A new and welcome front may be opening in the efforts to rein in an overly powerful and now explicitly state-backed financial services industry: challenging its claims that its activities are good for society. While the provision of credit is important to any economy beyond the barter stage, finance should be the handmaiden of commerce, not its master. But the perverse (and disproved) logic of financial economics, that markets are efficient (and by extension, virtuous) means that those associated with them can assert that their services are vital, even if what they are really doing is tantamount to looting.
One salvo comes tonight in the Financial Times, in “Overmighty finance levies a tithe on growth,” by Harvard economics professor Benjamin Friedman,
The crucial role of the financial system in a mostly free-enterprise economy is to allocate capital investment towards the most productive applications…
If a new fertiliser offers a farmer the prospect of a higher crop yield but its price and the cost of transporting and spreading it exceeds what the additional produce will bring at market, it is a bad deal for the farmer. A financial system, which allocates scarce investment capital, is no different.
The discussion of the costs associated with our financial system has mostly focused on the paper value of its recent mistakes…The estimated $4,000bn of losses in US mortgage-related securities are just the surface of the story. Beneath those losses are real economic costs due to wasted resources: mortgage mis-pricing led the US to build far too many houses. Similar pricing errors in the telecoms bubble a decade ago led to millions of miles of unused fibre-optic cable being laid.
The misused resources and the output foregone due to the recession are still part of the calculation of how (in)efficient our financial system is. What has somehow escaped attention is the cost of running the system…..
For years, much of the best young talent in the western world has gone to private financial firms. At Harvard more than a quarter of our recent graduates who have taken jobs have headed into finance…. we are wasting one of our most precious resources…..much of their activity adds no economic value.
Perversely, the largest individual returns seem to flow to those whose job is to ensure that microscopically small deviations from observable regularities in asset price relationships persist for only one millisecond instead of three…
In the US, both the share of all wages and salaries paid by the financial firms and those firms’ share of all profits earned have risen sharply in recent decades. In the early 1950s, the “finance” sector (not counting insurance and real estate) accounted for 3 per cent of all US wages and salaries; in the current decade that share is 7 per cent. From the 1950s to the 1980s, the finance sector accounted for 10 per cent of all profits earned by US corporations; in the first half of this decade it reached 34 per cent…
What makes a more efficient financial system worthwhile is not just that it allows us to achieve greater production and economic growth, but that the rest of the economy benefits. The more the financial system costs to run, the higher the hurdle…
Economic decisions are supposed to turn on weighing costs and benefits. It is time for some serious discussion of what our financial system is actually delivering to our economy and what it costs to do that.
A second effort is being mounted by French president Sarkozy is proposing international standards to rein in bank pay. This is a bold idea, since only international coordination can work to constrain pay, but the countries controlled by the financial classes are certain to reject or dilute any such idea.
From Linda Beale:
French President Sarkozy has seen how banks have responded to the financial crisis of their own making with extravagant bonuses for the very employees responsible for huge losses that led to central bank interventions and much taxpayer funding at stake. To put it starkly, he doesn’t like it. So he has proposed a solution.
According to BNA’s Daily Tax RealTime, he has announced plans for a proposal for bonuses modelled on the recent coordination among countries in dealing with tax havens and banking secrecy. The proposal, to be fleshed out at the September meeting of the G-20 governments, calls for a coordinated effort by the G-20 governments to reign in bonus behavior. Each country would agree to impose a tax on bonuses, to be levied at the same rate across the group. In addition, each country would agree to an overall limit on bonuses, calculated as a percentage of the bank’s revenues. The tax would be dedicated to financing guarantees of deposits.
The idea I like the best is restricting bonuses as a percent of revenue for any state-backed organization. That will lead all the people in safe fee businesses to decamp and eliminate the incentives to swing for the fences for the activities supported by taxpayers. I wish that this could serve as a shot across the bankers’ bow. However, a horde of professionals (lawyers, accountants, lobbyists) benefits from outsized Wall Street pay and will also fight tooth and nail to beat back any pay restraints.
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Seems to me that the focus on bonuses is a distraction from the crucial issue of cutting the banks down to size, i.e. not too big to fail.
First, three cheers for Mr. Sarkozy. His Mel-Gibson-in-cowboy-boots vibe and ultra-glam-fashion-model wife at first kind of made me wonder whether he was sort of paper mache doll. But he's had so much more gravitas on this crisis than any other "leader" and he's still at it. God Bless him. He can make France relevant again.
Second, the tortured internal logic of the economics profession is certainly a source of amusement, but it's also good to see Mr. Friedman's stabs at clarity. It is sort of humorous to consider that the "mispricing" of mortgages is apparent only in hindsight. At the time, of course, because all information possibly known is factored in to prices, those prices must have been the very peak of efficiency, the sublime heights of a newfound magic of riches. But now, Oh MY!, they were not. In theory, now if those prices weren't efficient then it's possible that ANY market price is not an indication of efficient resource utilization.
Hmmm. "Efficiency", a word that recedes like a shadow into the fog of thought. It seems that efficiency at time t=n means that whoever wants it most gets it if they have the cash, damn the consequences. But at time t=n+x, when the human pain builds to a level of tears and gnashing of teeth, well then the price at t=n wasn't so efficient after all and "Oh and how society's resources were misused."
Well, what exactly are society's resources anyway? There's a rub.
So prices are efficient as long as the bubble lasts, but when it breaks, they are not.
It sounds like there's something wrong with the theory of prices and efficiency.
Profits to finance need to be recomputed. The 34% for the first half of this decade is almost completely bubble driven, while the 2nd half will be losses from said bubble. I looked at Merrill's cumulative earnings for the 00's and it was, while still positive, very small. I'm sure it brought some losses with it to BoA that would have pulled it to a net negative.
Yves, you are a genius. There are pay limitations for government employees. Obviously we need pay restraints for state backed institutions. Get enough of these great sound bytes together and there will be no stopping you. Hooray!
Indeed – I agree with Jon: we need pay controls for taxpayer-backed corporations, as they are not private and so should be under taxpayer control. We back them, we control them.
"Pareto efficiency" is certainly messed up, crazyman. But the concept of "efficiency" in broader terms is certainly worth at least discussing. Quite obviously, we do NOT have efficient "resource allocation" in our economic system, however you cut the cake!
The FIRE sector gets more $$ going its way because they are the middle man: the one who takes your money (and everybody's $) and "allocates" it… so obviously, they are sitting right by the 24 inch cash pipeline, so a lot of the flow "drops" into their pockets. Assymetric info is a curse, and that is why we need tight regulation of finance, insurance and the like!
Yves
Thank you for focusing on this particular op-ed. It is so reasonably written and so obviously correct to anyone not in the finance field or completely co-opted, that it indeed is heartening to be able to at least hope that a pendulum may inexorably be swinging back the other way, or at least be near the end of its stroke before reversing course.
There seems to be a disconnect here: having asserted the likelihood that the most lucrative elements of high finance are "tantamount to looting," you go on to praise the effort to rein in the pay of the profiteers. That seems almost a non sequitur. If criminal activity has used technological advances to move itself outside the definition of the law, the proper move has always been to update the law, not regulate compensation of the de facto looters.
I mean, if the overt amorality of the solution doesn't put you off, then think of the unintended consequences: 1) doesn't limiting the compensation of those who actually do the looting merely shift a greater share of the illicit rewards to stockholders of the companies that employ them? And 2) won't the broader fraternity of looters the world over inevitably demand a similar arrangement, in lieu of prosecution?
led to millions of miles of unused fibre-optic cable being laid.
This is a clever abuse of circumstances and then it's used to justify his position.
Yes, fibre was laid. Is it 'unused?' Nobody has a fact-based answer question because it is the basis of the appearance of competition in the bandwidth industry.
The other logical failure is the artificial constraints on communication placed on American customers by the telcos and media conglomerates.
Even though the guy/girl is abusing facts, Why oh why does it take someone from Harvard to state the obvious before an idea gets some momentum?
@GB wrote: If criminal activity has used technological advances to move itself outside the definition of the law, the proper move has always been to update the law, not regulate compensation of the de facto looters.
Yves references more than the use of super-computers to monetize milli-seconds into profits. The recent disclosure of the frequency of Paulson's co-development with Goldman Sach's of Treasury Dept responses pre-Lehman & AIG better captures our drift towards legalize kleptocracy…as do the Bush & Obama-era appointments.
To see the challenge of using the existing government to outlaw such practices, revisit the challenge facing the Constitutional Convention of 1787 where many of the US Constitution framers & writers themselves were slaveholders and yet were empowered to decide on the legality & morality of slavery and its abolishment. A dilemma indeed.
The hindsight and real time recognition of amorality oft does little good in impacting how many decades it takes (and oh yes, whether a war is required too, as was the case of slavery) to get amoral activities outlawed once they’ve been deeply interwoven into daily life and cultural norms.
Who knows how Herculean a task it will be to get America to rein in the banking & finance sector. But it remains worth the fight.
Bankers don't need their bonuses reduced. They need to be in jail pour encourager les autres.
If you're trying to figure out why these Harvard grads are attracted to finance, the answer is right in front of your nose. These kids are smart. They know (or sense) that the money is made closest to the spigot of credit. If one can take risk with OPM, or better yet newly minted credit, they reap the benefits of the inflationist system.
It should be no surprise that they put themselves on Wall Street. Cutting bonuses will achieve something. Probably just driving off the credit spigot somewhere else. But if you want to restore meaning to economic "growth" then you need to destroy the inflationist system that teaches people that speculation on ever rising asset prices creates wealth, rather than productivity.
Professor Friedman's analysis is good, but I think Kevin Philips' is better. Kevin did not restrict himself to the 3% => 7% growth of traditional finance over the past 40 years; he focussed on FIRE (Finance, Insurance, & Real Estate), which grew from 10% to 20% of GDP over the same period. In so doing Mr. Philips captured better the harmful overgrowth of the finagling side of our economy.