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.