed income trading. Secondly, if your argument is correct, we’d see excess profits flow much more to venture capital, seed investing etc than to hedge funds. In fact, returns in venture capital have been negative over the last decade – Paul Kedrosky is usually excellent on this topic http://paul.kedrosky.com/archives/2010/12/vc_rumors_of_it.html .”

    Here I strongly disagree. I think most of the excess profits in finance come from capital allocation. Trading stocks and corporate bonds is asset allocation. VC is only a tiny portion of the capital allocation universe, so I’d expect profits from VC to be only a tiny portion of the profits to finance. And isn’t VC partly just people rounding up some rich doctors and lawyers to invest in new companies? If so, I wouldn’t expect them to make more than index funds–they don’t have any special skills. I’d expect the big money to go to those who had the knowledge to allocate capital wisely. These would include hedge funds, smart big investors like Buffett and Soros, CEOs who have to make decisions about where to allocate their companies capital. (I’d guess non-financial CEO incomes aren’t even counted in finance, but they should be.)

    It’s also possible that finance has grown as a share of GDP for reasons similar to health care, but my main interest is the out-sized gains at the top, which should be competed away if these guys didn’t have rare and valuable skills. My opponents seem to suggest they have rare and privately valuable skills which are not socially valuable. I respond that if the skills are rare and privately valuable, you’d expect a priori that they’d also be somewhat socially valuable, as our society faces much tougher choices about how to allocate capital than in the 1960s. That’s not to deny that SOME fortunes have been made on privately valuable and socially harmful investments. I just don’t see that as the norm.

    more to come . . .

  44. Gravatar of scott sumner scott sumner
    3. January 2011 at 08:49

    Shane, You may be right, but that’s really a completely separate issue.

    If there are problems with our copyright laws,we need to fix those laws, not fix finance. It’s finance job to spot new companies that are privately profitable.

    Dan C, You said;

    “Buffett makes a great deal of money for the reasons that Scott argues (superior skills), but he also has superior access to capital markets. Capital markets are inefficient, do in large part to government regulations, and superior skill in manipulating those political markets are rewarded.”

    I have two responses. First, it’s not clear to me that his advantages explain most of his wealth. After he got rich (perhaps through skill) he may be able to do some big deals you and I cannot do. But he also has the disadvantage of pushing up the price of stocks he buys, which I don’t have. he recently lamented that if he had less to invest, he could now earn much higher rates of return.

    You said;

    “Simply, capital markets are not as efficient as the Sumner model implies.”

    I think capital markets are inefficient in many ways, the government subsidizes banks, for instance. My point is that they are pretty competitive.

    You are flat out wrong about NBA salaries. The New England Patriot owner paid for his stadium w/o tax money, and he pays his athletes high salaries. They make a lot because there services are in high demand. They are highly productive. Even w/o any subsidies, pro athletes would make big incomes from all the TV money.

    You are also wrong about prohibition. The risk adjusted incomes were not high. This was due to competition. I don’t think any of my commenters realize just how powerful competition is. No matter how big the subsidy, competition will reduce incomes unless you have some specialized skill. perhaps a few mob leaders had specialized skills in running mobs, and earned big risk adjusted incomes. But most did not

    JL, You said;

    “Do you agree that the system is rigged to such a degree that something needs to be done soon, or not?
    Because this post, and your comments, read like an apology for the financial industry, it sends this message: “No Tyler, there are no big problems in the financial industry, it’s mostly just a secular trend. So we don’t need a major overhaul of the system”.”

    That’s just nuts. I’ve been one of the most severe critics of our financial system out there. I want to completely deregulate finance. Where do I defend our current regulations of finance in my blog post? Can you cite an example?

    DanC, I completely agree with your second comment.

  45. Gravatar of celestus celestus
    3. January 2011 at 09:52

    The thing I’ve never gotten is, shouldn’t incomes in finance be somewhat proportional to the amount of wealth invested in financial markets? And hasn’t the amount of wealth invested through U.S. financial firms grown much, much more than finance incomes (just consider growth in the stock market etc. since 1980- a ~300% real increase versus a ~100% increase in finance compensation)? So, if anything, finance employees’ “take” of the wealth they manage has actually decreased over time? Am I missing something?

  46. Gravatar of Shane Shane
    3. January 2011 at 09:55

    This post sounds to me like a longer version of something that the Fabulous Fab wrote:

    “Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the U.S. consumer with more efficient ways to leverage and finance himself, so there is a humble, noble and ethical reason for my job ;) amazing how good I am in convincing myself !!!”

    There is no a priori link between private value and social value–even finance knows this now.

  47. Gravatar of Morgan Warstler Morgan Warstler
    3. January 2011 at 09:56

    Scott, starting a bank is next to impossible. Don’t bullshit on this… I’m a start up guy… I’m the expert.

    Ask yourself WHY with all the money in tech start-ups is so hard?

    Answer: FDIC insurance. Getting FDIC approval is next to impossible.

    INFACT, what we have seen is all the dreggy losers who ran the last banks into the ground, starting new banks TO BUY UP the assets in the old banks when the FDIC does it Friday night liquidations.

    Look, answer his, IF I’m right, then do you change your opinion?

    Same thing with my REAL point you didn’t answer… you are cart / horse.

    IF Scott Sumner wants finance guys to be worth huge amounts THEN Scott Sumner will condition it on them working without ANY NET, without ANY chance at bailout – printing money or otherwise.

    But Scott Sumner is the champion money printing guy, and it is being done to keep the bankers in the game…

    YOU HATED the idea of liquidating the housing, forcing mark to market, forcing the bankers into bankruptcy… so what you think how we treat bankers with taxes or regulations means nothing.

    You have to earn your free market cred when it is time to screw the losers Scott, and since you don’t – you have not cred.

  48. Gravatar of Shane Shane
    3. January 2011 at 10:04

    I agree with you on this Professor Sumner: I do think that this actually represents an example of efficient markets. Capital is chasing the highest returns possible. It is just that these come from things of dubious social value.

  49. Gravatar of davver davver
    3. January 2011 at 10:13

    I worked briefly on Wall Street and I find your arguments a little silly.

    1) A lot of what Wall Street does has absolutely nothing to do with allocating capital in useful ways. Mostly, people were just looking for a way to get one up on the other guy. Using asymmetric information to take advantage of other market participants was rampant. If you go on your average trading floor its a lot of people and computers trying to be just a little bit faster or more clever then the next guy so you can earn a profit. Most of these people are not sitting around trying to figure out who the next Google is so they can raise capital for them. Even on some of the IPOs and legitimate business I worked on there was plenty of fraud and immorality.

    2) Whole new functions of Wall Street are zero sum games of dubious social value. My main area of work was derivatives research. I consider nearly the entire derivatives market, outside of futures used for commercial purposes, to be a giant dead weight loss. I don’t believe any of the propaganda that it reduces risk by distributing it more evenly or provides liquidity. Mainly, I think it simply helps people hide risk, and concentrates it in a few players who then rely on government backstop (see Tyler’s post). Mainly what I saw in derivatives was a way for highly educated people to convince less intelligent people with money to engage in complicated financial transactions they didn’t fully understand. There’s no link to creating capital to useful economic projects.

    3) Being smart doesn’t mean you are doing something socially useful. The people I worked with on my derivatives group all had multiple graduate degrees from Ivy League schools. That didn’t magically transform their profession into something that is good for society. Lots of smart people engage in lots of dubious activities. If anything having that kind of intellectual capacity means you can be incredibly dangerous if you choose to act unscrupulously. And finally, don’t you think we’d have a lot more Google’s if these people were actually working for Google or starting their own real economy companies, rather then just trading derivatives between each other.

    4) Since the financial markets are so intertwined it is impossible to distinguish the success of one actor from another. Let’s say I’m Goldmen. I engage in a trade with AIG where I profit immensely if mortgages default. AIG goes under and the government bails them out, with most of the money going directly to Goldmen. Goldmen has now been bailed out. It doesn’t matter what end of the trade they were on. These trades have counter parties, and if you choose a bad counter party you might as well have been on the wrong side of the trade, because you aren’t getting paid. You can’t say that its ok for hedge funds to get rich pulling fast ones on less sophisticated traders if the only way for those trades to get paid off is to have the government do the payoff.

    I just wish you would think this stuff through. Saying that allocating capital is an important function that should be well compensated is like saying the sky is blue. The important question is whether most of Wall Streets activities are really aiding in the efficient allocation of capital. I’d argue they don’t. Tyler did as well, you just ignored it.

  50. Gravatar of Morgan Warstler Morgan Warstler
    3. January 2011 at 11:31

    Flying along typos:

    Ask yourself why with all the money in tech start ups, you do not see countless new banks being started online?

    Answer: FDIC.

  51. Gravatar of Matt W. Matt W.
    3. January 2011 at 11:40

    I’ve only skimmed most of the comments, but I will say neither Scott nor Tyler have put enough emphasis on regulation and its effects on financial profits. It’s not a subsidy, per se, but the market for financial products grew to get around the US’s high tax rates. A big benefit of leveraged buyouts, for example, is shifting the balance sheet from equities to debt. The interest on debt then is tax-deductible for the company is an expense while profits are not, even though both go to investors.

    Competition should, and will, bring finance profits down for these products, but in a booming market revenues always increase faster than costs. This helps explains part of the bank profits in the last twenty years, as deregulation has spurred more and more new products and banks make big profits despite the profits on the old products being squeezed.

    The good news is that regulatory arbitrage should not create a lot of systemic risk and, done right, it is not very speculative. The bad news is that a lot of very talented people are making money for creating essentially nothing. Their salaries and bank profits are instead a zero-sum economic rent, taken from the government having less tax revenue.

    On a better note, I see most hedge fund managers as something like pro athletes and they mostly do add to the economy. For example, the top 0.0001 percent of pro athletes earn for more than the top 0.001 percent of football athletes. In the same way, the great traders such as Soros or Griffen consisently are first to process new information. As they become more successful, they get more and more capital to invest and earn even more money. In this regard I agree with Summer; by getting capital into the hands of the best people, assets will be priced more accurately. Even HFT guys make sure you don’t pay a penny too much or get a penny too little if you move assets in or out of your account.

    Also remember that a lot of bank profits were just paper, mark-to-market profits and they have to be netted against the ensuing mark-to-market losses. For example, many banks made a lot of money processing CDO’s and keeping the top tranches. These top tranches could be highly levered due to the low capital charges under Basel II and when times were good, they made a lot of money. But these were not profits and shareholders, including many top bank officers, took a huge hit when they went south. “Bank Profits” should instead be talked about in terms of sustainable profits after the risk is factored in.

  52. Gravatar of Matt W. Matt W.
    3. January 2011 at 12:04

    Morgan, I have an FDIC-insured savings account with ING, a bank that pretty much only exists online.

    There haven’t been more online banks because banking customers still want a physical branch, not because the FDIC has kept online banks from forming. The FDIC is a subsidy to banks, but the subsidy is competed away just like with farming subsidies.

  53. Gravatar of Morgan Warstler Morgan Warstler
    3. January 2011 at 12:30

    Matt W.

    You are wrong.

    Countless web guys have gone at this problem, and when they do they find out how hard it is to get FDIC insurance. Even if you are willing to pay the .77 cents per $100 (which is what the risky banks pay).

    http://www.fdic.gov/deposit/insurance/assessments/proposed.html

    Meanwhile for fun, next Friday night when the Fed takes over some more banks, go research the backgrounds of the acquiring banks… which read like the who’s who of bankers… it’s always some recently new bank “growing into new markets” but really a revolving door, of the guys who got us all into this mess.

    FDIC is a sham. And the question isn’t, “should we get rid of it?” It is, “since we have FDIC, what can we do to RUIN forever the lives of bankers that ruin FDIC banks?”

    With that mindset in place, just force banks to keep mortgages on their books for five years performing before they can be sold and bundled, and the whole ball game changes.

    Banking becomes boring and worth far, far less to the finance guys.

  54. Gravatar of Ashwin Ashwin
    3. January 2011 at 13:01

    Scott – the secondary trading that is the bulk of profits at banks and HFs is not equity trading (primary or secondary). As I mentioned its fixed income trading – stuff like currencies, bonds and derivatives on them. For your thesis to be true, it needs to be the case that making decisions on credit risk allocation and interest rate/currency risk allocation has excess returns and equity risk allocation does not. My thesis explains it quite simply – credit risk is the quintissential negatively skewed risk, especially when it is sliced and diced up into products like super-senior tranches etc.

    Monopoly power in specialized trading at big banks has changed since the 1980s in that we now have a huge derivatives and mortgage bond market which wasn’t there before. In fact, much of the growth in these markets is itself an endogenous strategy to make markets more complete and enable more efficient extraction of moral hazard rents. On the point of higher margins, take the simple example of IPO fees which are 2-3x higher in the United States than they are in Europe – same holds for derivatives bid-offers because there are many more serious players in Europe.

    “isn’t VC partly just people rounding up some rich doctors and lawyers to invest in new companies? If so, I wouldn’t expect them to make more than index funds–they don’t have any special skills.” If you really believe this, then there’s obviously no way I’m gonna convince you! Let me just say that if allocating risk capital is an activity with excess profits attached to it, then allocating early-stage capital is the riskiest slice of this activity and should atleast earn some part of this excess return, which hasn’t been the case for a long time.

  55. Gravatar of Matt Matt
    3. January 2011 at 14:07

    Ashwin, FICC trading probably accounts for 40% or so of net revenues at the flow monsters (GS, DB etc). Don’t know what percentage is like for buy-side firms (“hedge funds”, to keep things simple), but I doubt it’s that high overall(?)

    You may be able to argue that in some of the credit deriv space people were “profiting” off of insuring tail risk (in quotes because that’s picking up pennies in front of a steamroller). However, as far as I know, the ultimate holders of that risk were not generally the flow monsters, but were instead actors at the periphery of the markets like AIG and less sophisticated commercial banks.

    As for this:

    “Monopoly power in specialized trading at big banks has changed since the 1980s in that we now have a huge derivatives and mortgage bond market which wasn’t there before. In fact, much of the growth in these markets is itself an endogenous strategy to make markets more complete and enable more efficient extraction of moral hazard rents.”

    1) I’m not sure what you mean by “moral hazard rents”
    2) Rents get competed away. Banks are NOT monopolies, even in “specialized trading” (whatever you mean by that). 99.999% (not an exaggeration) of the trades done through a bank can easily be done through at least one other bank, and usually multiple other banks.

  56. Gravatar of Matt Matt
    3. January 2011 at 14:11

    Also, remember that making money as an intermediary only works because you have clients that are willing to pay the spread in order to do the transaction (whether to hedge or speculate).

    Sell-side firms make money because they provide products that their clients want at a price they’re willing to pay.

  57. Gravatar of JL JL
    3. January 2011 at 14:40

    Oh boy…

    First, I’ll repeat my question: Do you agree that the system is rigged to such a degree that something needs to be done soon, or not?

    So you (Scott) said:
    A: “I’ve been one of the most severe critics of our financial system out there.”
    B: “I want to completely deregulate finance.”

    Now I know that in your Friedmanite understanding of the word ‘deregulate’ A and B are mutually consistent.

    But in the Goldman Sachs world we actually live in, deregulate means less restraints, less oversight, less taxation, but keep FDIC, IOR, TBTF, QE, bailouts, etc.
    And this is because the Fin.In. has lobbyists who lobby for such things and call it deregulation.

    And that is why posts such as this one will be interpreted by reasonable people as apologetics for the financial industry.

    The only way to escape such an interpretation is to liberally intersperse qualifiers, e.g. “Now, I don’t mean to defend the financial industry (there is a lot that is wrong and needs to be fixed pronto), but …”

  58. Gravatar of csissoko csissoko
    3. January 2011 at 14:45

    “This once in a century banking crisis …”
    http://www.themoneyillusion.com/?p=8258#comment-49964

    I think many of the people who “question the high returns flowing to finance” are also expecting a financial crisis of equal or greater magnitude within the next decade or two. If you believe that the crisis of 2008 is in fact over and not just stage 1 or 2 of a much bigger phenomenon, then that probably explains your attitude to the returns earned by financiers.

  59. Gravatar of davver davver
    3. January 2011 at 16:05

    Matt,

    “Sell-side firms make money because they provide products that their clients want at a price they’re willing to pay.”

    You can provide clients a product they want at a price they are willing to pay and it still not be good for society. As a simple example I can offer hitman services and find willing buyers at a given price. However, being a hitman is not a socially valuable profession. We’ve made the act of killing illegal because its bad for society. Just as we’ve decided that its wrong for people to kill, we can decide its wrong to trade certain financial instruments. If trading in those instruments, even amongst willing parties, has a socially negative outcome then it should be illegal just like murder.

    Now, you might come down as saying I’m being a little too high and mighty. Too paternalistic. And in most of social activity I’d agree. I generally believe government shouldn’t get in the way of consenting adults in matters of commerce. However, we could all think of some examples in our society where government does meddle and its a good thing. In the financial sphere, rather then the real economy, I think the burden of proving social usefulness is much higher for participants. There are many reasons for such a stance that I hope you can figure out without my having to spell them all out. Having two consenting parties is a good piece of evidence in an activities favor, but it is not always enough in and of itself.

  60. Gravatar of TGGP TGGP
    3. January 2011 at 17:55

    Half Sigma thinks high profits are evidence of unfree markets and that investment banks have a gentleman’s agreement not to compete on price.

  61. Gravatar of TGGP TGGP
    3. January 2011 at 19:00

    I was too impatient with the discussion of ideology (and eager to listen to Hanson’s podcast) to listen to the entire episode of this EconTalk, but the notes indicate that Russ Roberts also regards the investment banks as an oligopolistic cartel. I think that does describe the ratings agencies, but I wouldn’t go so far for the rest of Wall Street.

  62. Gravatar of Scott Sumner: Fool or Genius? Scott Sumner: Fool or Genius?
    3. January 2011 at 19:19

    [...] a recent post, “Does Finance Deserve Its Earnings?” Scott Sumner writes: Many economists (even some [...]

  63. Gravatar of TheMoneyIllusion » Invisible Martians and Occam’s Razor TheMoneyIllusion » Invisible Martians and Occam’s Razor
    3. January 2011 at 19:29

    [...] recent post on finance produced some strong reactions.  Many were very good; indeed the comments by Ashwin were [...]

  64. Gravatar of David Larsson David Larsson
    3. January 2011 at 20:53

    “This once in a century banking crisis … ”

    The century is young yet. As Carl Sandburg wrote, “I am the grass, let me work.”

    ” … results in loans of several hundred billion to big banks, but many of the loans weren’t even needed or wanted by banks.”

    Certainly not according to their respective public relations departments. Funny, I could have sworn that a third of my father’s nest egg disappeared in a weekend. Maybe I just dreamed it. What a bunch of worry warts we all were!

    True, though, it was the western governments that were pushing this solution. Politicians who are in power when their banking systems become insolvent tend to have trouble remaining in oower. You could look it up. Even now, if the government required the banking sector to mark to “market” (if there is one) its real estate loans (let alone more exotic “assets” that those crafty finance people are always dreaming up n their innovation labs), I suspect that a discouragingly large percentage of the sector would be exposed as insolvent, which is why no one in power seems particularly interested in pursuing this particular approach.

    “The banks then repaid the loans”

    Or, at the very least, showed what good environmental citizens they were by recycling the riskless profits they made via borrowing from the Fed to buy Treasuries.

    I’m sorry, it’s just a little too soon after the entire western financial sector coLapsed for me to start celebrating how smart they all are and, therefore, entitled to get paid like Cliff Lee. They remind me a lot more of Lance Parrish. Who was he? Exactly.

  65. Gravatar of JohnnyCM JohnnyCM
    3. January 2011 at 21:00

    Yeah, unless I’m wrong, Yglesias owned you on this. His link’s text to this article: “Finance is earning money by doin’ work.”
    Highly-paid workers in corporate settings have a disproportionately high chance of being total douchebags who compete laterally rather than streamlining, because their logic is institution-oriented which isn’t always the same thing as product-oriented. So if we’re placing bets on whether administration-trained managers are or are not getting paid what they deserve, then we should take into account that we know there are some bad traunches in that pool, and adjust our expectations about the worth of bankers accordingly. You know what I mean?
    Also, when did we return to the labor theory of value?

  66. Gravatar of Matt Matt
    3. January 2011 at 21:22

    It’s sad and typical that you make this whole argument with a nice attractive intuitive story but just ignore all the obvious rent seeking, both that supported by the government and that supported by the “soft” corruption of high level corporate culture. How can you even pretend to yourself that you’re looking at the whole picture, and not just looking in your intro economics text for a simple argument to support your prior beliefs?

  67. Gravatar of FT Alphaville » Further reading FT Alphaville » Further reading
    4. January 2011 at 00:08

    [...] – Does finance deserve its earnings? [...]

  68. Gravatar of EUI EUI
    4. January 2011 at 02:11

    The move from over-simplified pseudo-Smithian ‘i harvest wheat, you mine iron’ to the real world is such a played out intellectual fraud one would cringe and mock if Sarah Palin were to dig it out yet of course economics is presenting it decade in, decade out as some sort of miners lamp to truth. The only problem is the canary in the coal mine is long since dead and you should have the wit to move past such frauds.

    Obviously you are a highly intelligent man but to present such ardent tosh as justification for the abandonment of mass employment policies and justification of naked avarice and wealth inequality leaves me bemused and saddened. Lets hope the gilded birdcage protects your own canary while the ‘units of production’ (sorry, working man) goes on losing out.

  69. Gravatar of EUI EUI
    4. January 2011 at 02:28

    RE JTapp

    “My problem is that the earnings > MPL problem doesn’t seem as big in finance as it is in professional sports– yet you never hear criticism of professional athletes. Someone who works in finance to allocate capital more efficiently helps create future wealth. This is much better for society than someone who scores 6 points which will be erased once the football game is over.”

    err… you do. You hear it all the time if you are connected to the ‘fans’ of sports – not the ones who curse when their star doesn’t perform but the many thousands who are disinterested when they see (usually over time) that the media-presentation of sports-as-iconic-heroes is merely a myth to feed a new generation of fans.

    Each year people turn away in droves as they see the real nature of ‘professional sports’. It happens when a sport turns from amateur to professional, it happens when a sport turns from ‘small time’ to ‘prime time’ and it happens when year after year stars profess their ‘love’ of a club and then hold them to contract negotiation ransom. Look at how baseball suffered when the strikes hit, look at the recent history of Manchester United from the Glazier take-over to this years ‘star threatens to quit’ saga.

    Of course, its not in the interests of any sports media to move beyond acknowledging the ‘upset’ of fans to reporting on the story of how hundreds of thousands walk away disillusioned with what sports has become.. there’s no sales dollar in that.

  70. Gravatar of Andew Andew
    4. January 2011 at 02:44

    Going back to your key original assumption – there are a few people that are very good at allocating capital, which given its importance today, explains why those in finance earn as much as they do.

    Why don’t we examine if there is any evidence of such skill. For example, does M&A “create value” for the purchasing company. All the studies I have seen on the subject suggest that most destroy value. Similar evidence can be found for mutual funds, hedge funds and private equity funds. Looking at average results obviously loses the fact that there are a few talented “capital allocators” out there, but one still needs to explain why even though the average financial sector worker is as good at allocating capital as a dart throwing monkey – they still earn multiples of other professions.

    The post also ignores the fact that the majority of those working in finance have absolutely nothing to do with capital allocation.

    As someone who works in finance, only in my most egotistical moments would I argue that the financial rewards are a result of having a gift for capital allocation.

  71. Gravatar of Tom Grey Tom Grey
    4. January 2011 at 03:49

    Scott, thanks so much for starting a great comment thread!
    @ashwin:
    we now have a huge derivatives and mortgage bond market which wasn’t there before. In fact, much of the growth in these markets is itself an endogenous strategy to make markets more complete and enable more efficient extraction of moral hazard rents.

    This is the winning idea for truth.

    Lehman should have gone bankrupt, and also AIG & all BigBanks that depended on AIG.
    The financial system that was “saved” with the TARP bailout was the one to extract moral hazard rents, and overpay top CEOs for being good at making such socially destructive bets.

    This system should be stopped, and would have been stopped if all the equity investors had lost all in their BAD capital allocation. But the rules of the game, by financial parasites, for financial parasites, want to keep this terrible system alive.

    Your larger point seems to be true, that with globalization and the growing importance of capital allocation, the returns to the capital allocation decision maker should be increasing. And, with non-financial CEOs making such important decisions, it does seem to be true. But that is not finance hedge wizards making the blueprint, nor financing the makers of the blueprints. Financiers are getting immoral rents.

    And my key insight is this: focus on excessive Finance pay is the primary way to get political will to make a system to stop the extraction of moral hazard rents by the TBTF/ connected financiers. Thus, your defense of big pay is a de facto defense of immoral rent extraction.
    This is true despite your explicit (radical free market) calls to scrap much of the moral hazard infrastructure.

    So, I think you’re right on the small point you want to make on capital allocation, but you’re more importantly wrong on the realpolitik point of getting the system to be changed to stop the gov’t bailouts of the rich. This change will occur, if it does, partly thru disgust at unfair compensation for bailout benefiting financiers, but it is this disgust you’re arguing against.

  72. Gravatar of Left Outside Left Outside
    4. January 2011 at 05:05

    “In the 1950s and 1960s it wasn’t that hard to figure out where capital needed to be allocated. Capital was allocated to produce steel, and the steel was used to produce cars and washing machines. Capital was allocated to the production of aluminum, and the aluminum was used to make airplanes.”

    Don’t you think you’re somewhat guilty of historicism here? You seem to be saying that because in hindsight it looked easy to find productive investments it must have been easy to find productive investments at the time. I think you’re on difficult ground here.

  73. Gravatar of Jim Jim
    4. January 2011 at 06:05

    Sorry, but if the taxpayer had not provided support, most of these liars and cheats would have gone bankrupt. They are no good at their job which is managing risk.

  74. Gravatar of Doc Merlin Doc Merlin
    4. January 2011 at 07:21

    “Your view at arbitrage skill makes no sense to me. Why wouldn’t others do the same thing? Presumably because they aren’t as good at spotting good investment opportunities as the hedge fund guys. But that’s exactly my point”

    There would be fewer regulatory arbitrage opportunities would congress not create them, so returns /and/ total profits would be lower. Yes these guys are good at what they do, and what they do is spot inefficient capital allocations and put them to more efficient uses. However, if congress, regulators, the Fed, etc create more and changing regulations, then there are always excess short run inefficiencies for wall street to arbitrage around. Because of the above, changing regulation and legal landscape acts as a subsidy to the financiers that are good at what they do. This is why I think they get paid so much.

  75. Gravatar of JoshK JoshK
    4. January 2011 at 07:31

    Hi, I always enjoy your posts. I trade rates for a large bank and can share my perspective with you:

    Most of what the bank does is provide services for the capital allocation industry.

    On the prop side it’s complicated and takes a lot of smart people and systems. This is a relatively small part of what most banks do.

    On the client side there is also the desire for brand name services. And there’s lots of client demand, so clearly the banks provide something they want. Maybe it’s interest rate exposure or risk reduction. Maybe it’s tax efficient equity exposure.

    And you may read about the one guy who makes a couple million bucks, but most people in this industry make a few hundred K. A top notch programmer can make $300k and a crane operator can make $250k. So I don’t know if there are really outlandish profits here. I think people just like scapegoats.

  76. Gravatar of scott sumner scott sumner
    4. January 2011 at 09:03

    Everyone, The comments will need to be short today, as I have a lot in three different posts. One point that may respond to issues many of you may be raising. I AM NOT DENYING THAT MARKET IMPERFECTIONS IN FINANCE RESULT IN SOME UNDESERVED GAINS TO THOSE IN THE INDUSTRY. My original title was misleading, as I used the term “deserved.” I am arguing that even in a perfect free market, with no distortions, and a level playing field, you’d expect the share of GDP going to finance to have risen in recent decades, and also for income to become much more unequal due to these structural changes. So that’s my general reply to those who raise specific problems in the financial industry.

    I’d also point out that my newest post attempts to address many of the questions raised here.

    Celestus, Partly based on the volume of investment, but also partly based on the complexity and difficulty of investment decisions.

    Shane, I agree about the lack of a priori link.

    Morgan, There are thousands of banks, they fail all the time. The industry is fairly competitive.

    Davver, I dealt with some of your objections in my new post. I don’t see how your post explains the rising share of GDP going to finance–mine does.

    Matt W, Those are good comments. In the comment section of my newest post I concede that regulatory arbitrage (not subsidy) is the most likely reason I would be (partly) wrong.

    Ashwin, You said;

    “Scott – the secondary trading that is the bulk of profits at banks and HFs is not equity trading (primary or secondary). As I mentioned its fixed income trading – stuff like currencies, bonds and derivatives on them. For your thesis to be true, it needs to be the case that making decisions on credit risk allocation and interest rate/currency risk allocation has excess returns and equity risk allocation does not. My thesis explains it quite simply – credit risk is the quintissential negatively skewed risk, especially when it is sliced and diced up into products like super-senior tranches etc.”

    A few comments:

    1. Both stocks and bonds are involved in capital allocation.
    2. Regarding T-bonds, I agree with you.
    3. In my newest comment section I discussed currency. Let’s suppose that the commission on trading currencies has stayed fixed since the 1980s, but that currency trading has increased greatly as a share of GDP, due to globalization. I’d say that sort of activity supports my hypothesis–as finance is helping to allocate capital around the world in a more sensible way. That should make finance more important. Now let’s suppose hedge funds do a lot of pure speculation in currency, unrelated to real economic activity. In that case it’s a zero sum game, for every winner there is a loser. They aren’t extracting money from me, they are extracting money from other hedge funds. No increase in the share of GDP going to finance.

    You said;

    “If you really believe this, then there’s obviously no way I’m gonna convince you! Let me just say that if allocating risk capital is an activity with excess profits attached to it, then allocating early-stage capital is the riskiest slice of this activity and should atleast earn some part of this excess return, which hasn’t been the case for a long time.”

    It’s possible you are right, but here’s why I’m not convinced. I recall reading that VC is only a very tiny part of capital allocation. So in that sense it’s not important. Your stronger argument is that it seems like exactly the sort of case I had in mind. Yes, it seems that way, but what if it isn’t? Suppose it’s just a way to raise funds from dumb doctors and lawyers, and the the real smart financiers don’t do VC, they allocate capital by being hedge fund managers, CEOs, billionaire investors, big bankers (commercial and investment.) I’m not saying you are wrong, but I’d need more data on why VC does poorly. Who’s actually involved in VC?

    Matt, Thanks for that info. It seems plausible to me that even big banking is somewhat competitive, but as I know less than either you or Ashwin, I don’t want to have a closed mind on the issue. I have no ideological reason to defend banks, as I hate all the sources of moral hazard and regulatory arbitrage they benefit from. I’m just trying to figure out the relative magnitudes.

    JL, We actually agree. In numerous other posts I’ve said if we keep FDIC, we need much more regulation of banking.

    csissoko, Totally wrong. My whole blog is devoted to prevented a repeat of this fiasco. I’d like to blow up the entire system and start over. NGDP targeting and no moral hazard. My point is that even if we did that, finance would make a ton of money in the 21st century economy.

    TGGP, Collusion almost never works in complex fields like finance–too many dimensions in which comp. can occur.

    I’d like to know the evidence Russ has. I often agree with him.

    David, Everyone, including me, has the same gut instinct as you about the crisis. But that doesn’t have any bearing on the argument I am making.

    JohnnyCM, I’m afraid I don’t follow your comment. And who’s using the labor theory of value?

    Matt, Those aren’t my prior beliefs, my prior beliefs are the same as yours.

    EUI, You said;

    “Obviously you are a highly intelligent man but to present such ardent tosh as justification for the abandonment of mass employment policies”

    Ummm, isn’t 90% of my blog devoted to “mass employment policies?”

    Andrew; You said;

    “Why don’t we examine if there is any evidence of such skill. For example, does M&A “create value” for the purchasing company. All the studies I have seen on the subject suggest that most destroy value.”

    In the 1960s much of finance was devoted to destroying value by creating conglomerates. After Michael Milken, it’s more devoted to using junk bonds to break up conglomerates and create value. That’s progress, isn’t it?

    Tom Grey, You said;

    “So, I think you’re right on the small point you want to make on capital allocation, but you’re more importantly wrong on the realpolitik point of getting the system to be changed to stop the gov’t bailouts of the rich. This change will occur, if it does, partly thru disgust at unfair compensation for bailout benefiting financiers, but it is this disgust you’re arguing against.”

    That’s a good argument. But even with all the disgust, Congress refused to do anything significant (even under the Dems!), and Basel III backed off from reasonable capital requirements worldwide. The battle was totally lost long before my blog post. But I agree, it does give aid to the enemy.

    Left Outside, I’m surprised you are the first person to call me on this. That would have been my number one objection to my post. I think I did exaggerate somewhat for dramatic effect, but I still think the tendency was for the economy to change in the direction I described. Most people seemed to buy that assumption, but you’re right it’s less true than I made it seem.

    Jim, Sorry, but you are wrong. The Fed would have been forced to stimulate the economy—come to think of it, that’s what they should have done anyway!

    Doc marlin, I agree, I’m just not sure it’s the biggest reason. But we both agree we need to fix the regulatory mess, otherwise we can never fix finance.

    JoshK, Thanks, I agree.

  77. Gravatar of davver davver
    4. January 2011 at 14:19

    “Davver, I dealt with some of your objections in my new post. I don’t see how your post explains the rising share of GDP going to finance–mine does.”

    Scott,

    I don’t have a problem with your thesis that SOME portion of the increase in GDP going to finance makes economic sense. I object to the idea that all, or even most, of the increase in GDP has real economic reasons behind them. Largely I view many of the new revenue generators for banks in the last 30 years with skepticism. The farther away they get from actual capital allocation, the more esoteric, the closer to zero sum games the less I view them as having economic value. That’s a huge portion of the increase in Wall Streets business, enough that we ought to ask questions about it and consider policy solutions if it truly is socially negative activity.

    I’m not advocating putting a blanket cap on financial compensation. I’m more looking at policies that restrict, perhaps even harshly, current wall street practices and lines of business that perhaps should not exist. Such an action would lower the financial share of GDP as a consequence, but not simply because I’ve arbitrarily decided it is too high.

    As for the matter of your post, I disagree with the following:
    “But for me to be wrong it also has to be true that those managers mostly lack the skill to spot socially beneficial investments, they concentrate on socially harmful ones. Isn’t that one assumption too many? ”

    Spotting socially beneficial investment IS much harder then ripping someone off. Good investing is hard. That is why so few people can do it well and so many people fail. The Buffets of the world do deserve tremendous compensation for their talents. Ripping people off, by contrast, merely requires one person be smarter or more connected then another. I really wonder if you’ve ever had any time working in finance. I only worked for a wall street firm for a brief time (a big name that did well in the crisis) and there was plenty of immoral action going on. People talked about ripping others off frequently. Lying and misleading were common. Its much easier to trick someone out of their money then to build something. That’s why we have laws against fraud, cheating, etc.

    The big difference between now and 30 years ago is that its much easier for wall street to cheat people. They’ve invented new methods, broken down some old ones, and made an art of regulatory capture. As such many activities that should not be allowed are. There’s nothing overly complicated about that story. Its one that has played out plenty throughout history.

    I know you have a hard time understanding how people can constantly be swindled, but it is just the world we live in. I played poker professionally to put myself through college (a talent the street prized). People came to my table every night to hand me money. Its hard to understand because your a smart guy, but its just the way the world is. It is very easy for smart guys like us to take advantage of regular people if we are allowed to. And in the financial world, a complex world that requires a sharp mind and significant education to understand, the regular chump doesn’t stand a chance.

  78. Gravatar of David Larsson David Larsson
    4. January 2011 at 15:50

    Scott, I appreciate your taking the time to respond. With respect, I took issue with some sentences you wrote (about once in a century events and banks getting government loan they didn’t need) that you presented as part of your “argument.” If that part of your “argument” is wrong, as I was asserting, then how is it that that “doesn’t have any bearing on the argument (you are) making?”. If that wasn’t part of your “argument,” then (i) why did you include it? and (ii) what other parts of your “argument” do you consider extraneous to your argument?

  79. Gravatar of Andrew Andrew
    5. January 2011 at 09:23

    Mr. Sumner,

    Interesting, although I think you need to investigate far (far) more the market imperfections to explain the abnormally increased share of high finance over the last 20 years (well out of line with the hundred year trend).

    I’d argue that there are a huge number of market failures (primarily asymmetric information / principal-agent problems) which explain the increasing share of overall GDP returns accruing to the financial sector. Having worked with the investment banking sector, there is a huge amount of rent capture, uncompetitive behaviour, market-for-lemons problems, winner’s curse etc.

    Andy Haldane (of the Bank of England) has work over the past couple of years demonstrating that increasing leverage is the dominant factor in explaining high returns over the past thirty years.
    https://docs.google.com/viewer?url=http://www.bankofengland.co.uk/publications/speeches/2009/speech397.pdf

    There is similar interesting analysis from the Future of Finance group – I could post it.

    thanks,
    Andrew.

  80. Gravatar of Andrew Andrew
    5. January 2011 at 13:22

    Martin Wolf has a great discussion of why the returns to finance are too high here:

    http://harr123et.files.wordpress.com/2010/07/futureoffinance-chapter91.pdf

  81. Gravatar of scott sumner scott sumner
    5. January 2011 at 17:07

    Davver, I answered this over at the newer post.

    David, I meant that I am also angry about the financial system. I meant that anger is not relevant.

    As far as once a century, all we can do is look backward. We know it’s the worst since 1933, maybe the worst in US history.

    I took you “pr” comment is a sarcastic joke–if you have some hard evidence, I’ll respond.

    Andrew. The focus of my post was not to claim that other explanations have no validity, but rather that you’d expect the share of GDP going to finance to have risen, even if those other explanations were not a factor. Obviously in a quick blog post I can’t beat back every alternative theory out there. I was trying to throw out a plausible explanation that I wasn’t seeing getting much consideration.

    Clearly the British government made a huge mistake bailing out the banks. They do not face a zero bound problem in monetary policy (because they can devalue) and that would have been the better way to deal with the problem. Short of that, raise the capital requirements much higher. I expect them to do neither

  82. Gravatar of Thoughts on a crisis | Morton and George Thoughts on a crisis | Morton and George
    5. January 2011 at 21:36

    [...] See Scott Sumner on moral hazard and why finance does deserve big rewards; See here for a more technical explanation of a lot of what I said [...]

  83. Gravatar of Recommended Reading: Finreg, Policy, Economics & More! « Stone Street Advisors Recommended Reading: Finreg, Policy, Economics & More! « Stone Street Advisors
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  84. Gravatar of Is Income Redistribution the Key to Economic Growth? | Contrarian Musings Is Income Redistribution the Key to Economic Growth? | Contrarian Musings
    9. January 2011 at 16:11

    [...] sector is now more conservative and less likely to lend to new firms. Some, such as Scott Sumner here, have argued that the financial sector deserves to capture a greater share of profits but having [...]

  85. Gravatar of The Finance Cooler | Blog | Rent Extraction and Competition in Banking as an Ultimatum Game The Finance Cooler | Blog | Rent Extraction and Competition in Banking as an Ultimatum Game
    11. January 2011 at 13:46

    [...] two recent posts [1,2], Scott Sumner disputes the role of financial rent extraction in increasing inequality. His best [...]

  86. Gravatar of Scratching the surface of “who gets rich, and why?” « Blunt Object Scratching the surface of “who gets rich, and why?” « Blunt Object
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    [...] Does finance deserve its earnings? (The Money Illusion) As long as we have an economy that is increasingly dominated by “idea companies,” where the idea is really, really hard to discover and really easy to implement once discovered, finance will earn huge gains.  [...] [...]

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