Sunday, February 20, 2011

The Financial Sector and Its Contribution to Society

Two recent articles address the question of Wall Street’s utility to society. John Cassidy leads with an article in The New Yorker: What Good is Wall Street. His subtitle, “Much of what investment bankers do is socially worthless,” conveys a hint of his conclusion. He reminds us that after the Great Depression new regulations for the financial sector created a stable economy.

“During this period, major financial crises were conspicuously absent, while capital investment, productivity, and wages grew at rates that lifted tens of millions of working Americans into the middle class.”
Cassidy then concludes by asking this question:
“Since the early nineteen-eighties, by contrast, financial blowups have proliferated and living standards have stagnated. Is this coincidence?”
Tyler Cowen picks up the topic of income inequality in an article in the American Interest: The Inequality That Matters. Cowen begins with a broad discussion of the subject and concludes that the fact that we have people that are superrich is not necessarily a sign that the lower 95 percentile are suffering from inequality. He concluded that things are not as bad for most of us as they might appear. That is a topic to be argued another day. Cowen then goes on to describe a class of excessively-rich people whose wealth is a danger to society: those making a killing in finance. Cowen answers Cassidy’s question not only with a “No,” but with a “Hell no!”

His view of the financial community leads him to finish with this intriguing statement:
“Is the overall picture a shame? Yes. Is it distorting resource distribution and productivity in the meantime? Yes. Will it again bring our economy to its knees? Probably. Maybe that’s simply the price of modern society. Income inequality will likely continue to rise and we will search in vain for the appropriate political remedies for our underlying problems.”
Let us see how these authors arrived at their conclusions. We will begin with Cassidy.

The financial sector plays a positive role when it acts as a source of funds for entities in need of funding, whether they are individuals looking for a loan, startup companies looking for financing, or established corporations wishing to raise money by selling bonds or shares. The financial sector should also assume the important responsibility of making sure money is used wisely. An unwise loan should be seen as risk of financial loss by the bank making the loan.

What are financial institutions really doing?
“Yet Wall Street’s role in financing new businesses is a small portion of what it does. The market for initial public offerings (I.P.O.s) of stock by U.S. companies never fully recovered from the tech bust. During the third quarter of 2010, just thirty-three U.S. companies went public, and they raised a paltry five billion dollars. Most people on Wall Street aren’t finding the next Apple or promoting a green rival to Exxon. They are buying and selling securities that are tied to existing firms and capital projects, or to something less concrete, such as the price of a stock or the level of an exchange rate. During the past two decades, trading volumes have risen exponentially across many markets: stocks, bonds, currencies, commodities, and all manner of derivative securities. In the first nine months of this year, sales and trading accounted for thirty-six per cent of Morgan Stanley’s revenues and a much higher proportion of profits. Traditional investment banking—the business of raising money for companies and advising them on deals—contributed less than fifteen per cent of the firm’s revenue. Goldman Sachs is even more reliant on trading. Between July and September of this year, trading accounted for sixty-three per cent of its revenue, and corporate finance just thirteen per cent.”

“In effect, many of the big banks have turned themselves from businesses whose profits rose and fell with the capital-raising needs of their clients into immense trading houses whose fortunes depend on their ability to exploit day-to-day movements in the markets. Because trading has become so central to their business, the big banks are forever trying to invent new financial products that they can sell but that their competitors, at least for the moment, cannot.”
The trading activities that have the major business component consists of buying and selling traditional investment vehicles, and creating, buying and selling nontraditional financial instruments such as collateralized debt obligations (CDO) and credit default swaps (CDS).

It is hard to see what social or economic value these institutions bring to the traditional markets by throwing their financial weight around. Markets are most stable when investors are in them for long-term gains. It is not clear that long term gains are part of their agenda. Investors hope for a steady but gradual increase in value. Speculators are after the higher returns on investment that are usually associated with greater risk and volatility. These outfits would seem to be playing the role of speculators, and there is at least circumstantial evidence that volatility has increased as they have become more active in the markets.

CDOs are probably best described as a good idea gone wrong. As a vehicle for distributing risk they provide some economic value, but the same vehicle can be used to hide risk and pass it on to someone else, a big factor in the recent financial collapse. A CDS is nothing but a bet.
“When an investor or financial institution buys this kind of swap, it doesn’t purchase a bond itself; it just places a bet on whether the bond will default. At the height of the boom, for every dollar banks issued in bonds, they might issue twenty dollars in swaps. “If they did a hundred-million-dollar bond issue, two billion dollars of swaps would be created and traded,” Schlosstein said. “That’s insane.” From the banks’ perspective, creating this huge market in side bets was very profitable insanity. By late 2007, the notional value of outstanding credit-default swaps was about sixty trillion dollars—more than four times the size of the U.S. gross domestic product. Each time a financial institution issued a swap, it charged the customer a commission. But wagers on credit-default swaps are zero-sum games. For every winner, there is a loser. In the aggregate, little or no economic value is created.”
Some of the more inventive financial instruments have other goals that do not contribute much to the economy.
“Banks often design complicated trading strategies that help a customer, such as a pension fund or a wealthy individual, circumvent regulatory requirements or reduce tax liabilities. From the client’s viewpoint, these types of financial products can create value, but from society’s perspective they merely shift money around. ‘The usual economists’ argument for financial innovation is that it adds to the size of the pie,’ Gerald Epstein, an economist at the University of Massachusetts, said. ‘But these types of things don’t add to the pie. They redistribute it—often from taxpayers to banks and other financial institutions’.”
Cassidy has illuminated some of the basic dynamic that is at work in big financial institutions. The picture that emerged was of an industry focused on generating profits from transactions that contributed little to the economic health of the nation. He also touched on an aspect of the risk involved in these activities, but it is Cowen who emphasized risk and its danger and associated it directly with the growth in income inequality.

To understand how risk feeds into income inequality, it is more helpful to think of these financial institutions as a collection of individual traders rather than a monolith. An individual can take someone else’s funds and create an investment situation that makes a lot of money. It can take months or years to figure out that this was ultimately a bad investment. Meanwhile the trader has acquired a lot of income. When the investment goes sour he does not have to give the money back. At worst, he is temporarily out of a job. The losses are passed on to the company as a whole, and ultimately to the stock holders. Do the shareholders care? Probably not, according to Cowen.
“Moreover, smart shareholders will acquiesce to or even encourage these gambles. They gain on the upside, while the downside, past the point of bankruptcy, is borne by the firm’s creditors.”
But do the firm’s creditors have any worries?
“Perhaps more important, government bailouts minimize the damage to creditors on the downside. Neither the Treasury nor the Fed allowed creditors to take any losses from the collapse of the major banks during the financial crisis. The U.S. government guaranteed these loans, either explicitly or implicitly.”
And now we see the crux of the problem.
“In short, there is an unholy dynamic of short-term trading and investing, backed up by bailouts and risk reduction from the government and the Federal Reserve. This is not good…. it means that banks take far too many risks and go way out on a limb, often in correlated fashion. When their bets turn sour, as they did in 2007–09, everyone else pays the price.”
They earn their profits in the good times, but they accrue no real penalty in the bad times. But even in the good times they are siphoning huge amounts of potential capital out of the economy and putting it to less useful purposes. If their bad behavior causes economic tumult and drives people out of work, the penalty is borne by others.
“It’s as if the major banks have tapped a hole in the social till and they are drinking from it with a straw. In any given year, this practice may seem tolerable—didn’t the bank earn the money fair and square by a series of fairly normal looking trades? Yet over time this situation will corrode productivity, because what the banks do bears almost no resemblance to a process of getting capital into the hands of those who can make most efficient use of it. And it leads to periodic financial explosions. That, in short, is the real problem of income inequality we face today. It’s what causes the inequality at the very top of the earning pyramid that has dangerous implications for the economy as a whole.”
Cowen is not optimistic about the ability of regulators to control the behavior of the large financial institutions. In part because regulators are always fighting the last war, and in part because the issues and organizations are so complicated.
“For the time being, we need to accept the possibility that the financial sector has learned how to game the American (and UK-based) system of state capitalism. It’s no longer obvious that the system is stable at a macro level, and extreme income inequality at the top has been one result of that imbalance. Income inequality is a symptom, however, rather than a cause of the real problem. The root cause of income inequality, viewed in the most general terms, is extreme human ingenuity, albeit of a perverse kind. That is why it is so hard to control.”
Lest we forget Cowen’s gloomy conclusion, it will be repeated here.
“Is the overall picture a shame? Yes. Is it distorting resource distribution and productivity in the meantime? Yes. Will it again bring our economy to its knees? Probably. Maybe that’s simply the price of modern society. Income inequality will likely continue to rise and we will search in vain for the appropriate political remedies for our underlying problems.”

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