Invisible Martians and Occam’s Razor

Say I’ve got a crazy uncle.  He tells me that there are Martians in his closet.  When I go to look I don’t see any.  “There invisible,” he replies.  I suppose that’s possible.  Or the closet might be empty.  Which alternative seems more plausible?  Occam’s Razor says you should go for the simplest explanation.

My recent post on finance produced some strong reactions.  Many were very good; indeed the comments by Ashwin were extremely good—better than my post.  But I still think Occam’s Razor’s on my side, and I’d like to explain why.  Having said that, I don’t mean to suggest my opponents are seeing invisible Martians.  Ashwin might well be correct.  I’ll let you decide.

The basic idea was that the structure of the economy had changed in such a way as to make financial skills far more valuable than in the 1960s.  I define “finance” as the business of allocating capital, which is a bit different from how it shows up in the national accounts.  For instance, I believe the CEOs of major non-financial companies are being paid (in part) for the decisions they make in allocating capital.  I argued that two changes in the economy had made skill at allocating capital much more important; high tech, and globalization.  But the way, I think these are also the two forces that did in communism.  Remember that the 1960s were the golden age of the Soviet economy.  If all you have to do is churn out iron and steel and washing machines and apartment buildings, it can be done passably well with central planning.  Of course even then the American economy was superior to the Soviet economy, but less superior than later on, when the decisions were about whether to allocate capital to Google or Genzyme, or whether to build that auto parts plant in Detroit or Mexico or China.  It’s no longer about simply mobilizing capital to mass produce clearly defined output of stuff we all know consumers will want.

I argued that those with great skill in spotting good investments would be expected to earn much higher incomes in the modern economy than in the economy of the 1960s.  And that you’d expect income to become more unequal, with some particularly big incomes going to the top.  The strongest arguments against me (and you should look at the comment section, because I won’t be able to do them justice) revolved around the fact that finance is distorted by all sorts of government intervention, which allow the big investment banks to earn enormous profits.  I’ll call this the subsidy argument; although later I’ll address more sophisticated versions that involve market power.

As an analogy, it would be like me claiming that the fast rising salaries of athletes (since the 60s) is due to growing TV money, and my opponents claiming that it’s due to public funding of stadiums.  I used the analogy of farming, which receives lots of government subsidies, but still sees rather modest average incomes, due to competition.  My opponents accepted the fact that this analogy applied to the smaller banks, but not to the big banks, hedge funds, and billionaire investors.  They argue that there are barriers to entry; that certain types of trading are effectively controlled by oligopolies, and that insiders have other related advantages.  I don’t completely dismiss their arguments, but for the following reasons I’m not convinced either:

1.  I’ve always believed that oligopolies are more competitive than they look.  It’s still a dog eat dog world out there, a real struggle to survive.  Lehman and Bear Stearns recently went bankrupt (or almost bankrupt, in the case of Bear Stearns.)  Yes the creditors of BS were bailed out, but the shareholders lost a lot of money.  The most oligopolistic industry in the world might be big jets, where two firms split the market.  And yet Airbus and Boeing seem to compete fiercely for sales.  In contrast, there are dozens of big banks competing in a globalized market.  I must defer to my opponents on the specifics of big banking, as I am not an expert, but are the areas where only a few banks dominate, such as trading certain types of securities, really enough to explain the extraordinary fortunes being earned by the wealthiest financiers?  I’d like to see some data on earnings from market making as a share of GDP.

2.  Hedge funds are much less regulated than big banks, and yet some of the most spectacular earnings go to the managers of top hedge funds.  So that would seem to undercut their argument that it’s all about barriers to competition.  It’s been argued that some of the profits that hedge funds earned came from activities involving the big banks, which are effectively subsidized by the Treasury (as Too Big to Fail means they can borrow at very low rates.)  Here’s Ashwin:

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, at least in the cases of UBS and Magnetar this is not conjecture but based on publicly available information.

Yes, but that doesn’t really undercut my competition argument.  Why don’t others try to get those investments in subsidized markets?  Competition should still drive down the rates of return earned by hedge funds.  The only counterargument I can see here is that only a few hedge fund managers know how to find these easy pickings created by government subsidies.

But now we are veering dangerously close to the world of invisible Martians.  I claimed that the big earnings of rich financiers reflect their skill at allocating capital.  Others say they are benefiting from government favoritism.  I point out that competition should eliminate those gains in industries like hedge funds.  They say the hedge funds are dabbling in subsidized areas.  I ask why others don’t get rich doing this.  Perhaps only a select few have the skill to do these types of investments.  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?  To be clear, I never said that financiers never benefit from government subsidies, indeed my whole post had a completely different focus.  I argued that one would expect the recent structural changes in the economy to greatly enrich finance.  Either the gains to hedge fund managers come from talent, or they don’t.  And if the returns come from investment talent, then why wouldn’t one expect them to be able to make large amounts of money allocating capital in our dynamic modern economy.  And if they don’t have any special talent, why aren’t we all so rich?

Here’s what I think is the simplest explanation:

The return to hedge fund managers, CEOs, billionaire investors, and Goldman Sachs employees has soared in recent decades because their skills are far more socially valuable than the 1960s, when the biggest decision was whether GM should put tail fins on Cadillacs.  This dynamic, fast changing environment is like a big playpen for the shrewd and savvy investor.  We all know how the founders Microsoft and Google and Facebook got really rich because their “product’ can be produced at ultra-low marginal cost.  Or how great cost savings can be achieved by moving capital overseas.  In that sort of world it’s no surprise that investors who allocate capital to profitable ventures also get much richer than in the world where big corporations raised capital to make predictable products using American labor.

It seems to me that this should be the standard explanation, and any alternative explanation should have the burden of proof.  Instead it usually seems like the opposite is true.  I constantly read opinion pieces that seem to simply assume that the big earnings in finance are unwarranted.  Partly this is a backlash against the behavior of banks in the recent crisis.  I’m just as outraged by our financial system as the next guy.  But those are completely separate issues; one issue is secular trends in financial income, the other is bad regulation in banking.

Some commenters accused me of defending the financial system, which is absurd given that I have been a strong critic of the entire system.  The big bankers would be horrified if I was given dictatorial power over regulation.  I’d get rid of all the moral hazard.  But the investment banks and the hedge funds would still make boatloads of money in a completely free markets.  Perhaps a tad less, but the profits still would have soared in recent decades.

Others pointed out that my description didn’t match the Wall Street they knew.  Yes, lots of managed mutual funds rip off investors, and add little social value.  But that’s always been true, and with the rise of indexed funds is actually becoming less true over time.  Commissions don’t explain the huge growth in income to Buffett or Soros or the big hedge funds.  I doubt it even explains Goldman’s success.

Others argue my hypothesis is inconsistent with my belief in the EMH.  But I’ve never argued the EMH is true for everyone.  I’ve argued it’s a useful theory for regular investors like me, for regulators, and for academics.  But someone has to be doing the work of figuring out where capital should be allocated, and I presume they are rewarded for their efforts.

Some pointed out that my argument seemed to fit venture capital best, but their earnings are modest.  No, the reason the VC earnings are modest is because VC is only a tiny part of capital allocation.  And many investors in VC are not particularly sophisticated.  Others argue that trading shares in secondary markets doesn’t fit the description of allocating capital.  But I say it does, indeed even short selling plays a role in allocating capital.

Some accuse me of defending the wealth of financiers.  But I’m not making a moral argument here.  Because I’m a utilitarian I don’t pay any attention to the concept of “deserving” the money you make.  Our tax policy should redistribute money in the way that best maximizes aggregate utility, and pay no attention to whether it looks like various people’s incomes are “earned.”  Unfortunately I used the term ‘deserve’ in my post title, so I “deserved” that criticism.  🙂

Because of lack of time I will fall behind in my comments.  I’ll catch up eventually.

PS.  Some people talk about the big profits trading currencies, T-bonds, etc.  This is probably a naive question, but precisely who are these profits being extracted from?  If it’s companies that trade, why don’t the companies lean on their own bank for a better deal than GS can provide?  What am I missing?  It’s a learning process for me as well.


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91 Responses to “Invisible Martians and Occam’s Razor”

  1. Gravatar of Shane Shane
    3. January 2011 at 20:08

    If capital can find higher returns in speculation than in producing innovations and productivity gains, it will. Government bailouts are not necessary for this; all that is necessary is no attempt to reign in speculation. You seem to be assuming that this is evidence that these pursuits are increasingly important, because they generate high profits.

    But it seems more likely that the reverse is true–the tremendous private gains these generate make them seem much more important than they really are. When we think of how important and useful finance has become, what do we think of? Facebook and Twitter, which are fun but ultimately of only modest social value at best. Where are the new innovations? Perhaps some would say that they are more quiet and less flashy than those of the early internet age. Where, then, is the evidence of a high correlation between finance profits and productivity or other measures of increased economic efficiency? In the last ten years, my computer and cell phone have gotten marginally faster. But there has not been vast new leap forwards in productivity that one would expect would correlate with these kinds of very high returns. The economy has largely stagnated as finance has become so much more profitable.

    And then there is the last rationalization–the claim that these profits are warranted because they generate liquidity. In Samuel Johnson’s time, patriotism was the last refuge of scoundrels; today, it’s the canard about generating liquidity and efficient pricing. Can’t we get these things for cheaper? Just because these profits are possible in our current financial system does not mean they are necessary or useful. I’d bet real money that high profits could go away tomorrow and hardly impact the real economy.

  2. Gravatar of gnikivar gnikivar
    3. January 2011 at 21:16

    I think on an instinctive level, people find the idea of financiers earning massive amounts of money disturbing. However, the US has seen labor productivity growth substantially above the average for developed countries in the last two decades despite the fact that investment rates in the US are lower than those of other wealthy countries. I think a big part of this is that the American financial system allocates capital with incredible efficiency.

    Second, the rate of financial sector growth may not be as high as some people think. I strongly suspect that much of the financial services growth is corporations outsourcing services previously done in house.

  3. Gravatar of Doc Merlin Doc Merlin
    3. January 2011 at 21:20

    Two things:
    1.
    In the stock world we speak of two types of profit.
    Beta and Alpha:

    Beta is market returns as the market rises, this can be caused by inflationary central bank expansion or by the stocks gaining value due to the market doing better. Beta is gained by using a strategy that uses EMH.

    Alpha is money you gained because you are better than some poor sucker who is doing worse. Either you:

    a) conned someone into accepting bad assets by lying materially and not telling them they were designed by Paulson to fail. (as GS did in the Abacus scandal),

    b) or you maneuvered your way so that you would be able to use your contracts to zap all the liquidity in a market, and this render it not efficient for a small period of time, in order to take over (this is similar to a Bear raid) which is what VW did to Porche recently.

    c) Or you have insider info that allows you to beat the market, like all the many many many recent arrests and raids on hedge funds recently (WINIFRED JIAU, WALTER SHIMOON, MARK ANTHONY “TONY” LONGORIA, MANOSHA KARUNATILAKA, JAMES FLEISHMAN, DANIEL DEVORE, DON CHING TRANG CHU, RICHARD CHOO-BENG LEE, DR. YVES BENHAMOU and many others, this list I made here is just last wednesday.) Congressmen and regulators also do this.

    2. You say you believe in EMH, but if EMH is true then hedge fund managers should NOT be more productive than the market over the long run. I.e.: all long run gains should be beta.

    3. You claim their high salaries are from being highly marginally produticive. I claim its from barriers that give them the edge. The ban on insider trading is a good example. Many hedge funds use insider information to beat the market, because they know its hard for them to get caught at it, wearas if the company’s CEO did it, he would much more likely get caught. Because the corporate officers can’t insider trade as easily without getting caught, the information doesn’t reach the market as quickly, giving an opportunity for hedge funds, which are a bit slower but less likely to get caught to do it.

  4. Gravatar of Bryan Willman Bryan Willman
    3. January 2011 at 21:21

    I think there are two things afoot.

    1. Computer hardware, computer software, and most other innovative high return ventures don’t have “too-big-to-fail” nor “socialization of losses” – instead they have liquidations. So the real complaint isn’t that Wall Street types got big salaries or bonuses, but rather, that they got them at taxpayer expense after a bailout.

    2. The last few decades have seen a kind of “class structure” emerge – members of various elites make lots of money, others feel left out in the cold. The media bombards people with messages about how education is an overpriced disaster in this country, and how people with special skills are making a killing.

    (This is speculation on my part – I had special skills and was very well compensated, albeit for very hard work.)

  5. Gravatar of Paul Paul
    3. January 2011 at 21:48

    I think the biggest problem that I see with Sumner’s argument is the lack of evidence. Sumner claims that the skill set needed to allocate capital well is in very small supply; he provides some anecdotal evidence that the skills needed for VC in tech. and science is in short supply, and then says that VC has little to do with the social value generated by finance. Is the talent necessary to do finance necessarily in short supply? I’ve gotten the impression that is very difficult to obtain even an entry level job on Wall Street without an Ivy League degree, which sounds a whole lot more like a network of privilege than a meritocracy or an open marketplace. It isn’t like incredibly motivated and talented outsiders have any way to start their own hedge funds. Mr. Sumner seems to have forgotten that the people who get paid to allocate capital aren’t paid a market wage; the only reason they are allowed to allocate capital is that they have clawed their way to the top of the social hierarchy. There isn’t anyone more powerful than they to tell them no. After all, they allocate “capital” i.e. resources. Which is to say that they control resources in a way that no other category of workers do. If we had a more assertive military, they would sit atop the social hierarchy, they would decide how capital was allocated, and they would also have outsized incomes.

    As well, where is the evidence that finance has created greater world economic growth? The world is a complex place, so that is an incredibly difficult assertion to defend.

  6. Gravatar of David Pearson David Pearson
    3. January 2011 at 22:25

    Scott,

    So some people can consistently earn arbitrage profits — beat the market? Its ironic that you would be defending the anti-EMH thesis. Occam’s razor applies: the existence of outperforming managers can be explained by a simple normal distribution of returns. Why resort to an explanation that requires some sort of arbitrage profits available to only some investors? If you were so sure who these clever managers are, then why not invest all your assets with them on a levered basis? Surely you could make a fortune that way.

    BTW, a simpler theory holds that the “bacon” of many outperforming hedge fund managers was saved by the Fed’s 2008 liquidity interventions. In other words, they were all short liquidity and volatility using various strategies, and their funds would have failed were it not for the Fed’s actions. If you ask Bernanke, a few tens of billions thrown hedge fund manager’s ways is a small price to pay for avoiding a depression. And of course these managers know this in advance, which is why they will short liquidity and volatility again, sparking yet another crisis. This is but one example of how “stabilization” creates unintended behaviors, which in turn result in a fragile financial system fraught with systemic risk.

  7. Gravatar of rob rob
    3. January 2011 at 22:45

    It seems investment banks do allocate capital, but not in the way the name “investment bank” makes you think they would. They don’t tend to take long-term positions in individual stocks, sectors or countries. That’s for philistines. Investment banks are mostly nano-financiers. Even without HFT they tend to make short-term trades. Of course, they are also perennially short volatility, as TC emphasizes.

    Why then are nano-financiers paid more handsomely than mutual fund managers? Is it because — as we all know — mutual fund managers can’t beat the market, but proprietary traders can? For the sake of argument, assume that is the case: Long-term investors use blunt instruments while nano-financiers surgically cut away any remaining inefficiencies. Makes perfect sense. I can see why the specialists would be paid more.

    But there is one thing I don’t understand. The proprietary traders, quants or otherwise, trade based on predictive price pattern recognition. i.e, they use the past to guess the future. They are much like people who are good at rock, paper, scissors: they detect the subtle tells and patterns of their opponent’s behavior and use it against them. How then does short-term trading result in better capital allocation than without it? After all, quants aren’t paying attention to the fundamentals of the businesses they trade in. They trade based on price momentum or fleeting windows of predictive correlation between securities. Does that better allocate capital? Or are they merely increasing the vig for slower investors? I suspect nobody knows for sure.

    The model in my head is this: the value of Wall Street is geographical (if only metaphorically geographical.) It is a hub, and it generates value from its hubness. It doesn’t allocate capital so much as it allows others to allocate capital. All that proprietary trading is just market-making, grease in the gears. Wall Street is like network TV back in the days when network TV was powerful. It is competitive, but it is still an immature industry. 15 years ago nobody had heard the term hedge fund. Now we have all properly learned to despise them. I suspect that like the fate of network TV, competition will gradually erode the strength of the Wall Street hub. Individual investing will become more popular and managed accounts less. Proprietary trading will become harder and harder to consistently make money at as it becomes increasingly competitive and will start to become victims of the EMH much as mutual funds already are.

    So I believe this is still the salad days for market-makers, but desserts will be here before they know it.

  8. Gravatar of Jason Jason
    3. January 2011 at 22:52

    If we’re going for Occam’s Razor here, how’s this:

    http://arxiv.org/abs/cond-mat/0002374

    N individuals, exchanging value J along with a (random) Brownian market with mean return m and variance 2s^2. Solution in mean field approximation is a Pareto wealth distribution for large wealth fraction with an exponent ~ 1 + J/s^2.

    J large, exponent increases, Pareto distribution becomes narrower and you have more wealth equality.

    s^2 large, exponent decreases, Pareto distribution becomes wider and you have more wealth inequality.

    Bouchaud and Mezard go on to see what happens if you add in a (flat) tax that redistributes wealth. Turns out this also reduces wealth inequality.

    So this leaves a few possible explanations:

    1) Inequality is being driven by the reduced value of economic exchanges relative to per capita wealth.

    2) Inequality is being driven by an increase in market volatility.

    3) Inequality is being driven by lower taxes.

    4) A little bit of each.

    Looking at the DJIA as a proxy for general market volatility, you can see it is high before 1929, low after, and then starts to rise in the 1970s:

    http://www.nytimes.com/imagepages/2008/01/05/business/20080106_soapbox_graphic.html

    So 2 is definitely part of the story. So is 3. Now, 1 is definitely not true — savings rates have been decreasing from the 80s to the 2000s while inequality has been rising. This effect may actually mask how strong the effects of 2 and 3 are.

    Now in this model, everyone has exactly the same abilities, yet inequality results. So it is difficult for me to believe that there are people really good at capital allocation when a model where no one is especially good can come out with the same income inequality. Occam’s Razor tells me it is random.

    Now whether these incomes are deserved is entirely another question! Someone who goes into a casino and makes big bets and comes out on top totally deserves their income. They just shouldn’t think they are smart or something … because in most worlds it came out the other way.

  9. Gravatar of Marc Marc
    4. January 2011 at 01:05

    Regarding your question regarding FX, I remember reading, a few years ago, a study that looked at FX traders at Citi (as the largest FX house at the time) and the study concluded that access to such a large amount of trade flow data gave its traders an edge and allowed them to win on their trades 57% of the time as opposed to 50% for participants without access to the same information. The numbers might not be exact as I am quoting from memory, but that’s the gist of the argument.
    You can certainly find the same asymmetrical information advantage in other OTC products, such as bonds. Maybe this is part of the reason why banks are so opposed to central clearing of their derivatives trades. They would lose this asymmetrical information advantage stemming from their access to flow data.

  10. Gravatar of Vitas Vitas
    4. January 2011 at 01:06

    Your theme about invisible Martians it so interesting: now on my pc I trying to explain how crazy is to regulate prices. And try to use example from my childhood, then I was searching gnomes in a radio. Yes I’m not found gnomes, but got some electricity. Very interesting – different continents and the same minds! Your uncle right: invisible gnomes are everywhere! On my writing I also include “ž”decline effect” that’s mean something to understand become impossible.

  11. Gravatar of honeyoak honeyoak
    4. January 2011 at 01:08

    “Some people talk about the big profits trading currencies, T-bonds, etc. This is probably a naive question, but precisely who are these profits being extracted from?”

    these profits are mostly being made from the marginal investor in the asset. they are not a direct transfer from the issuer of the underlying asset. The federal reserve does not write a check every year to all holders of US currency.

    for example if I were to trade 1 yen for 1 dollar in period 1 and then the exchange rate were to drop to 1 yen = 1.2 dollars in period two. this would create a paper loss of 17% of my original portfolio. this loss however would not involve any money gained by the speculator that sold dollars and bought yen until I traded my portfolio back into its original position. i could do this many ways(not necessarily trading back directly but by buying foreign goods or trading with someone who does) it is that “trading back” in aggregate that pays the hedge funds so much money.

    where this gets confusing is when we are dealing with assets that can be issued at will and provide real cash flows. in such a scenario it is better to imagine that the security is in fact two deferent arrangements with two balance sheet transactions. one is between the issuer and the holder of the security (this is equivalent to dividends or coupons) and the other is between the marginal buyers of that security (i.e. the cash flow discounted) at any given moment (this is the so called market price).

    This gets even more complicated because there are often many dispersed marginal buys of the asset( companies, consumers, financial institutions)as well as many holders of the assets (employees, investors, the government). In fact most agents do a mixture of both in a complicated way. it used to be that investment banks strictly engaged with risks associated with holding the asset (i.e. market making) but now they in fact are engaging in risks associated with trading the asset.

  12. Gravatar of Bogdan Bogdan
    4. January 2011 at 02:13

    I think this is formally explained by institutional economists through transaction economies. The service sector helps reduce transaction costs and thereby increase allocative efficiency, that’s why developed modern economies have big service sectors; and finance is simply the tip of this modern transaction economy. It’s hard to dismiss this broad fact.

  13. Gravatar of Morgan Warstler Morgan Warstler
    4. January 2011 at 02:26

    Scott, at worst, you lie. At best, you are are an idiot. I think you lie.

    When confronted with the opportunity to GUT the banks: mark to market on housing, liquidation at $1 auction of foreclosed housing stock, basically ANYTHING Andrew Mellon would have called for in 2008….

    You folded like a cheap suit.

    You argument is WHY allow the economy to suffer, just so the game has losers?

    And your argument means you value something as more important than the game being played fairly.

    So, Sumner’s ideas are polluted by an unwillingness for fairness on the downside. Which means you get NO room to moralize on the upside.

    The argument flows like this:

    Since in the primary instance, Sumner will not gut the bankers when they lose, in secondary market manipulations to rectify things we are justified.

    BTW, who cares about hedge funds?

    This is about Goldman-Sachs, and every other TARP player. You supported TARP, you are not a free-market advocate.

  14. Gravatar of Nick Nick
    4. January 2011 at 05:25

    I very much like this series, as it it wholly consistent with the view that as things of value are digital instead of material it moves us into a world with almost zero marginal costs.

    The problem with the other argument is, what is the difference between good capital allocation and someone who takes a highly skewed bet? Why is that investing in a CDO^2 in 2005 (where you lose lots of money in the then-tail event of housing prices decline), but investing in Apple in 2005 (where you lose lots of money in the then-tail event where Steve Jobs gets hit by a bus) is good capital allocation? Is it only because you find good capital allocators with the post hoc fallacy (c.f. Taleb)?

    Just about any human endeavor is negatively skewed, since gains are difficult to come by, but total losses are very easy to accomplish. So are there any good capital allocators who are not taking long-tailed bets? If not, then isn’t the job of capital allocation merely the job of deciding which bets have the relatively lowest probability of hitting that tail?

    Ultimately, I think that proof that income inequality actually results from increasing digitalization, whether it be in entertainment, sports, or finance, is the following question: if rampant piracy were legal, would those high incomes still exist? If there was no such thing as copyright, would JK Rowling be as wealthy? If any company could use Tiger Woods’ likeness without his permission, what would be the hit to his earnings? If Goldman’s proprietary trading positions, algorithms, and strategies were public, would they make as much money? It’s not that they are merely picking up nickels in front of steamrollers, it’s that they have chosen which steamrollers not to get in front of quite well. If everyone had access to their knowledge, would Goldman make less money?

  15. Gravatar of Silas Barta Silas Barta
    4. January 2011 at 05:41

    Scott_Sumner, you seem to be arguing in a big circle. Here’s what I get as your argument:

    – Finance (that is classified as such) deserves its increasing earnings
    – (but you use a different definition of what counts as finance depending on whether your defending the trend or the financiers)
    – because allocating capital is a much harder job than in the past
    – as shown by how much harder it is to judge Google/Genzyme compared to Cadillac fin/no-fin
    – but the very people making those harder judgments are admittedly the tiny “VC” portion of the economy.

    Alright, so then … the big finance incomes are explained by the need for better judgment, but that judgment is only necessary for the tiniest portion.

    It seems to me that to make your case, you would need to establish that a high fraction of these finance dollars are being earned from (plausibly) good capital allocation decisions. But really, the only good examples of game-changing, wealth-gushing capital decisions are those

    Really, most of the finance income over the past ~10 years came, not from this valuable process, but from things like:

    – deceptively hiding risk (i.e. shoddy mortgage-backed securities and inscrutable credit default swaps)
    – regulatory arbitrage
    – high frequency trading (whew! Thank goodness the share price was corrected by a few ppm a few milliseconds earlier!)
    – lucky guessing (which produces an income that counts toward the finance total but a corresponding loss that doesn’t)

    If a bulk of finance income actually comes from things like this rather than genuine Google/Genzyme type decisions, I haven’t seen you advance an argument for it. And yet (I suspect) a bulk of the “finance is ripping us off” intuition comes from the belief that they’re doing things in the above list rather than adding genuine value (like the canonical Goog/Gen decision would be). Thus, finance is suspected to only reallocate wealth rather than increase it.

    So where are all these brilliant, ultra-necessary finance decisions that make up a bulk of finance income? If the top 10,000 finance earners for 2005-2010 died tomorrow, would our ability to pick the next Googles be significantly diminished?

  16. Gravatar of Silas Barta Silas Barta
    4. January 2011 at 05:43

    Sorry, fourth paragraph above should end “But really, the only good examples of game-changing, wealth-gushing capital decisions are those from VC.”

  17. Gravatar of Bill Gee Bill Gee
    4. January 2011 at 05:48

    From what I gather from your posting is that the reason why those who allocate captial are paid obsene amounts of money is because on some level society desires it. You also said that the system is fraught with moral hazard.

    Are you then saying that on some level, society desires moral hazard or at least society desires to turn a blind eye to it because they feel that the ends (successful capital allocation) justifies the means (moral hazard).

  18. Gravatar of Hugh Hugh
    4. January 2011 at 05:51

    Ron,

    “Proprietary trading will become harder and harder to consistently make money at as it becomes increasingly competitive and will start to become victims of the EMH much as mutual funds already are.”

    That’s been said before. For instance, Brad Delong is now claiming that Bob Rubin was after just those efficiencies during the Clinton Administration. However, it didn’t happen then. What makes us think it’s any more likely now?

    Now, I’m not an economist. (I work for a living 🙂 However, it’s worth pointing out that there may be differences between markets for products and markets for intermediation. If I’m an efficient widget producer, there’s only one other party I really need to satisfy, which is the widget buyer. As more consumers buy my stuff and don’t buy yours anymore, I’m able to ramp my production up.

    For an intermediary, the market is already there. If there are 500 shares of IBM outstanding and 490 belong to me, the purchaser of the 11th share must come to me regardless of my implied commission. Volume and capacity considerations should matter greatly and might impede new entrants.

    The other problem is that there are two other parties and possibly a large buy-sell spread. I may buy 100 shares of IBM from you when you’re desperate to unload a lot (capacity advantage, again) and unload them later to someone else at a competitive price. Neither the buyer nor the seller is going to worry about the spread in this case. Nominal fees may matter in some cases, but that’s likely not where you’re making your money.

    If I’m a new entrant in the intermediation market, I can try to be efficient, but by this logic, I probably lack a lot of capacity and the only other thing that anyone cares about is the price. So my incentives are to grow as large as I can and make my cut as large as possible. No one’s equipped to care, as I see it.

  19. Gravatar of Tom Grey Tom Grey
    4. January 2011 at 06:04

    Why don’t others try to get those investments in subsidized markets? Competition should still drive down the rates of return earned by hedge funds.

    Actually, I think all the “fly-by-night” mortgage brokers, trying to get borrowers to borrow more than they could afford, for too-expensive houses — these are, in fact the “others” who are trying. And, just as you say, competition was driving down the rates of return.
    Oops, risk adjusted rates of return.
    Oops, risk adjusted rates of return, before bailouts.
    Those “others” all have different work, or unemployment.

    It wasn’t the “others” who got bailed out. It was the biggest, the highest paid, the worst, including Fannie & Freddie & AIG & thus Goldman.
    Bah.

  20. Gravatar of OGT OGT
    4. January 2011 at 06:10

    If you can’t argue the facts, argue theory, if you can’t argue theory, invoke Occam’s Razor.

    That said, I think Occam’s Razor points in precisely the other direction. In a truly competitive market place we would see these excessive profits competed away. There is no coherent argument that allocating capital is ‘harder’ now, if anything with the aid of technology the field is being deskilled, as most trades are now made via algorithm’s.

    And when all else fails offer anecdotes… A friend of mine in marketing jumped to a finance firm a couple of years ago because the the pay was 50% higher than independent agencies or other industries, he works less and doesn’t think it’s very challenging. I asked him why they paid so much, he said because the pay scale for everyone in finance is just much higher. He doesn’t allocate any capital.

  21. Gravatar of DanC DanC
    4. January 2011 at 06:14

    What happens on the margins?

    Scott can be correct that skilled allocators of capital will be rewarded. The more rare the skill and/or the greater the need, the higher the rewards.

    But is the need to allocate capital today greater then the need to generate capital to build railroads 100 years ago, or consolidate the steel industry, etc. Organizing capital to generate economies of scale seems to be a rather consistent goal throughout the industrial age. And people like JP Morgan were certainly rewarded for their skills in putting deals together.

    Are the high salaries on wall street a function of the growth in high tech and globalization?

    High tech, as evidenced by the tech bubble, seemed to have little trouble raising capital, huge amounts of capital, for even the least viable business model. Are high incomes in the financial sector needed to allocate capital to these firms?

    Have supplier credits declined so much in global expansion? Perhaps fear of China’s potential failure to honor intellectual property rights has made some firms fearful of expanding relationships. But in general, wouldn’t firms extending supplier credit have better insight into global investments then the typical wall street firm? In any case, is this a big source of profits on wall street.

    What was the problem with housing sector. Government policies that encourage home ownership and government policies that encouraged lenders to take greater risks. A Fed that held interest rates too low. And a believe on the part of lenders that they had reduced the risk of their portfolio of loans through various financial contracts. At what point in the process can you justify high incomes?

    I’m uncertain that demand for “financial” services has increased that much. And I’m also uncertain that the supply of people who can do the job is that restrained.

    Why do the children of Chicago politicians often go into the insurance business? Why do some powerful politicians also have law practices that specialize in zoning cases? Why do many businesses seek out these politically connected firms? How high is the corruption tax?

    Are businesses willing to pay a premium to hire a politically connected firm? Are firms willing to pay a premium to hire politically connected individuals?

    Once upon a time I met with a man who was in charge of the business affairs for a financial firm. He covered Central America. I asked him about his background and how he had risen to such a position. His technical expertise was limited. His connections were amazing. He came from a very wealthy family. Had played baseball with Castro as a youth. He knew many of the leaders of various countries on a private level. He told me that if he ever had a technical question, his firm employed hundreds of highly skilled workers who could quickly respond on the viability of any potential project. The skill in short supply was his ability to gain access. He had a seat at the table.

    The more government regulations control the economy, the more valuable people who have access to the power structure become.

    In that scenario, the skill in short supply is an ability to gain access to the power structure that increasingly controls the financial sector. On the margins this can become very valuable.

    Perhaps on wall street they have created a cartel of politically connected players. If the seats at the table are limited or you share the monopoly profits with potential competitors you can maintain the cartel. If the government actors have incentives to limit access, they can help the cartel. Look at the number of high ranking political figures that wander in and out of financial firms with hugh, really huge, paydays. Look at political contributions from financial firms.

    With regard to sports, I said that player incomes would be lower if the owners lacked the skill to acquire public subsidies. TV revenue certainly increased player salaries. But so did gambling help spur the growth of TV viewership. And the growth of the internet gave birth to fantasy sports that increased interests.

    So I would still argue that public subsidies have increased player salaries. Imagine how the bottom line of GM would have changed if GM could have depreciated the decreased value of an aging unionized workforce, the way sports teams can depreciate their players? Or the tax code that allows firms to deduct the cost of luxury suites.

    However I agree that the ability to manipulate the public sector for subsidies is quickly duplicated by competitors. The competitive advantage is quickly competed away in the form of higher prices to buy a franchise and higher prices for athletes. But the fact that the gains from the political manipulation skills are competed away does not mean that the wealth transfer from the public sector stops.

  22. Gravatar of James in London James in London
    4. January 2011 at 06:59

    “I’d get rid of all the moral hazard. But the investment banks and the hedge funds would still make boatloads of money in a completely free markets. Perhaps a tad less, but the profits still would have soared in recent decades.”

    Where is the evidence?

    And anyway, if the Greenspan/Sumner/Fed Put remains part of the game then you haven’t got rid of all the moral hazard. This Put is very well understood by the financiers. Indeed the market crashed in September 2008 and banks began hoarding cash precisely because of fear the Put wouldn’t be enacted.

    Gullible monetarists like yourself believe that the eventual implementation of the Put was because the Fed woke up to its duty. To many others it was a clear call from the Fed’s friends at Goldman Sachs that GS were next on the list for the chop after Lehmans (though possibly just after Morgan Stanley). Merrills knew saw this danger too and jumped into the arms of BoA.

  23. Gravatar of Matt M Matt M
    4. January 2011 at 07:12

    Scott,

    Interesting post. I think the simple answer is the money and credit creation by fractional reserve banking and the Fed. The banks (specifically prime brokers) are the first recipients of the newly created money/credit. They allocate this newly created free capital towards profitable ventures using their market maker status to leverage and generate abnormal returns.

    The reason that hedge funds make big profits wihtout the govnerment implied safety net and Fed discount window access is that the market is continually increasingly distorted by the process above. Yes, many hedge funds have abnormal crazy gains, which could be due to skill of the managers or luck, but many, many more hedge funds failed over this time as well.

  24. Gravatar of scott sumner scott sumner
    4. January 2011 at 07:19

    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.

    Shane, Speculation is socially beneficial as it tends to stabilize prices (buy low sell high.) I have other posts explaining the slowdown in GDP growth after 1973, which was less pronounced in the US than most developed countries.

    gnikivar, Both very good points, I wish I’d made them.

    Doc Merlin, I am opposed to insider trading laws, this would allow information to reach the markets more quickly. However, companines can still have rules against insider trading.

    I dealt with the EMH issue in my post.

    Bryan, Only a tiny, tiny percentage of finance earnings come from taxpayer bailouts. The part that comes from implicit subsidies like FDIC is bigger, but still tiny in my view.

    Paul, You said;

    “I’ve gotten the impression that is very difficult to obtain even an entry level job on Wall Street without an Ivy League degree, which sounds a whole lot more like a network of privilege than a meritocracy or an open marketplace.”

    I visited a Wall Street firm last summer and this definitely is not true. I met lots of young traders, and they were math majors from schools all over the Midwest. If you have talent, they’ll hire you.

    You said;

    “As well, where is the evidence that finance has created greater world economic growth?”

    My argument in other posts is that liberalization around the world helped mitigate a sharp slowdown in economic growth after 1973, but in most countries growth still slowed.

    David, I’m not talking about “arbitrage profits,” I’m talking about returns to allocating capital to its best uses in a fast changing and complex world.

    rob, A few comments.

    1. I’m told HST is already getting much harder to do, so you’re right about that.

    2. I named 4 types of financiers: hedge fund managers, CEOs, billionaire investors (Buffett), and big banks (investment and commercial.) You’ve cite 1/2 of one of those 4–investment banks. And then you’ve cited one of there activities–HST. If the big increase in the share of GDP going to finance is mostly coming from HST I will admit I was wrong, and do a very public mea culpa.

    Jason, Unfortunately I am so busy that some of the went over my head–I’d need more time to think about it. But be careful of time series data, as it is distorted by non-secular trends due to bull markets. It looked like income was getting much less equal in the late 1920s, but that was just an artifact of the bull market–as soon as the market crashed income looked much more equal. I am pretty sure the recent upswing is more durable, not just due to a rising stock market.

    Marc, Ok, but how big a commission is there on fx trades? Wouldn’t slightly smaller but still large banks be able to do almost as well, and provide companies with fx trades at only a slightly higher commission? I’m wondering if the quantities here are large enough to serious skew earnings. But that info is helpful, and makes some sense. The next question is whether this has gotten worse since 1980–is it driving increased inequality, and increased profits by finance?

    Honeyoak, To follow up on what I said to Marc, recall that increased globalization was one of the two factors I cited, along with high tech. Now lets suppose that the commission on fx trades has stayed at a constant 1%, but globalization has greatly increased the amount of fx trades as a share of GDP. Wouldn’t that support my hypothesis? It’s not exactly capital allocation, but it’s helping to facilitate a more sensible global allocation of capital.

    Bogdan, Yes, that’s part of it.

    Morgan, I don’t lie, maybe I’m an idiot.

    I did not support Tarp.

    Nick, Those are good points, and in the first post I did mention that my ideas overlapped somewhat with the economics of superstars, which is well understood.

    On the trading issue, does the following sound correct: There are two types of trades, zero sum bets where one side’s gains equals another side’s losses, and positive sum bets having to do with the allocation of real capital. Either could make income more unequal, but only positive sum bets could justify a bigger share of GDP going to finance. With zero sum bets for every financier who gains a dollar, one losses a dollar.

    Silas, You said;

    “- but the very people making those harder judgments are admittedly the tiny “VC” portion of the economy.”

    No. VC is only a tiny part of capital allocation. I am talking about all of capital allocation; high tech, services, globalization. Indeed almost everything is more complex except old-line purely domestic traditional American firms. Hedge fund investments very much figure into my argument, so do the investment decisions made by CEOs. Ditto for loan decisions of commercial banks, which are more complex in the US, and also more global. Perhaps I shouldn’t have even mentioned Google, I know that is a small share of GDP. I’m thinking much more broadly.

    Lucky guesses don’t increase the share of GDP going to finance. But I do think you have a good point about regulatory arbitrage. I do think that’s a problem, and if I’m wrong that’s the most like reason. I still think the factors I cite would predict an increasing share going to finance, even in a perfect world, but obviously it’s a question of magnitude–how much is regulatory arbitrage.

    Bill Gee, I’m not sure there is any such thing as “what society desires” about moral hazard. The public doesn’t even understand it, so I don’t see how they could have an intelligent opinion. You’d get different poll results depending on how the issue is framed. (Pro-banker or pro-depositor.)

    Tom Grey, I completely agree with you on F&F and AIG. I don’t believe Goldman was bailed out. I seem to recall the government forced them to take TARP money. Is that right?

    OGT, As I pointed out a competitive market should NOT compete away the earnings I am discussing, you are flat out wrong about basic economic theory. Reread the two posts.

    DanC, You said;

    “But is the need to allocate capital today greater then the need to generate capital to build railroads 100 years ago, or consolidate the steel industry, etc. Organizing capital to generate economies of scale seems to be a rather consistent goal throughout the industrial age. And people like JP Morgan were certainly rewarded for their skills in putting deals together.”

    Need has nothing to do with earnings. Teachers and farmers are needed, but don’t earn very much. Big earnings go to those with rare and valuable specialized skills. I’m arguing that it’s much harder to allocate capital in the modern global economy than the US economy of the 1960s. I have no idea what the income distribution was in the 1800s, so I can’t comment.

    You said;

    “High tech, as evidenced by the tech bubble, seemed to have little trouble raising capital, huge amounts of capital, for even the least viable business model. Are high incomes in the financial sector needed to allocate capital to these firms?”

    Yes, because it also matters where the capital goes. It doesn’t flow equally to all firms.

    I don’t see how your cartel theory applies to hedge funds, which have seen some of the biggest gains in income.

  25. Gravatar of scott sumner scott sumner
    4. January 2011 at 07:20

    James, Monetary policy has nothing to do with moral hazard–totally separate issues.

  26. Gravatar of scott sumner scott sumner
    4. January 2011 at 07:26

    Matt, That’s wrong, I can do an OMO any time I want. Sell a bond for cash, or for a check, and then cash the cheek. Selling bonds to the Fed is no insider advantage–anyone can do the same thing. And cash isn’t “free capital.”

  27. Gravatar of Doc Merlin Doc Merlin
    4. January 2011 at 07:28

    @Scott
    “James, Monetary policy has nothing to do with moral hazard-totally separate issues.”

    While true, the NY Fed does fiscal policy now (bailouts for example) as well as monetary policy.

  28. Gravatar of DanC DanC
    4. January 2011 at 07:56

    I remembered Becker and Posner blogging on this topic.

    http://www.becker-posner-blog.com/2007/07/hedge-funds-and-rent-seeking–posner.html

    From that post by Posner

    Suppose that for an investment of $1 million a product having a commercial value of $4 million can be invented and brought to market in three years, but that for an investment of $2 million it can be invented and brought to market in two years and eleven months. The extra month of output would be unlikely to have a value to society equal to or greater than the extra $1 million spent to get it to market a month sooner, yet if that investment would enable the investor to obtain a patent because he was the first to invent, it would yield him a net of $2 million ($4 million minus $2 million). The problem is not that the successful inventor obtains a return in excess of his cost; this is essential to motivate invention because of the risk of failure. The problem is that he may carry his investment beyond the point at which an additional dollar in investment would yield a dollar in additional value to society. I am skeptical that the situation in the financial management market is the same. No doubt, as Frank argues, there are diminishing returns to financial management because there are only so many underexplored financial opportunities. ….

    A company whose stock price rises because investors have correctly determined it to be undervalued can raise capital at lower cost and thus attract resources to an activity in which the resources will be worth more than they are worth in their present use. But there is no economic law that says that the reward of a financial manager is always equal to the contribution that his management makes to the efficiency of the economy. It may be much greater. This is most easily seen by supposing that luck plays a large role in investment success. Then a career in financial management might attract substantial resources (in the form mainly of the opportunity costs of the time of the financial managers) that produced private rather than social value–private value in the form of large rewards that were the product of luck rather than skill. That would support Frank’s conclusion. Frank points to overconfidence bias as a factor in attracting people to the hedge funds and private equity firms irrespective of the social value of such careers. That bias has been well documented, but so has a force that tugs in the opposite direction–risk aversion. Kenneth Arrow long ago argued that because of risk aversion, there is underinvestment in risky but socially productive activities; his example was innovation. Overconfidence bias, to the extent it offsets risk aversion, may actually improve economic efficiency, a possibility that Frank ignores.

  29. Gravatar of Silas Barta Silas Barta
    4. January 2011 at 07:58

    @scott_sumner:

    VC is only a tiny part of capital allocation. I am talking about all of capital allocation; high tech, services, globalization. Indeed almost everything is more complex except old-line purely domestic traditional American firms. Hedge fund investments very much figure into my argument, so do the investment decisions made by CEOs. Ditto for loan decisions of commercial banks, which are more complex in the US, and also more global. …

    Yes, this is what I was complaining about in my first two bullets: you’re defending “the” officially-reported share that finance takes, while actually defending a different share that’s computed a different way, using different referents (e.g. including speculation losses and non-financial CEO decisions, when the official “finance income share” definition does not).

    If you count the brainwork that went into developing e.g. the iPhone/Pad platform into an entire new market, as being valuable, most would agree with you. But when you start defending it as an example of the officially-reported “finance” share, you’re wrong: it’s not counted in the finance share, and it’s not what people criticize as part of outsized “finance returns” — because here, you can point to the good that the high earners accomplished. (HFT, not so much.)

    In short, you’re defending something else, while gaining notoriety for calling it “finance” because you’re using a non-standard (but reasonable) definition of it.

    Does that about sum it up?

  30. Gravatar of DanC DanC
    4. January 2011 at 08:03

    From Becker in the same Blog

    Some hedge funds may earn more than they deserve because it is so difficult with a limited time series on asset returns to determine whether good performance in the past was due to superior skills or good luck. Lucky funds would end up with not only more assets but also with higher fees per dollars of assets than their true performance merits. Unlucky funds would be in the opposite situation. This does not necessarily raise the overall earnings of the average fund manager, but it may increase the inequality of earnings among managers that would affect which men and women get attracted into the industry. Frank also claims that overcrowding arises because hedge and other equity funds poach on each others’ opportunities. In effect, real resources are spent by funds in a socially unproductive way because they partly take opportunities away from others. This argument is not without some merit, but other considerations imply the opposite, that too few human resources go into fund management. Funds have continued to discover new ways of packaging risk and managing that add value to society, but the incentive to invest in such innovations is limited because many important discoveries are readily copied by other funds. It is not clear to me that the forces like this one that make for under entry into fund management are greater or lesser than those making for overinvestment. So it would be unwise to motivate the taxation and regulation of hedge and other equity funds under the assumption either that too many human resources have entered this industry, or that the industry needs special encouragement through the tax-regulatory mechanism.

  31. Gravatar of DanC DanC
    4. January 2011 at 08:06

    sorry another Becker comment

    To be sure, the new skills at handling risk and aggregating large financial resources has contributed to some major excesses, such as the Internet stock bubble, or the too generous expansion of mortgages to families with bad credit risks

  32. Gravatar of Matt M Matt M
    4. January 2011 at 08:54

    “Matt, That’s wrong, I can do an OMO any time I want. Sell a bond for cash, or for a check, and then cash the cheek. Selling bonds to the Fed is no insider advantage-anyone can do the same thing. And cash isn’t “free capital.”

    What is OMO? Selling bonds to the Fed that purchases them with newly printed money isn’t an advantage and you personally can do it?? What? Please tell me how.

    Also, I referred to “free capital” incorrectly. I meant that big banks can leverage to infinity with no fear of a bank run due to the discount window and lendor of last resort. They can borrow for “free, (ie. discount rate)

  33. Gravatar of Ashwin Ashwin
    4. January 2011 at 08:56

    Scott – your comment that competition between banks and hedge funds should mitigate inequality deserved a longer response hence this new post on why I think it does not http://www.macroresilience.com/2011/01/04/rent-extraction-and-competition-in-banking-as-an-ultimatum-game/ .

    To summarise, synthetic rent extraction markets are closer to an ‘Ultimatum Game’ than they are to competitive “real economy” markets. The absence of moral hazard rents doesn’t simply change the price and quantity of many financial products – it ensures that the market does not exist to start with.

    If the various parties to a trade (bank, HF etc) cannot come to an agreement, there is no trade and no rents are extracted. The central bank commitment provides an almost unlimited quantity of insurance/rents at a constant price. Therefore, there is no incentive for any of the above parties to risk failure to come to an agreement by insisting on a larger share of the pie.

    In a world with unlimited potential bank stockholders, creditors and employees and unlimited potential hedge funds, the eventual result is unlimited rent extraction and state bankruptcy. The only way to avoid inequality in the presence of such a commitment is for every single person in the economy to extract rents in an equally efficient manner – simply increased competition between hedge funds or banks is not good enough.

    Thanks for stimulating my mind to sharpen my thesis!

  34. Gravatar of nyd nyd
    4. January 2011 at 09:30

    “Some people talk about the big profits trading currencies, T-bonds, etc. This is probably a naive question, but precisely who are these profits being extracted from?”

    The counterparty (generally) crosses the bid/offer spread and so pays the spread to the dealer. It’s just market-making.

  35. Gravatar of Shane Shane
    4. January 2011 at 09:36

    Professor Sumner, you’re a saint for answering so many comments. So I’ll direct this to the general group, and maybe someone with sympathetic views can answer it.

    The whole premise of the post seems off to me–that we’d expect finance to be expanding as a share of GDP. Wouldn’t we expect the opposite to be the case? There are a few sectors in which technology seems to be raising costs and expanding it as a sector of the GDP rather than lowering it–health care is one, finance is another. Isn’t it easier and easier to allocate capital now if anything? There’s so much information available, so why should it be expanding its hold? Shouldn’t finance be shrinking, letting more productive sectors expand? In the same way that health care should be shrinking as people get healthier?

    If this expansion is unjustified, then it represents a drag on the larger economy, just as the dead weight of the medical cartels clearly does. The classic argument is that speculation is useful because it creates efficiency, accurate pricing, balances risk, etc. etc. But why was the level of speculation in the 90s, 80s, or even the 70s not sufficient to produce these things. Where is the evidence that pricing assets a few seconds quicker than they otherwise would have been is that useful? It clearly has some utility. But where’s the evidence that it is truly justified relative to the share of the economy now devoted to this activity?

    The argument seems to be that finance needs to grow as a share of the economy, because of changes since the 60s. By extension this means that without the rise of finance, growth would have slowed even more quickly over the past several decades. It simply seems intuitively more logical that the rise of non-productive cartels that increasingly dominate the economy–finance, health care–is more likely to be a cause of, rather than a solution to, the problem of slowing growth. Why is this feeling misguided?

  36. Gravatar of James in London James in London
    4. January 2011 at 09:42

    Scott
    While you may well think monetary policy and moral hazard are two totally separate issues, the banks benefitting from oodles of extra liquidity see it differently. You are just way too naive about the banks, you need to get inside one for a while and see how they really work. They and their counterparties increased their leverage because the believed in the Greenspan Put, it was even enshrined in the credit ratings agencies explicit “standalone” ratings and “implied support” ratings. It was grossly anti-utilitarian and unethical too, but it was there.

    When the banks excess, bubble-spurred, leverage collapsed, as it had to, the banks rightly became far less trusting of one another. This process led to the liquidity squeeze at the weaker players (first the wholesale-funded retail lenders, WAMU and Countrywide, and then wholesale-funded wholesale lenders, investment banks LEH, MS and GS). This process was the market at work, moral hazard playing out.

    The Greenspan, Sumner, Fed Put stopped that natural process before it hit MS and Goldmans, they were just TBTF despite deserving their just deserts for failed business models. You see this as a mere liquidity crisis whereas I and others see it as a much needed shake-up of implicitly-government sponsored, inefficient and probably corrupt industry.

  37. Gravatar of Jeff Jeff
    4. January 2011 at 09:55

    Scott,

    I remember reading somewhere that if not for the various bailouts, the losses that would have been suffered in the financial industry would have been greater than its cumulative profits since the Depression. I don’t know if that’s true or not, but it certainly seems possible that all of the large banks, with the possible exception of JP Morgan, would have failed if not for the AIG bailout. Add in the GSE payouts on failed MBS, and it becomes clear that the taxpayer is the real source of Wall Street profits, not financial acumen. There are likely to be something like 10 million foreclosures before this is through, and the loss per foreclosure is in the neighborhood of $100K. That implies foreclosure losses on mortgages alone of about a trillion dollars. Throw in short sales and the number gets bigger. Total mortgage losses on U.S. mortgages is likely to be north of $2 trillion before this is over. This is also roughly the net worth of the financial sector, but the broadest measures of market valuation of the sector are down only about 20 percent from the 2007 peak. So a rough guess is that 80 percent of the losses are going to be picked up by the taxpayers.

    About hedge funds: Sure, some hedge fund guys make a lot of money. But many more of them lose money. You just don’t hear about them due to survivorship bias. It’s like Hollywood, where a few actors make it big, but the vast majority of people trying to be like them fail. The music business is similar: it’s not enough to be talented, you also have to be lucky and/or have connections.

    What you have in the finance industry is not skill at allocating capital, but skill at rent-seeking.

  38. Gravatar of Nick Nick
    4. January 2011 at 10:22

    “There are two types of trades, zero sum bets where one side’s gains equals another side’s losses, and positive sum bets having to do with the allocation of real capital. Either could make income more unequal, but only positive sum bets could justify a bigger share of GDP going to finance. With zero sum bets for every financier who gains a dollar, one losses a dollar.”

    This is right, but there is a little more to the story. Even zero sum trades have ripples that are ultimately capital allocation movements. The buyer had to get the funds from somewhere – maybe the bank’s management gave him larger limits. And the seller is going to put that money to work somewhere, re-allocating it (or give it back to someone else who will), when they don’t you get really strange things like negative Treasury yields or rising gold prices ;).

    So the capital allocation is not really happening at the individual trader level (which is consistent with the gut reaction that a trader who just “provides liquidity” is not really doing the job of allocating capital), but rather at the bank management level where a group’s capital limits are decided. But the trader has lots of negotiating power with management so he captures lots of the value-add.

  39. Gravatar of Tom Grey Tom Grey
    4. January 2011 at 10:27

    I understood that Goldman was to lose some $20bn (hedged against! they claim) if AIG went under.
    http://www.nakedcapitalism.com/2008/09/aig-bailout-saved-goldman.html

    So . (test link)
    Also Reuters.
    http://www.reuters.com/article/idUSTRE52H0B520090318

    I believe AIG failing would make Goldman call in their hedges, and make the Big Hedge funds fail. All the rich, overpaid CEOs were in on the socialization of sub-prime mortgage risk, for their own quarter by quarter profits.

    I assume they believed in a soft landing, plateau of house prices rather than an overbuilding boom and bust — but those builders were also trying to compete for the speculative MBS profits from F&F and too much AAA rated junk.

    The builders failing in 2006 should have led all Big Banks to start divesting themselves of MBS stuff (maybe Goldman did? don’t know) — but they all seemed to believe their own BS, that the CDS risk management was actually working. And, without systemic failure, they may have been right for individual banks. But the oversupply of AAA rated financial products based on house prices, which was then used in Tier 1 capital of most banks, created the systemic failure that Credit Default Swaps were supposed to protect against.
    (“allowing” some 60 trill USD notional value financial products, with some large percent of it rated at AAA, is the AAA inflation that is too-little discussed with respect to this crisis.)

    Some more of my speculation:
    On capital allocation, I think it quite hard to do in practice, especially at the most important VC level. What about Google deciding to buy companies, or Apple, or HP to buy Compaq? In fact, the big actual new allocation decisions are made by the CEO (& staff?) of the big successful companies, not by outside Finance folk. The financiers make some (excessive) 3% fee for M&A, much like overpaid real estate brokers did. But yes, as the quantity of financial product that investors buy goes up, the total fees for intermediation go up, even if the fee per transaction goes down.

    But as MBS / CDS is reduced, the fee income should be going down. I don’t know what the revenue streams of Goldman actually are (guess I should look … later).
    Glad Stanford won the Orange Bowl! (Couldn’t watch it in Slovakia.)

  40. Gravatar of Michael E Sullivan Michael E Sullivan
    4. January 2011 at 10:45

    Scott,

    IIRC, Goldman, like many other large financial operators, was indirectly bailed out in that they held a great deal of AIG debt that would have lost a lot of value absent the bailouts.

  41. Gravatar of Bruce the Canuck Bruce the Canuck
    4. January 2011 at 10:51

    The problem with your theory is that it’s nothing more than a dressed-up argument that most of the value in society is produced by decision makers, not content-producers or goods-producers. That because good or bad decision making can have a powerful influence on output, decision makers deserve great rewards.

    This argument can and has been made in every era by every kind of abusive leadership. It was made by the romans. It was made by kings and communists. It is made by crackpot dictators. It is not new. It’s the oldest bullshit in the world.

    It’s simply blatant classism. You are engaged in naked class warfare, under a cloak of ornate financial jargon. Having vanquished the working class, now the target is the creative and technical class.

  42. Gravatar of Luis H Arroyo Luis H Arroyo
    4. January 2011 at 12:28

    Bruce the Canuck, when you say:

    “This argument can and has been made in every era by every kind of abusive leadership. It was made by the romans. It was made by kings and communists. It is made by crackpot dictators. It is not new. It’s the oldest bullshit in the world.”

    I suppose you are well informed. If Kings, Romans and communists are all the same, The history is quite simple: Everytime is the same.

    To defend the higher incomes for the more productive persons is not classism: it is individualism.

    I have understand well the argument of prof Sumner: a rising lot of GDP has gone to financial sector since the 60´s until now. I agree with him that an important share of it is due to higher productivity, in spite of a share not so related with it.
    Since 1960 until now, I think is quite impossible to explain this rising output to finance by reason of cheating, subsidies, moral hazard… That have been always in all the markets. If not, we live in a continuous conspirative world…

  43. Gravatar of Luis H Arroyo Luis H Arroyo
    4. January 2011 at 13:01

    Sorry. Mistake. “I have understood”

  44. Gravatar of Tom Grey Tom Grey
    4. January 2011 at 13:37

    @Bruce, I do, in fact, fully agree with Scott that more cash should be going to the decision makers. However, I don’t think that in most cases the decision maker is the financiers. It is more often folk like (pompous) Donald Trump, who either gets financing for his dreams, or not. But the financiers get a cut of all the successes, and usually get a lot of protection against failure.

    On MBS junk, nakedcapitalism also writes about illegal frauds, which are not now being investigated so much.
    (test 2)

    http://www.nakedcapitalism.com/2011/01/attorney-general-tom-miller-renegs-promise-to-prosecute-mortgage-fraud.html

  45. Gravatar of Benjamin Cole Benjamin Cole
    4. January 2011 at 15:28

    OT and sorry to beat a dead horse.

    But John Taylor-John Taylor!- in 2006 praised Japan’s then QE. I was looking-in vain-for anything contemporary on his website that revealed he was against the Fed being too loose on Bush’s watch. He evidently gave no papers then sying the Fed ought to tighten up.

    The following paper is great-and meaningful today.

    “Lessons from the Recovery from the “Lost Decade” in Japan:
    The Case of the Great Intervention and Money Injection”

    by

    John B. Taylor
    Stanford University

    Background paper for the International Conference of the
    Economic and Social Research Institute
    Cabinet Office, Government of Japan
    14 September 2006

    In the last three years, the Japanese economy has improved greatly compared to the decade-long period of near zero economic growth and deflation that began in the
    early 1990s. Once again Japanese economic growth is contributing to world economic growth as the expansion in Japan begins to set records for its durability.

    What has been responsible for this recovery?

    The banking and other economic reforms of the Koizumi administration have been very important, and such reforms will need to be continued to sustain strong economic growth in the future.

    However, the key to the recovery, in my view, has been the quantitative easing of monetary policy that began in March 2001, but which really took off in 2003 and 2004 with substantial increases in the rate of growth of the monetary base. Since I had been of the view that a primary cause of the lost decade in Japan was a change in monetary policy, it is particularly gratifying to have seen these monetary injections and resulting economic recovery in these years.”

    Now, Taylor says QE is bad for America-while we have imperceptible inflation, and feeble job growth.

  46. Gravatar of broadstrokes broadstrokes
    4. January 2011 at 15:33

    Profits in finance are tolls – they get a cut from transactions coming and going. There are more transactions than ever, and the number is always increasing, and so go their profits. You could call this “productivity”, and the increased traffic somehow justifies their pay, but that would be craven.

    The more money they shift around, the more pointless products they create, the richer they get – nothing ever even has to pay off.

    As far as their capacity to intelligently allocate capital, maybe you haven’t noticed, but money is effectively free. Nobody really needs their services or their superhuman powers of judgment to get a giant bag of cash from a gullible VC.

    Finance are gatekeepers and toll booth operators. They built and control the transaction system, but they aren’t adding value for anyone. They haven’t for a long time.

  47. Gravatar of David L. Kendall David L. Kendall
    4. January 2011 at 15:46

    Scott, why do you think that invisible martians is not a simpler explanation? It’s incredibly simple.

  48. Gravatar of Benjamin Cole Benjamin Cole
    4. January 2011 at 16:02

    There hs been an explosion of capital in the last 30 years. So, it makes sense that finance guys would be in demand.

    The high rents are obnoxious, but then a lot of things are. A progessive consumption tax salves many ill feelings.

  49. Gravatar of Dustin Dustin
    4. January 2011 at 16:16

    Benjamin: “Now, Taylor says QE is bad for America-while we have imperceptible inflation, and feeble job growth.”

    Imperceptible inflation?? Haven’t you been watching that PhD economist Glenn Beck? C’mon!

    Hyperinflation is almost here now, thanks to the Fed printing too much money and debasing the currency.

    And remember, America is learning her economics by watching Glenn Beck.

  50. Gravatar of Benjamin Cole Benjamin Cole
    4. January 2011 at 16:53

    Dustin-

    Many are predicting more inflation. I think inflation is dead for years.

    Hyperinflation certainly did not happen in Japan, when they tried QE for several years, although their economy began to grow. Do you think John Taylor would have recommended a policy for Japan that would lead to hyperinflation?

    I do not know John Taylor, and he seems to be a decent and friendly fellow. However, he is very partisan. I suspect he is not backing QE now as he wants Obama out.

    As for Glenn Beck or Sarah Palin–well, let’s just say I hope what passes for the right-wing today moves onto other topics, and I think they have. The news cycle has passed QE by.

  51. Gravatar of Dustin Dustin
    4. January 2011 at 17:18

    FWIW, I was being sarcastic. But, Beck is still harping about the Fed. I’m pretty sure he mentioned just tonight that food prices are rising because of money printing by the Fed. It’s all part of Obama’s plan to destroy the country and usher in socialism. Top down, bottom up, and inside out.

    And millions and millions of Americans watch him every day. Millions and millions of Americans learn their economics from him.

    Jesus wept.

  52. Gravatar of Matt Matt
    4. January 2011 at 17:40

    Scott,

    “Commissions don’t explain the huge growth in income to Buffett or Soros or the big hedge funds. I doubt it even explains Goldman’s success.”

    No to Buffett, Soros and hedgies. Yes to GS. Goldman makes its money one basis point at a time, day in, day out, intermediating. Buffett, Soros and the hedgies (and all sorts of actors in the “real economy”) go to places like GS to execute their trades and pay a small toll in return. The long-term story of the financial intermediaries is of spreads going down and volumes going up.

    “PS. Some people talk about the big profits trading currencies, T-bonds, etc. This is probably a naive question, but precisely who are these profits being extracted from? If it’s companies that trade […]”

    Yes, it’s the companies that trade. And those companies can call up, on demand, half a dozen brokers and get quotes…

  53. Gravatar of marcus nunes marcus nunes
    4. January 2011 at 19:44

    Scott
    A bit off topic, economists at the Australian National University have come up with an NK model to show that if the Fed had followed the Taylor Rule in 2002-2005, things would have been much worse!
    http://cama.anu.edu.au/Working%20Papers/Papers/2010/Groshenny_372010.pdf
    Which sends us to a post you did one year ago:
    https://www.themoneyillusion.com/?p=3894

  54. Gravatar of davver davver
    4. January 2011 at 20:07

    “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.

  55. Gravatar of Lorenzo from Oz Lorenzo from Oz
    4. January 2011 at 22:18

    James in London: The Greenspan put was surely the policy of not responding to general difficulties in the market as the Fed had in 1929-32. But it is a general policy, a general provision of liquidity in market downturns or crises. It does not stop individual assets or firms going bad, it merely stops the crisis becoming contagious. Changes in the market structures of firms (e.g. corporatisation of partnerships) , in prudential regulation and bailing out specific institutions surely have much more to do with bad practices in financial markets than crisis-accommodating monetary policy. Sure, acting like the Fed did in 1929-32 would have cleared out a lot of dodgy practices, but the price might reasonably be regarded as a touch high.

  56. Gravatar of davver davver
    5. January 2011 at 06:28

    I thought a follow up was in order as I anticipated possible objections.

    The question might arise why is it bad if regular folks, who are bad at managing money, lose their money to “smarter” market players. The question in my mind is smarter in what way. Remember, there are two ways to make money off the unprepared:
    1) Engaging in the painstaking process of real investment valuation and trade when the market gets out of whack.
    2) Scam less prepared suckers.
    It is entirely possible for money to flow from average people who aren’t good at allocating capital to people who are very good at playing the market (#2), but not at allocating capital (#1). It is not a guarantee that capital is flowing to those best at investing it just because people are making money.

    Second, you might ask why regular folks that don’t know much about investing simply find agents who do. This has two problems:
    1) The ability to raise funds determines who allocates them. A very good salesmen can convince financially unsophisticated people to invest with them even if they are not good at investing. After all, if the people knew how to determine who was good at investing they would probably have enough knowledge to invest themselves. Thus guys like Madoff manage to raise huge sums despite not being able to allocate capital.
    2) There is a principal agent problem even if all the parties are acting honorably. The agents incentives are always different then those of the people whose money he is managing. If he has a benchmark the goal is to beat that benchmark, not to take care of other peoples money. If his goal is to generate fees he encourages hyper trading. Etc.

    I don’t know if its naivety or lack of experience, but you really need to take a critical look at the streets activities and see there is a LOT of fraud, cheating, and downright useless activity going on.

  57. Gravatar of James in London James in London
    5. January 2011 at 06:46

    Lorenzo from OZ
    “General provision of liquidity … does not stop individual assets or firms going bad, it merely stops the crisis becoming contagious.”

    Good to see you making the link between monetary policy and moral hazard, something Scott can’t or doesn’t want to see. It muddies his theory too much if market participants start to modify their behaviour in expectation of certain monetary policy actions.

    The moot point is how contagious is contagious? How much creative destruction would the market allow unaided?

    I believe that without the Greenspan/Sumner Put, that I regard as part of the TBTF problem, banks would be much, much less leveraged and thus much, much less profitable. Their customers would not buy anything like the same quantity of financial products at prices that would enable banks to retain returns at 2x their cost of capital.

    Corrupt, corporatist, lobbying, banks like to counterargue that there would be a lot less finanical activity as a result (correct) and much less economic growth (possibly – but at least the market wouldn’t be distored by TBTF subsidies).

  58. Gravatar of OGT OGT
    5. January 2011 at 07:21

    Ashwin- I read a number of your posts, all really good. I especially found the negative skewness point. The Fed’s lender of last resort activity has shifted the entire shape of investment strategies used by big banks and their counter parties. A graphic presentation of a negative skewed distribution with the left tail truncated by a line to indicate the Fed Lender of Last resort put offers a great visualization of the phenomena.

    Scott- Having duly re-read your posts, I find my opinion of them little changed. For one thing you don’t seem to articulate a clear on either the role of finance in the economy or the source of their revenue increase.

    Bear in mind we are not talking only about a few superstars earning returns but a broad increase in share of income to the sector as a whole. If we take the role of finance as investment intermediaries I think we should a priori be concerned with an increasing share of wealth sticking to their hands, especially following a lost decade in the market and in median wages. If financial intermediation is functioning well it should be difficult for them to capture an increasing share of national income because the prudent and ingenuous investments will lead to real innovation and growth through out the economy. If, on the other hand, investment is becoming more difficult for some reason, a proposition I doubt, then we should be even more concerned about growth entropy.

  59. Gravatar of Ashwin Ashwin
    5. January 2011 at 08:04

    OGT – Thank you! The fact that bailouts and Fed liquidity schemes result not simply in increased “risk” but specifically an explosion in negatively skewed bets is central to all my posts on this subject. Thirty years ago, banks would find it difficult to exploit this tail-risk insurance, but now the markets are so complete that it’s easy.

    James from London – You’re right to make a link between monetary policy and moral hazard. The adaptive consequences of monetary policy as it has been practised by Greenspan and Bernanke are a big reason for our current malaise. Unlike Bagehot whose view on lender-of-last-resort activities was to lend freely at punitive rates on good collateral, the practise of the Fed and the ECB seems to be “lend freely at the repo rate on junk collateral”! Apologies to keep plugging my own posts but this one http://www.macroresilience.com/2010/10/18/the-resilience-stability-tradeoff-drawing-analogies-between-river-management-and-macroeconomic-management/ summarises the ecological viewpoint that I have via a comparison to river flood management.

  60. Gravatar of marcus nunes marcus nunes
    5. January 2011 at 10:34

    Scott: Check out this Barro interview on the GD:
    http://thebrowser.com/interviews/robert-barro-on-lessons-great-depression
    This Q&A segment is revealing about Bernanke:
    So what else should I be reading on the Great Depression?
    There’s Ben Bernanke’s research in the 1980s – that’s probably his most important contribution in terms of macroeconomics and financial economics.
    Yes, I saw the Dow Jones Newswires quote on Bernanke’s book, Essays on the Great Depression, which made me laugh: “With some observers saying that the ongoing financial crisis could be the worst since the Great Depression, the greatest living expert on that period is getting the chance to apply its economic lessons.”
    Well Bernanke was thinking that way in April 2008. I remember talking to him at the time, just after the Bear Stearns initial intervention. I got a chance to ask him a question about why they were so aggressive at that time when things didn’t look so bad. And his response was that basically he was worrying about a Depression-type scenario – and trying to act early to nip that in the bud.

    So what is the thrust of his book and why is it important?
    It’s focusing on the Great Depression as a credit implosion, not so much the money supply, which Friedman and Schwartz had emphasized, but a somewhat related phenomenon, which is credit availability. That had been imploding from 1929 through to the trough, early in 1933. So it’s really focusing on the credit aspects and trying to measure that, particularly by looking at patterns in interest rates.

  61. Gravatar of DanC DanC
    5. January 2011 at 10:39

    Recent WSJ opinion

    http://online.wsj.com/article/SB10001424052748704723104576062083357423022.html?mod=WSJ_hps_sections_opinion

    “What is clear from the list is that the notion of equal protection ensconced in the Constitution was missing in September 2008. Rather than trying to spread both the burden and benefit of the bailout evenly among members of the U.S. financial services industry, key decision makers at the Fed and Treasury arbitrarily determined which companies should become wards of the federal government (AIG) and which should be permitted to live on (Goldman Sachs and Morgan Stanley). Goldman Sachs was permitted to live by enjoying markedly lower interest rates and access to credit facilities amounting over time to approximately $600 billion.”

  62. Gravatar of scott sumner scott sumner
    5. January 2011 at 12:16

    Doc Merlin, I oppose bailouts.

    DanC, All true, but there is a powerful force in the other direction. People rarely own 100% of anything. What they do as managers or investors to help a company, also helps passive investors.

    Silas, A fair criticism, but your asking way too much of a blog post. let me clarify:

    1. I am claiming that there is large overlap between my definition and the official definition, particularly for the super high incomes like hedge fund managers.

    2. I am making an intellectual point that the proper definition of what I have in mind (capital allocation) is not exactly what the government measures. But I don’t include inventing iPhones, just deciding to fund new projects.

    3. I’m writing a short blog post–throwing an idea out there. I don’t have time to pour over the national accounts and come up with the exact measure of what I have in mind. I do accept that my argument would need far more empirical work to be accepted. I’m just laying out the theory.

    DanC, I agree with your second Becker quotation.

    Matt, I don’t disagree about leverage.

    Regarding open market operations. A bank sells a 3.3 million dollar bond to the Fed, and gets 3.3 million in cash. I sell the same 3.3 million dollar bond in the NYC bond market, get a check, cash it at my bank for 3.3 million in cash. It’s exactly the same.

    Ashwin, To be honest, I went to school before game theory was taught, and don’t feel competent to address your argument. But I’ll make a few observations anyway.

    If you are right, then I presume the excess returns would be earned by hedge funds dealing with banks, which is where the back door government subsidies come into play, not hedge funds dealing in equities, T-bonds, forex, commodities, foreign government bonds foreign corporate bonds, etc. Is that right? Then why wouldn’t all hedge funds engage in the banking schemes to extract rents form Uncle Sam? Maybe one answer is that the banks are in the drivers seat, as their number is limited by regulation, and they extract most of the gains. But it doesn’t seem that way to me, as a casual observer.

    It’s possible this is off topic, but it’s the best I can do.

    I still have a hunch that if you are partly right, I’m also partly right. And that even if we fixed banking, hedge funds would make more than they did in earlier decades because of all the difficult to spot investment opportunities in our modern economy. But obviously I have no proof.

    nyd, I guess I worded my question poorly. Suppose the currency trades that are part of real trades in goods has increased modestly, but speculative currency trades have soared as a share of GDP. Then there is no gain to the financial sector from speculative trades, as the commission gain to the market-maker is offset by losses to the two traders. So I’m wondering how much of the commissions are extracted from ordinary people and companies not in the financial sector. I like index funds, precisely to avoid handing money over to the financial sector.

    Shane, You aren’t completely wrong. I agree about health care. And I’m sure you are partly right about finance. Much of finance deals with massive regulatory barriers, or opportunities for regulatory arbitrage. That is wasteful. But I’m not sure you are right about us having lots more information than the 1960s. Yes, we get information in milliseconds, instead of several minutes via a phone call, or inspecting paper reports. But I had in mind something else. The economy was much more predictable and transparent back then. Decisions on allocating capital were easier to make and mistakes were less consequential. The 2000 tech bubble was an early example, the housing bubble more recent. I do agree that the housing bubble was a product of bad government regulation, but I think the tech bubble was simply the market making a mistake in allocating capital, in a world where it was much harder to see what needed to be done, then when we built steel mills to supply steel to car factories whose output we could predict fairly accurately. People who make those decisions well should be highly compensated, essentially they are doing outside the firm what used to be done inside the firm when our economy was more dominated by large conglomerates.

    James, If by ‘Greenspan put’ you mean stable NGDP growth, it’s a pity they gave up on that. Otherwise the good times would still be rolling.

    Jeff, You said;

    “I remember reading somewhere that if not for the various bailouts, the losses that would have been suffered in the financial industry would have been greater than its cumulative profits since the Depression.”

    Totally false, at least for the big banks. The bailouts go to small banks and F&F. The big banks were often pressured to borrow the money, and paid it back as quickly as the government would allow them to.

    Yes, I agree many hedge funds lose money. I was trying to also explain increased income inequality. And the total share of national income going to finance has risen, despite the losers.

    Nick, I think you are right, but don’t see how it fits in to my argument.

    Tom Grey, It’s hard to know. Initially it was expected that AIG was in super bad shape. Now it looks like they will fully repay the government. So the $20 billion figure is speculative. In any case, would that have been enough to sink GS? They are a very profitable firm.

    By the way, I’m as shocked as anyone that the government will apparently come out of the TARP program with a profit. It’s still a horrible way to do things, and creates moral hazard, but I don’t think it’s obvious that big bank profits are coming from the taxpayer. Yes, they benefit from lower borrowing costs, but I’m not convinced that explains the rising share of GDP going to finance.

    Michael, See my previous answer. I certainly am not defending bailouts, BTW.

    Bruce, Yes, that is my argument, but it doesn’t apply to non-market economies. And even in the US the application is highly debatable.

    Thanks Luis.

    Benjamin, Taylor will be proved wrong about the threat of overheating.

    Broadstrokes, Yes! Money is free!! No need to ask hard questions about where it should be allocated.

    David, I do like the invisible Martians idea. It is more fun than empty space.

    Matt, I find that GS argument hard to believe. For years I’ve been told GS makes lots of money because they are full of the smartest guys on Wall Street, who make all sorts of shrewd investments. And now you tell me they are just intermediaries, doing something any moron could do?

    Your point about currency trades supports my argument.

    marcus, Thanks, I’ll have to address that later, when I have more time.

    davver, You said;

    “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.”

    But these don’t exist in a free market. We need to get rid of the government regulations that encourage all of this. If we can’t, then we need to do things like banning sub-prime mortgages and raising capital requirements so we don’t have to bail out banks in the future.

    It’s not hard to manage money. Put it in the bank, or buy indexed funds.

    James, Lorenzo isn’t disagreeing with me. I agree that investors form expectations of NGDP growth. So what?

    OGT, Of course I’m as upset with our financial system as anyone here. So that’s not the issue. But you still don’t really address my argument. You’re just saying you disagree that investment decisions are becoming more important.

    Ashwin, You don’t understand James’ argument. He wants to have the central bank punish us with Depressions for our sins, Bagehot would not agree with him. He opposes stable growth in NGDP or any other macro aggregate you care to target.

    Marcus, Thanks for the Barro interview. Yes, Bernanke learned the wrong lessons.

  63. Gravatar of broadstrokes broadstrokes
    5. January 2011 at 12:38

    What would the world look like if there was more capital than productive use for it? Where corporations have upwards of $40bn just sitting in bank accounts?

    Would there still be a need to ask hard questions about where it should be allocated?

  64. Gravatar of Morgan Warstler Morgan Warstler
    5. January 2011 at 12:59

    Scott, you didn’t like the bailout, but you fought off liquidation every other way you could… save the IOR issue.

    And now, after the fact, you act like it matters if we got paid off… there’s NO way we wouldn’t get paid back – they just keep pouring profits into the banks. It is a scam to even mention, “paid back.”

    It isn’t a question of Depression or not, or bank’s moral hazard – it is about you in relation to banks.

    Once you wave away the need for crushing the losing banks, you lose the moral authority to say they shouldn’t be regulated, taxed, deserve big pay, or anything else.

    If you want to target NGDP, then on every other issue you have to deliver brutal Mellon style justice. You need to say, “if we target NGDP, here’s how it screws the bankers, here’s how it screws Krugman.”

    And hit that gong relentlessly, when the blood of progressive economists and banksters flows red in the streets…. you’ll be the next Friedman.

  65. Gravatar of Silas Barta Silas Barta
    5. January 2011 at 13:19

    @scott_sumner: Thanks for the reply, but I really don’t think our disagreement hinges on hard-to-find empirics. For example, the company that financed the iPhone platform (which developed into an entirely new market) was the same as the one that made it — Apple funded it with re-invested profits. This is a huge, canonical example of the kind of “finance” that people approve of, but don’t call (and isn’t reported as) finance income.

    And this isn’t some edgecase: if you were to run through all the plausible examples of good capital decisions, they come exclusively from sectors *not* classified as financial, not “Wall Street” type: think about who was actually responsible for getting capital to Amazon, Google, eBay, social networking, smartphones, the real innovation we want. The Goldman-Sachs high-frequency trader didn’t have a hand in any of that.

    Therefore, I doubt that there is significant overlap between the capital allocation decisions you laud as difficult and important, vs. the finance income most people think they are talking about.

  66. Gravatar of davver davver
    5. January 2011 at 14:30

    “But these don’t exist in a free market. We need to get rid of the government regulations that encourage all of this. If we can’t, then we need to do things like banning sub-prime mortgages and raising capital requirements so we don’t have to bail out banks in the future.”

    You’re saying opportunities for fraud, misinformation, and worthless paper shuffling don’t exist in the free market? What planet are you from. Are you observing the same market as me? Have you lived in the same country? There’s a lot more in this post that makes me wonder if you have any practical experience in finance, its little more then pie in the sky academic theory.

    “It’s not hard to manage money. Put it in the bank, or buy indexed funds.”

    When you do this the bank manages the money for you (or in the case of index funds nobody manages it at all). If they don’t do a good job then its not managed well. Since it is not their money and they are an agent and the people giving them the money to manage don’t know how to select good managers it is easy for it to be mismanaged. Is this a difficult concept?

    Honestly, I don’t know your background. I linked in here from another site. But it seems like you’ve been far away from the nitty gritty of actually being in finance and seeing how it works.

  67. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    5. January 2011 at 16:00

    1. The question you are asking is wrong. The premise that statistics you cite accurately reflect the value added by financial activities is wrong. Before the war, small retail stores extended credit directly to customers, nowadays, this activity is outsourced to the financial industry. Every company has accounts receivable and accounts payable, every company is allocating capital on a micro level, companies that allocate capital to successful activities thrive, companies that allocate capital to bad projects fail. The right question is to ask why are we seeing increased outsourcing of financial activities.

    2. There are good causes of increase in outsourcing of financial activities. This outsourcing is facilitated by increased use of IT, it is facilitated by greater macro stability, it is facilitated by beneficial business process innovations.

    3. There are harmful causes of increase in outsourcing of financial activities. A lot of finance is just an arbitrage of different taxation of income from debt and equity instruments. A lot of finance is related to the collection of TBTF subsidies (Lehman is the case where the size of the too-big-to-fail subsidy was severely overestimated ex-ante). A lot of finance is related to exploitation of mispriced FDIC insurance, mispriced LOLR insurance etc. Don’t get me started on Fannie and Freddie…

  68. Gravatar of James in London James in London
    6. January 2011 at 07:57

    Thanks for trying to understand my position. Obviously, no one can “oppose stable growth in NGDP” it’s apple pie, after all, and I don’t “oppose” apple pie. I do “oppose” growth based on TBTF-guaranteed levereage, that I think will lead to blow-ups.

    I also “oppose” inflation based on either stable or the eventually unstable government-sponsored growth of the money supply. And especially oppose it when it is used to finance large fiscal deficits, cheating in my view.

    At the end of the day macroeconomics is largely fraudulent politcal manouevring by various interest groups. Leave “macro” to the market and let a thousand flowers bloom, including numerous competing monies. Your defence of the Greenspan Put (in your version justified as targetting stable NGDP growth come what may) is a promise to bail out the banks come what may. The outcome of that cannot possibly fit with your utilitarian libertarianism.

  69. Gravatar of Jeff Jeff
    6. January 2011 at 12:41

    Totally false, at least for the big banks. The bailouts go to small banks and F&F. The big banks were often pressured to borrow the money, and paid it back as quickly as the government would allow them to.

    TARP was a smokescreen. The real bailouts were elsewhere.

    1. Paying off the AIG CDS at 100 cents on the dollar was purely to the benefit of the big banks who were the counterparties. Goldman Sachs alone got $12.9 billion, Merrill Lynch $6.8 billion, BofA %5.2 billion, Citi $2.3 billion and Wachovia $1.5 billion. Had AIG been allowed to go bankrupt, most likely none of that money would have been paid out yet, and the ultimate recovery would be only a fraction of it.

    2. Assuming the liabilities of Fannie and Freddie, whose obligations were NOT an obligation of the taxpayer, is going to cost several hundred billions. This is a back door bailout for the holders of the trillions of dollars worth of securities that Fannie and Freddie guaranteed. Paying out on those guarantees is what is going to cost the taxpayer a 12-figure sum. Most of the worst of these securities are currently on the books of big Wall Street firms.

    3. Government policies that arrest or slow down the house price decline also benefit the holders of private-label MBS, who are again concentrated on Wall Street.

    4. The government pressured the FASB to change mark-to-market rules for MBS and other securities because otherwise many large financial institutions would not be able to hide their insolvency. This lets them stay in business and keep paying big executive bonuses for a few more years.

    It may be hard to remember, but prior to mid-2008, most federal regulators vigorously and regularly denied that any institution was “too big to fail”. This speech by Dallas Fed president Richard Fisher explains why they should have stuck to their guns.

  70. Gravatar of Jeff Jeff
    6. January 2011 at 12:45

    Arghh! Wrong Fisher speech. I meant this one.

  71. Gravatar of Lorenzo from Oz Lorenzo from Oz
    6. January 2011 at 20:51

    James in London: Scott is right, I am agreeing with him. I share your moral outrage, I just think you have misidentified the problem. If the UK was affected by the Greenspan put then so was Canada and Australia: but we did not have the same problems because we had different structures and regulations in our financial, particularly our banking, industries.

    It muddies his theory too much if market participants start to modify their behaviour in expectation of certain monetary policy actions. Surely Scott’s analysis is precisely about that, it is just he identifies different policy actions as having the effects you complain about.

  72. Gravatar of James in London James in London
    7. January 2011 at 05:10

    Lorenzo
    Canadian and Australian banks of course operated partly under the Greenspan Put, but their regulators “sort of” appreciated that fact and severely limited their behaviour (although recent expansionism by some Canadian banks, RBC in particular, indicate some dangerous hubris might be kicking in).

    US regulators didn’t realise what the banks were up to, or were paid (bribed) to turn a blind eye, and in my view they still don’t realise so enmeshed are banksters in the regulatory “structure”, Bill Dudley’s position being the most conflicted since … Hank Paulson’s.

    I don’t think the solution is bailing out the banks via inflating the economy as Scott argues in favour of. I think Australian and Canadian bank regulation will fail sooner or later, like all bank regulation as the regulated evenutally capture the regulators(see Ashwin’s good post and links above) – especially when

    Better to leave the creative destruction to the market, and don’t be scared of deflation (as Scott and the banksters like to carry on about – there is no bogeyman!). The market will work out how much liquidity squeeze is enough and then relax. Conservatives (and Constructivists/Managerialists) of left and right don’t like this solution but it will work.

  73. Gravatar of Doc Merlin Doc Merlin
    7. January 2011 at 05:55

    @James In London:
    ‘Canadian and Australian banks of course operated partly under the Greenspan Put, but their regulators “sort of” appreciated that fact and severely limited their behaviour (although recent expansionism by some Canadian banks, RBC in particular, indicate some dangerous hubris might be kicking in).’

    Canadian and Aussie banks are /way/ less regulated than their US counterparts.

    ‘US regulators didn’t realise what the banks were up to, or were paid (bribed) to turn a blind eye, and in my view they still don’t realise so enmeshed are banksters in the regulatory “structure”, Bill Dudley’s position being the most conflicted since … Hank Paulson’s.’

    Its actually way worse than what you say, even Bush saw the housing crisis coming and tried to fix Fanny and Freddy, but was blocked by the Dems which were in bed with Fanny and Freddy.

    The rest of your argument I agree with entirely.

  74. Gravatar of James in London James in London
    7. January 2011 at 06:48

    “Way less regulated”. There is regulation via rules with little or now discretion and therefore blindly, hopelessly ignoring the substance of what is occurring, like in the US and developed in the UK under the FSA. Then there is regulation via principles and “eyebrows” as in Canada and Australia and the UK in the old days under the Bank of England. Real LOLR, acting like real commercial insurance companies understand the tricks that their customers can get up to get around the rules – the UK FSA and the US financial regulators failed hopelessly in this game.

    BTW, Lorenzo, sorry about the cricket. Is it reflective of having it all too easy Down Under these days?

  75. Gravatar of spencer spencer
    7. January 2011 at 09:52

    You argue that the financial types deserve high compensation for the hard job of allocating capital they have done over the last couple of decades.

    I agree that allocating capital is a hard job, but it looks to me like they did a miserable job in the 1990s and 2000s. They deserve to be fired not highly paid.

    So what did they do in the 1990s — they created one of the largest stock market bubbles in history with the market PE at two to three times the historic norm. As a consequence they were essentially providing free capital to way too many ridiculous start up firms. Yes, by its nature capitalism is wasteful in this manner and we are probably better off because of the technology bubble they financed. But to argue that the financial types did a good job of allocating capital in the 1990s is beyond my understanding. The stock market is still trying to recover.

    So what did the financial types do for an encore in the 2000s?

    They financed the construction of about twice as many homes as the economy needed. Household formation implies that we should have built some 1.1 to 1.3 new homes annually in the 2000s. Yes, back in the 1970-80s when the baby-boomers were growing up we needed over 2 million new home, but not in the 2000s. This has to be one of the greatest misallocations of capital in human history.

    I can see how we may be better off because of the tech boom even though it was an amazingly inefficient process but how can anyone argue that the housing bubble made up better off.

    Basically the only reason many of the financial types are still employed is that the government decided it was the lesser of evils to bail them out. But they did a miserable job of allocating capital in the 1990s and 2000s and really deserved to be unemployed, not highly compensated.

  76. Gravatar of dtoh dtoh
    7. January 2011 at 15:50

    Scott, very nice piece. I was a principal architect of the derivatives business at a major investment bank in the 80s, and I have thought a lot about the subject of compensation in the finance profession. Your piece addresses this main considerations, but I’m not sure you have it quite right. A few observations.

    1. High pay for performance. Very true. There is a lot of money to be made by allocating capital efficiently and there is a big difference between being good at it and being really good at it. It’s like hitting .320 in baseball. There are some people in the finance business who can generate social value at rates that are orders of magnitude higher than anyone else. It is a very rare skill

    2. Coat Tail Riders. A lot of people working at financial institutions don’t produce much but because of their managerial or political skills they get a big share of the value genearated by the actual producers.

    3. Social Value. I think you need to be careful how you define this. A lot of transactions are driven by tax, accounting and regulatory considerations and have no social value.

    4. Oligopolies. Stable oligopolies may tend to converge toward cooperative/collusive behavior over time. To a certain extent the oligopolies are maintained by government regulation, but there are very high natural barriers to entries in some areas like bond trading, equity underwriting, etc. where you can’t compete unless you are already in the market and seeing the flows. I was recently involved in setting up a private bank. It required about $25 million in capital to meet compliance requirements. So partly it’s government regulation that leads to oligopolistic profits and partly it’s natural market inefficiencies.

    5. Hedge Funds, Money Managers. The only way to explain this is stupid investors. It’s harder to pick a good stock picker than it is to pick a good stock. Many investors pick money managers based on advice heard at cocktail parties. Whey anybody would pay most of these managers anything other than a basic transactional/ clerical fee is beyond me. The death of fixed commissions on shares turned everyone into a money manager.

    6. Cheap Capital. Over the last 10 to 15 years, the financial firms have made a ton of money because they can borrow at risk free rates (through an implicit government guarantee) while they are investing in higher risk/ higher return assets. They keep the gains; the government picks up the losses. IMO, this is probably the biggest factor driving the high compensation. Blaming the bankers for this is stupid. Their behavior is entirely rationale. The politicians are regulators are 100% at fault. The problem could be easily solved with reserve requirements the rate of which is tied to risk of the assets and the length of time for which they are being held.

  77. Gravatar of Lorenzo from Oz Lorenzo from Oz
    7. January 2011 at 19:35

    James: on the cricket, thanks. It is good for the soul or something, bringing us down to earth 🙂 Though I suspect our housing prices will also at some stage, and then we will really find out how good our financial regulation is.

    I think you greatly underestimate the costs of deflation. I take your point about regulations being gamed: try how quantity controls on land use are gamed, for example. Indeed, encouraging the “gaming” (such as political donations) is much of the point, as are wealth effects for homeowners. But free market banking is not a political goer for the forseeable future, so the question becomes how to do regulation properly.

    Concentrate on prudential regulation (including transparency: one cannot be prudent about what one can not see clearly) and let the rest go seems the way to go.

  78. Gravatar of Matt Matt
    9. January 2011 at 20:14

    “Matt, I find that GS argument hard to believe. For years I’ve been told GS makes lots of money because they are full of the smartest guys on Wall Street, who make all sorts of shrewd investments. And now you tell me they are just intermediaries, doing something any moron could do?”

    It’s not so easy to do it when there are dozens of other intermediaries around trying to do the exact same thing, squeezing your margins. Flow trading is a competitive business.

    Look, you don’t have to believe me, but I’ve worked for one of the Street’s bigger broker-dealers for a while now, and I have a pretty good sense where we and our competitors make our money. It’s not by making naked bets on the market. It’s by taking customer orders, sometimes reslicing the risks a bit to be able to hedge it cheaper, then passing it on. Basis point by basis point, day in day out.

  79. Gravatar of scott sumner scott sumner
    10. January 2011 at 18:52

    broadstrokes, If capital was worthless, then yes, you would not need to worry about how it was allocated.

    Morgan, You said;

    “If you want to target NGDP, then on every other issue you have to deliver brutal Mellon style justice. You need to say, “if we target NGDP, here’s how it screws the bankers, here’s how it screws Krugman.”

    Google my National Review article, and read the last few paragraphs.

    Silas, I don’t think the hedge fund managers who make billions do so through HFT. They allocate capital. Didn’t investment banks do the Google IPO?

    davver, Banking is highly competitive, there are 1000s of banks. How can banks that do lots of “worthless paper shuffling” pay higher interest rates on deposits than more efficient banks?

    You are right that I know little about finance, however.

    123, I agree, indeed that was going to be in my next post.

    James, If you also support stable growth in NGDP, why do you think we disagree?

    Jeff, I completely agree about F&F, but not AIG, which will probably repay its loans.

    You said;

    “3. Government policies that arrest or slow down the house price decline also benefit the holders of private-label MBS, who are again concentrated on Wall Street.”

    Government policies (the Fed) caused much of the fall in house prices, which hurt banks badly.

    I also oppose TBTF.

    Spencer, People that do important things that are very difficult to do are very well paid regardless of whether they screw-up on occasion or not. The screw-ups show how hard the job is.

    Do you think Soviet-style central planners would have allocated capital to Yahoo, Google, and Facebook?

    dtoh, I mostly agree, although I wonder why oligopolies in finance don’t compete vigorously like oligopolies in other fields do.

    My main point is that even without the problems you mention, finance would be doing increasingly well.

    Matt, OK, but doesn’t the argument that trading is highly competitive undercut the argument that finance makes huge monopoly profits?

    Also note that dtoh, who worked on Wall Street, has a different view–check out his comment above, where he says the big money is from smart trading.

  80. Gravatar of dtoh dtoh
    10. January 2011 at 23:52

    Scott,

    1. Completely agree that finance is attracting a bigger share of GDP for the reasons you state. A lot of people will not agree that finance produces social utility… but it’s too obvious Duh Yawn! It also partly explains 20 years of low/no growth in Japan. It’s easy to allocate capital when all you have to worry about is textiles, steel and shipbuilding (even the Soviets had a good run back in the 20’s.) But as you say there is no way a dirigiste bureaucracy is going to be able to allocate capital to a Google or a Facebook. Capital allocation is a lot harder now.

    2. The question that needs to be asked though is not why the finance sector has grown but why compensation and capital returns in finance are disproportionately high. That’s the interesting question and totally separate from why the sector has grown.

    3. With respect to oligopolies I speculated that “stable” oligopolies will tend toward cooperative (collusive) behavior. It’s well known in game theory that if you have participants play a prisoners’ dilemma or similar simulation repeatedly you get very different results than if the participants play it only once. I think the same thing happens in finance. I suspect there is probably also some research about the number of participants as well as the size and frequency of deals/transactions that partly explains behavior in the finance industry.

    4. With respect to Matt’s point. Different divisions within the banks make money in different ways… grind it out basis point by basis point, big advisory fees, smart trades, etc. The meltdown (and a lot of the money made in the last 10 15 years) however was really simple…. the banks borrowed short term at low rates (thanks to an implicit government guarantee with no restrictions) and went long risky assets. Bet someone else’s money, get to keep any gains. You’re dumb not to do that trade all day long. Totally rationale behavior on the part of the bankers. Exact same thing happened with the S&L industry.

  81. Gravatar of roger erickson roger erickson
    11. January 2011 at 09:22

    “I’ve always believed that oligopolies are more competitive than they look.”

    Beliefs have no place in a discussion of logic – the world is always more complex than your beliefs.

    Criminals often arrange to have a monopoly on producing current razors, even Occam’s – whether they’re in S&Ls, at TBTF banks, the FED, or even the Treasury & White House. Talk to Bill Black, or any local FBI office.

    http://www.amazon.com/Best-Way-Rob-Bank-Own/dp/0292706383

    http://wallstreetpit.com/56520-pressures-on-the-paradigm-the-fall-of-the-new-monetary-consensus

    To your point, the public as participant is going to play differently each time the “prisoners dilemma” game is repeated. When pushed far enough, grandchildren eventually relearn lessons their grandparents learned the hard way, and their complacent parents forgot. Over multiple generations, the relearning gets progressively easier, until it is captured. By then, there are always plenty of other problems, so the great game continues – but based on reality, not your beliefs.

  82. Gravatar of Full Employment Hawk Full Employment Hawk
    11. January 2011 at 15:33

    “if we target NGDP, … here’s how it screws Krugman.”

    Krugman will argue that when the economy is in a liquidity trap the Fed cannot succeed in targeting NGDP, unless it makes the inflation rate increase by several percentage points, which it is unwilling to do. This is a legitimate issue calling for serious scholarly debate about substance and about how the economy works. It calls for the use of theoretical arguments and empirical evidence, not screwing people. Krugman would agree that if the economy is not in a liquidity trap and the Fed able AND WILLING to do the job of restoring the economy to full employment effectively, discretionary fiscal policy is not needed.

    If economics is to ever become a real science, like the natural sciences are, this ideological partisanship has to go.

  83. Gravatar of Matt Matt
    11. January 2011 at 21:46

    dtoh, that carry trade is precisely what the smarter banks avoided doing (or at least were so nimble in getting out of that they didn’t get smashed when it unwound). repo funding of illiquid trades is scary stuff…

    As far as businesses:

    There’s flow trading, which accounts for the majority of profits today

    There’s some smart structured trades…really bespoke stuff you can eat a bigger piece of because a lot more work goes into satisfying customer demands with it. More important in 2007 than today, obviously

    Then there’s real prop stuff. Dirty word today, and the most obvious examples of it are going to disappear from the banks and get shuttled into the hedgies. We’ll see about jumping ship to buy side. I get the feeling bank employees across the street are going to get some pretty big lumps of coal this year. 🙁

  84. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    12. January 2011 at 06:41

    @Full Employment Hawk

    It is quite likely that with NGDP level targeting there would be no liquidity trap in the current crisis. Even if this is not true, the expected duration of liquidity trap would be shorter, and deviation from full employment smaller if NGDP level targeting is implemented. In any case large enough dose of credit easing will always prevent the liquidity trap, although I recognize that the Fed has set a very high bar for credit easing.

  85. Gravatar of scott sumner scott sumner
    12. January 2011 at 14:15

    dtoh, Your comment about Japan reminds me of how people complain about how American CEOs are overpaid, and point to the low paid Japanese CEOs, Yes, but they earn their low pay, as the Nikkei is at 1/4 the level of 1991.

    I am still skeptical of the oligopoly theory. Classroom experiments are not relevant, what is relevant is that real world oligoplies in other industries compete vigorously.

    I agree about the moral hazard problem.

    Roger, I’m not sure how your comment, or the items you link to, relate to my post. Wray is criticizing New Keynesianism. How does that relate to oligopoly?

    You said:

    “Beliefs have no place in a discussion of logic – the world is always more complex than your beliefs.”

    Is this something you believe?

    Full Employment Hawk, I believe Krugman claims 5% NGDP growth is impossible if in a liquidity trap as it would require high inflation, and if you had high inflation then real GDP would grow really fast as the SRAS curve is now flat. This inflation plus real growth would greatly exceed 5%.

    I find that a bizarre theory, and I see no reason to believe it. Indeed I expect the recent QE2 to create about 5% NGDP growth over the next year. And I think markets do as well, so I presume markets don’t buy Krugman’s views of AD. His view also implies the Fed couldn’t raise inflation expectations from 1.2% to 2.0% (over 5 years), but it just did exactly that.

    Matt, I wish I knew more about banking. Indeed I wish I worked for a big bank.

  86. Gravatar of Matt Matt
    13. January 2011 at 03:13

    I’m sure a number of them would consider hiring you, scott. I’m not the only one on my floor who reads you.

  87. Gravatar of dtoh dtoh
    13. January 2011 at 06:49

    Scott,
    I’m not sure Japanese execs get lower pay. Lower wage and bonus compensation for sure, but becasue of the tax system a lot of compensation is shifted to retirement payments (taxed on half the amount at a lower rate), housing (what is the economic value of $200 million company provided residence), etc., etc.

  88. Gravatar of dtoh dtoh
    13. January 2011 at 07:00

    Matt,
    Good points.
    Not sure there were many nimble banks other than Goldie, and IMHO the remnants of their partner culture made them somewhat stupid managers (i.e. they didn’t do as much of the carry trade as others….many of whose execs and traders walked away from the meltdown with a pile of cash they had made in the good years).

    I think the structured trades will come back. So much of it was just a way around poor government regs. There will also be a market for this.

  89. Gravatar of scott sumner scott sumner
    14. January 2011 at 05:42

    matt, That’s good to hear.

    dtoh, That’s interesting. The pay gap is so big (I believe more than 10 to 1) that I simply assumed total comp was also higher in the US. Is it possible the amenities make that much difference? If you are right then someone should definitely do a paper on that, as most economists probably believe what I do.

    Regarding you second comment, I agree that evading government regs is a big problem in finance–leads to a lot of socially wasteful activity.

  90. Gravatar of D. Watson D. Watson
    14. January 2011 at 08:18

    Scott,

    I know you keep swearing off EMH posts, but do you have any comment on The Economist’s article on momentum trading? Happy New Year (first comment since)
    Derrill

  91. Gravatar of ssumner ssumner
    14. January 2011 at 18:44

    Derrill, Happy New Year to you. All I can say is that if this were going to be true in the future, why wouldn’t mutual funds just hold stocks in the top 20%. They’d earn excess returns of 9%, which would make the mutual fund company super-popular. I recall when Fidelity became very profitable because Peter Lynch picked stocks effectively. The Economist makes it all seem so easy. Somehow I doubt it, although it’s possible I am wrong.

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