Sunday, January 20, 2013

How much value does the finance industry create?



That is the question asked by John Cochrane in this recent draft essay (non-PDF version here), in response to a recent Journal of Economic Perspectives article by Robin Greenwood and David Scharfstein. Both should be required reading for any introductory finance class. There is so much in these essays that one blog post couldn't hope to adequately cover the topic, so don't expect this to be anything resembling a complete response.

Everyone knows that the finance industry has grown in America. In 1980, finance took home about 5% of all the income in America; in 2007, about 8%. This has led many people to question whether all this activity is worth what we pay for it; in other words, how much of the increase in finance-industry GDP is actually value added, and how much is "rent" extracted from the rest of the economy?

Cochrane makes the excellent point that the question of "How much value does industry X really create?" is always an incredibly difficult question to answer:
I don’t claim to estimate the socially-optimal “size of finance” at 8.267% of GDP, so there...After all, if a bunch of academics could sit around our offices and decide which industries were “too big,” which ones were “too small,” and close our papers with “policy recommendations” to remedy the matter, central planning would have worked.  A little...modesty suggests we focus on documenting the distortions, not pronouncing on optimal industry sizes.  Documenting distortions has also been, historically, far more productive than pronouncing on the optimal size of industries, optimal compensation of executives, “global imbalances,” “savings gluts,” “excessive consumption,” or other outcomes. 
Cochrane also describes how we should go about documenting the distortions:
We start with the first welfare theorem: loosely, supply, demand and competition lead to socially beneficial arrangements.  Yet the world around often doesn’t obviously conform to simple supply and demand arguments...First, maybe there is something about the situation we don’t understand. Durable institutions and arrangements, despite competition and lack of government interference, sometimes take us years to understand. Second, maybe there is a “market failure,” an externality, public good, natural monopoly, asymmetric information, or missing market, that explains our puzzle. Third, we often discover a “government failure,” that the puzzling aspect of our world is an unintended consequence of law or regulation. The regulators got captured, the market innovated around a regulation, or legal restrictions stop supply and demand from working. 
This list applies to almost any policy question in all of economics. Sometimes, policy fails. Sometimes, the market fails. And sometimes things are working better than we realize, with our limited data and models.

In casual discussions of finance in the media and blogs, we've heard all of these ideas before. The idea that finance is excessively large due to collusion with the government (policy failure) is probably the most prominent - this is the idea that big banks have the government in their pocket, allowing them to dump their risk onto the taxpayer (through bailouts) while keeping their gains for themselves. Market failure - "How does making 10 billion trades a minute benefit anyone?" - is also something you hear about. And of course, there is always the question of "If large parts of finance are valueless, why would people, especially rich people who are probably pretty savvy, pay for these things? Maybe value is being created and we just don't understand it."

It's important to belabor this last point. Economists know some things, maybe a lot of things, but this is absolutely dwarfed by the size of the things we don't know and don't understand. If this blog has had one "unifying theme," it would be the depth of our ignorance. So when economists urge caution in using policy to change large sectors of the economy, this doesn't necessarily mean "We know that the free market is always perfect and good and that policy can't help." (That is something that ideological libertarians often say, and I think it's extremely unhelpful for the econ profession when they say it.)

Instead, caution about policy is very similar to doctors' maxim of "first, do no harm." As a doctor, you wouldn't say "I can't figure out how this organ is helping the body function, so let's just take it out." Similarly, it would be foolish to say "I don't see how this finance industry is adding value, so let's regulate the heck out of it." We start with the presumption that things are there for a reason - in biology, because evolution put them there, and in economics, because...evolution put them there.

Of course, if the organ explodes and threatens the rest of the body, then you take it out. And when an industry explodes, like the finance industry did, you use policy to manage the damage. And if you can, you figure out why this organ, or this industry, tends to explode, and you figure out if there are ways you can prevent an explosion, or see it coming, without creating nasty side effects.

But the question of whether finance is unstable and tends to explode (and how to deal with that) is very different from the question of whether its compensation is equal to its value added. People should understand that difference!

Anyway, on to the meat of the issue. Again, there's way too much for one blog post, so I'll just add a few thoughts of my own. Really, you should go and read both. Twice.

In their JEP article, Greenwood and Scharfstein chart the well-known growth of the finance industry in America. They identify which areas of finance have grown. Basically, the big growth areas were 1) asset management, and 2) housing-related finance. Asset management grew because a lot of assets went up a lot in value (think of the stock boom in the 1990s), and asset managers continued to charge the same fees as before. When assets do better, the same percentage fee gets you a lot more money, so this caused the finance sector to grow. As for housing-related finance, this has been much-discussed in the media; it includes shadow banking and the entire apparatus that was developed to handle trading of mortgage-backed assets.

Greenwood & Scharfstein also briefly discuss ways that these expanded activities might cost more than their value-added. Cochrane's essay, on the other hand, is all about this question. Cochrane basically runs down the full list of finance-sector activities whose value has been called into question, and discusses the ways that each activity might add value. Handing your money to an asset manager and paying a proportional fee, for example, may be highly preferable to doing your own asset-picking, which research shows to be a losing game. Here's Cochrane:
Individual investors, many of whom actively manage their portfolios and whose decisions in doing so are the stuff [of] many behavioral biases, may be doing a lot better with 1% active management fee than actively managing on their own. As a matter of fact, individual investors are moving from active funds to passive funds, and fees in each fund are declining. Many of their fee advisers are bundling more and more services, such as tax and estate planning, which easily justify fees. At least naiveté is declining over time. 
Quite true. And I think Cochrane leaves out another possible function of money managers - the "money doctors" idea being promulgated by Andrei Schleifer. This is the idea that even if people are willing to take risks in exchange for returns, they have emotional fear of actually pulling the trigger and investing in long-term, high-return assets like stocks. Asset managers, by holding rich people's hands and appearing very professional and knowledgeable, calm this fear, much as doctors make people less afraid of taking pills. Even a money manager whose fees exceed his "alpha" may be creating value for society by overcoming human anxiety and stopping rich people's capital from sitting trapped in big stacks of gold bars in their basements. Voila - value creation.

Then again, I think Cochrane also leaves out a reason for concern. We know people are bad at picking stocks, in large part because they trade too much. What if people are bad at picking asset managers for exactly the same reason? If individual investors (or institutional investors like pension fund managers) act like "funds of funds", might they not switch their money rapidly from hedge fund to hedge fund, chasing recent performance, much like day traders ineptly picking stocks? This sort of "higher-level over-trading" could be very costly and bad for markets - after all, haven't we all heard the horror stories of hedge funds who saw a big opportunity coming, but had to close out their position and take a loss because their investors backed out too soon? That sort of thing could create large costs for asset managers, who are then forced to pass on those costs to investors via higher fees. Voila - value destruction.

As for the heavy trading we observe in financial markets, it seems to be necessary in order to incorporate information into the prices of financial assets. Of course, it could create problems as well. Cochrane sums up the dilemma very nicely:
I conclude that information trading...sits at the conflict of two externalities / public goods. On the one hand...“price impact” means that traders are not able to appropriate the full value of the information they bring, so there can be too few resources devoted to information production (and digestion, which strikes me as far more important). On the other hand, as Greenwood and Scharfstein point out, information is a non-rival good, and its exploitation in financial markets is a tournament (first to use it gets all the benefit) so the theorem that profits you make equal the social benefit of its production is false. It is indeed a waste of resources to bring information to the market a few minutes early, when that information will be revealed for free a few minutes later.  Whether we have “too much” trading, too many resources devoted to finding information that somebody already has in will be revealed in a few minutes, or “too little” trading, markets where prices go for long times not reflecting important information, as many argued during the financial crisis, seems like a topic which neither theory nor empirical work has answered with any sort of clarity.
Exactly.

Cochrane goes on to discuss "information trading" in great detail, and I encourage you to read everything else he has to say on the topic.

One related area of research that Cochrane doesn't mention, by the way, concerns the question of excess volatility, as famously discovered by Robert Shiller and demonstrated repeatedly since then. Even an asset market that is "efficient" in the academic-finance-prof sense of the word - i.e., unpredictable - may still swing more wildly than the real value of the assets. This can happen if people trade based on "noise" - if they believe that false information is actually true. A lot of the "information trading" people do may actually just serve to incorporate false information, rumors, and noise into the prices. That's clearly not a value-adding activity, and it does incur trading costs. This could be closely related to the tendency of investors to over-trade, but at an aggregate level instead of an individual level. If there's something coordinating the "noise traders" - some sort of fad or mass sentiment or herd behavior - then the same force that causes people to switch their stock holdings too often might cause markets to gyrate, racking up trading costs but destroying value. This is a separate issue from the issue of "tournaments", and also one that needs to be answered quantitatively (again, easier said than done!).

Cochrane also discusses the "shadow banking system" that was set up to do housing finance in the 2000s. I won't go over all that, but you should read it. I would, however, like to highlight this interesting point:

In any case, following the 2007-2008 financial crisis, and perhaps more importantly the collapse of short-term interest rates to zero and the innovation that bank reserves pay interest, this form of “shadow banking” has essentially ceased to exist. RIP.   
To drive home this point (and to complain about any analysis of the size of finance that stops in 2007), here are two graphs representing the size of the “shadow banking system,” culled from other papers. From Adrian and Ashcraft (2012, p. 24), the size of the securitized debt market... 
 
And from Gorton and Metrick (2012), a different slice of securitized debt markets:  


This highlights an interesting point that often gets lost in discussions like this: Value-destroying activities often get naturally eliminated over time. This is evolution at work.

There are other examples. For instance, in Liar's Poker, Michael Lewis describes his job as basically being the ripping off of fools. As a bond salesman for Salomon Brothers in the 80s, he basically had a rolodex full of fools, many of them in Europe. When a client wanted to rip off a fool, he would call up Salomon, and Michael Lewis would find a fool to take the bad end of the trade, earning middleman fees in the process. Or sometimes, Salomon traders themselves, doing "proprietary trades" with the firm's own portfolio, would do the ripping off. In any case, eventually the fools wised up, and Salomon collapsed and was bought out. That wasn't the end of "face-ripping," though, as the broker-dealer industry came to call the practice. If you believe Greg Smith, it was alive and well at Goldman Sachs in the 2000s. Note that it's perfectly legal to take a fool's money. Broker-dealers have no fiduciary duty to their clients when acting as middlemen. But it still seems like a value-destroying activity, and over time, a firm or industry that does it will lose its reputation and lose its clients. That is evolution in action.

The real questions here are, 1) how long will evolution take, 3) what will be the collateral damage when a value-destroying business dies out, and 3) can policy act faster than evolution, in a reliable manner, to curb value-destroying industries before nature curbs them?

In other words, the bar for policy intervention to curb value-destroying industries should be pretty high here. Eventually, swindlers, hucksters, and useless rentiers will be driven from the market. When we contemplate giving them a kick to speed them on their way out, not only must we ask ourselves "Is this activity value-creating?", but also "Can policy improve the situation fast enough, and safely enough, to justify the possibility that policy might make a mistake?" Just as in medicine, many treatments may not be wort the risk, even if they are effective.

Anyway, this is getting long, and I've barely even scratched the surface of the relevant issues. You can spend your entire life thinking about these issues, and barely even scratch the surface (though you may add lots of value to society!). If you are interested in the question of whether finance is worth it, go read Greenwood & Scharfstein, and go read Cochrane. But don't expect to come away satisfied that you know the answers! As in many areas of human endeavor, the size of our understanding is dwarfed by the size of our ignorance.

120 comments:

  1. John S1:18 PM

    "We know that the free market is always perfect and good and that policy can't help." (That is something that ideological libertarians often say, and I think it's extremely unhelpful for the econ profession when they say it.)

    Alright. But prominent economists say all kinds of things that are *factually wrong* (or at best highly misleading) and get away with it all the time.

    Exhibit 1, Krugman: "Under the gold standard America had no major financial panics other than in 1873, 1884, 1890, 1893, 1907, 1930, 1931, 1932, and 1933," Krugman wrote. "Oh, wait."

    http://www.huffingtonpost.com/2012/08/27/paul-krugman-gold-standard_n_1832767.html

    I don't support a centrally managed gold standard. But citing the 19th century US banking panics as evidence against a gold standard is completely misleading b/c a strong case can be made that it was the flawed govt regulations of the banking system that was to blame.

    What flaws? (1) The ban on branch banking (which made the system weak and fragile); and (2) the requirement that "national banks had to purchase $100 (face value) in government bonds, to be deposited for safekeeping with the federal comptroller of the currency" "for every $90 of notes they issued" (Selgin, p. 3)

    http://www.cato.org/sites/cato.org/files/pubs/pdf/pa060.pdf

    The National Bank Act of 1863 wasn't implemented on ground of "economic efficiency"; quite obviously, it was a convenient way to create a forced market for federal debt to help finance the war. But does Krugman even hint at this? No. Do most monetary economists even know this history? If they do, they never mention it.

    W/o honest dialog on the path dependency that influences the current system we have, I don't see how we can ever have a productive debate.

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    1. I think PK's point is that the gold standard did not prevent panics, irrespective of their causes.

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  2. "If this blog has had one "unifying theme," it would be the depth of our ignorance."

    Really? The Fatal Conceit has been the "unifying theme" of your blog? For some reason I doubt that.

    "The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design." - Hayek

    "This highlights an interesting point that often gets lost in discussions like this: Value-destroying activities often get naturally eliminated over time. This is evolution at work."

    This evolution can't occur without consumer choice...

    "The government should not help to save Chrysler, of course not. This is a private enterprise system. It's often described as a profit system but that's a misleading label. It's a profit and loss system. And the loss part is even more important than the profit because it's what gets rid of badly managed, poorly operated companies. When Chrysler loses money…it's got to do something. When Amtrak loses money it goes to congress and gets a bigger appropriation. […] It's the stockholders of Exxon who ultimately are buying it. If they don't like what Exxon is doing with their money, they have a perfectly good alternative…they can sell the stock. And as the stock went down, if the stockholders didn't like it, they would pay somebody to change the policy which Exxon is following. We have a far greater degree of control over what Exxon does than we have over what a lot of our government corporations do." - Milton Friedman

    If we want this essential evolution to occur in the public sector then we need taxpayer sovereignty...

    "Each taxpayer could be contributing to a community which would become more reflective of the kind of world in which he or she would like to live. Gaudeat Emptor!" - Daniel J. Brown The Case For Tax-Target Plans

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    1. ""This highlights an interesting point that often gets lost in discussions like this: Value-destroying activities often get naturally eliminated over time. This is evolution at work."

      This evolution can't occur without consumer choice..."

      Of course it can - and it often does. Inside every single firm and organisation.

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  3. Noah --

    I appreciate you highlighting these two papers; I will try my best to read them this evening. However, to your last point on financial survival of the fittest: doesn't that idea fall apart with TBTF? Salomon didn't fall apart simply because they ran out of fools -- it's because they were foolish themselves, betting in markets that were becoming increasingly crowded. Those crowded markets still exist, but the losing participants operate under the protection of a financial license to kill...

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    1. However, to your last point on financial survival of the fittest: doesn't that idea fall apart with TBTF?

      Yes...for quite a while. Eventually the costs to supporting the crappy banks will become too big for the govt. to bear and they'll all go down together...

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    2. Redwood Rhiadra2:13 PM

      The government would be going down with the banks (I'm pretty sure that's what you mean by "they'll all go down together). There's a term for this - it's called "failed state", and having the U.S. become a failed state is *unacceptable*.

      Which means that we as a society cannot *afford* to simply let financial survival of the fittest weed out the non-useful institutions. We HAVE to be more proactive than that.

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  4. But the question of whether finance is unstable and tends to explode (and how to deal with that) is very different from the question of whether its compensation is equal to its value added.

    No, with respect, those appear to be related questions. One of the fundamental problems in finance appears to be asymmetric bets (heads I win, tails you lose): the banker gets a huge pay day if a gamble pays off and the client, or government, picks up the loss if the gamble fails. A financial system which is regularly exploding and destroying value may not be economically entitled to any compensation.

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    1. A financial system which is regularly exploding and destroying value may not be economically entitled to any compensation.

      Sure! I didn't say the questions were unrelated, I said they were very different questions. Which they are.

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    2. Anonymous11:41 AM

      Noah, you're being a little disingenuous here. If the financial system creates negative value, but gets positive compensation, then we know the answer to the "question of whether its compensation is equal to its value added."

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    3. Noah, you're being a little disingenuous here. If the financial system creates negative value, but gets positive compensation, then we know the answer to the "question of whether its compensation is equal to its value added."

      Of course that's true. But it is far from obvious that the finance sector, in total, creates negative value. Without a finance sector, our economy would crash and burn and die. So some positive value is being created.

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    4. Anonymous9:28 PM

      Absalon repeats an oft-stated but not really correct view on asymmetric bets - "One of the fundamental problems in finance appears to be asymmetric bets (heads I win, tails you lose): the banker gets a huge pay day if a gamble pays off and the client, or government, picks up the loss if the gamble fail." That's not really been true. Creditors have been protected - not only depositors who are FDIC insured, but all sorts of other creditors (bondholders, derivatives counterparties) who in theory should have been exposed to loss.

      Shareholders of failed firms - Lehman, Bear Stearns, AIG, etc. - really took it on the chin, however. As for all the arguments about cash vs. stock compensation, the aggregate employee ownership of stock at Lehman and Bear Stearns was about 25% and 30%, respectively. In other words, employees of each of those firms lost billions collectively, and individual senior managers lost tens or hundreds of millions. I think that the issue of aggressive, risk-taking traders is actually more complicated because of this problem. Just paying traders in restricted stock isn't going to change anything if the culture is still one of aggressive risk-taking or if there's a lack of understanding about how risky certain moves are.

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  5. It's important to ask these questions with a good degree of precision:

    "How much value does the finance industry create?"

    vs.

    "Would the finance industry create about the same amount of total value to society, or more, including everything -- like their power to pervert government with their monumental money -- if their astronomical incomes were a fraction as much through taxation, regulation, and/or other means (like a mere $10 million/year, instead of $100 million, or $10 billion per year -- I know there's such a tiny incentive to work hard for just $10 million, or even, gasp, a single million or hundreds of thousands, even if that put you in the same income position as before, the same prestige ranking)?"

    Or

    "Clearly a good finance industry gives society far more net-utility than none at all, but if we changed aspect X about our finance industry, would it create far more net value?"

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    1. Note the reference to positional externalities, the pink elephant of economics.

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    2. Yeah, if all you can make is $10 million/year, or, horrors, hundreds of thousands, you might as well go "on the dole" and live off of food stamp Top Ramen with your family in a hole in the ghetto -- until you reach your lifetime limits, and the children go into foster care and you get the good life of homelessness.

      And, of course, believe me, if $500,000 were just as high a percentile in income as $5 million was before, or even $100 million, people would still salivate over it about as much. See the literature on economics' pink elephant, positional externalities, or this post:

      http://richardhserlin.blogspot.com/2012/02/to-john-cochrane-re-positional.html

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  6. Noah, brilliant piece. I will read the linked pieces too.

    However I would pick Cochrane up on one point. The shadow banking system has not "essentially ceased to exist" - it is alive and well. In fact at $67tn globally it's bigger than ever, though the US share of that has fallen. It just doesn't use MBS as collateral any more, because they are no longer perceived as "safe". It uses T-bills instead - of which there is a critical shortage. What Cochrane's charts show is the death of private mortgage securitization, not the shadow banking system itself. Excess reserves and IOER do cause problems for the flow of funds in the shadow banking system but certainly not enough to kill it, as Cochrane suggests.

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    1. Interesting! How about the practice of banks keeping risks.off balance sheet and not counting these in determining their capital requirements?

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    2. That's more mixed, in some areas there has been a decline as bailouts etc. have involved serious examination of some banks. However, many other banks have escaped that level of scrutiny and there's no evidence that they have pulled the risks on balance sheet.

      (If they had pulled the risks on balance sheet, it would show up in changes in the profile of the capital requirements - not much sign of that overall outside already investigated banks.)

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  7. One possible reason for the expansion of finance is the movement of business and investment from private ownership to ownership through public markets. Companies like MacDonalds, Walmart and Staples have replaced millions of Mom and Pop businesses. Well to do businessmen might have invested in an apartment building thirty years ago - now they might buy units in a REIT.

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  8. Robert J. Shiller (Case-Shiller fame) has written a book about that - 'Finance and the good society'.

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  9. Anonymous3:23 PM

    Noah:

    Does any of this shed some light on creating a Tobin tax, a financial transactions tax, that cuts down on "noise" trading? I tend to favor such a tax-your thoughts?

    Also, one does have to wonder if the age of pension funds managing a good half of American assets (post World War II) was a better way, in terms of transaction costs and directing savings to investment opportunities, than the anarchy and hucksterism of CNBC we have today in modern finance/investment...

    Frank

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    1. Does any of this shed some light on creating a Tobin tax, a financial transactions tax, that cuts down on "noise" trading? I tend to favor such a tax-your thoughts?

      Not this, no, but there is plenty of research on the subject. I favor a flat dollar Tobin tax, say, $1 per trade.

      Also, one does have to wonder if the age of pension funds managing a good half of American assets (post World War II) was a better way, in terms of transaction costs and directing savings to investment opportunities, than the anarchy and hucksterism of CNBC we have today in modern finance/investment...

      Yeah, I'm just not sure...

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    2. Doesn't that distort the market in favor of large traders over small? I'm curious what purpose you see such a tax having; if the point is to cut down on speculation and limit its effects on prices you definitely want to tax a billion dollar trade more than a million dollar trade.

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  10. Anonymous3:33 PM

    Noah, great piece

    AS your further develop your thinking, it seems to me you might one to consider questions raised by the following:

    1. The connection between size the acquisition of information with value. As a rule, the more certain information is the more valuable it becomes. An aspect of scale/efficiency appears to be that larger financial firms have access to more certain information, due to their size. I.e., what one is seeing is increasing returns to scale.

    2. You write that, "Handing your money to an asset manager and paying a proportional fee, for example, may be highly preferable to doing your own asset-picking, which research shows to be a losing game."

    This begs the question, why is picking assets on one's own a losing game? Having worked 35 years around the securities business, I would argue that such has happened because our regulation of securities and public firms has wholly failed (example today, Dell). This failure means that someone is going to make fees not earned (Dell, again, is a great example)

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  11. If the job of the financial sector is to allocate capital, shouldn't the rise in the assets of the financial sector show up as increased performance of the real world economy? Certainly not the case in the EU. See OECD Insights at: http://oecdinsights.org/2012/08/29/is-the-financial-sector-worth-what-we-pay-it/ for more discussion.

    From the article: "A basic capitalist tenet is that the market represents the most efficient way to allocate capital. How well is it working?

    We are rapidly evolving a fast-moving, increasingly cybernetically interlinked capital marketplace that, as Lord May observes in the Santa Fe Institute Journal, has become intertwined in ever-more complex interdependent patterns. He goes on to ask how much are we, societally, paying the financial sector to allocate capital? More importantly, is the sector allocating capital to further societal goals, or merely enriching itself and a narrow segment of the world’s population? Human nature is powerful. John Stuart Mills said, in Social Freedom: “Men do not merely desire to be rich, but richer than other men”.

    Benjamin Friedman holds, in The Moral Consequences of Economic Growth, that “greater opportunity, tolerance of diversity, social mobility, commitment to fairness and dedication to democracy” derive directly from economic growth. He shows that even during stagnation–let alone recession and depression–those values can vanish easily. Brad Delong observes, in reviewing Friedman, that if the majority of the people do not see an improving future, these values are at risk even in countries where absolute material prosperity remains high."

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    1. If the job of the financial sector is to allocate capital, shouldn't the rise in the assets of the financial sector show up as increased performance of the real world economy?

      YES!

      I was going to discuss this in the post but it was getting too long.

      Now, it's nearly impossible to verify finance's contribution to non-finance GDP, or total factor productivity (which is where it should really show up). But comparing the UK (an economy that underwent heavy financialization) to Japan (an economy that underwent almost no financialization), I notice that the UK outperformed Japan by quite a lot over the last two decades, and even since the crisis, in terms of TFP and per-capita GDP growth. It certainly seems possible to me that financialization helped the UK, relative to Japan. Anecdotally, Japan suffers from unproductive industries galore, which might benefit heavily from the kind of creative destruction wreaked by leveraged buyout firms on U.S. companies in the 80s (though inequality and/or insecurity might increase too). Also, Japanese consumption is anemic, in part because savings have a very low real yield; a liberalized financial system might change that, and help end their deflationary trap.

      But this is no proof, and not even really evidence; it's just a conjecture. The point is that we can't infer from slow growth that financialization isn't helping; we've got to have a benchmark.

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    2. If the job of the financial sector is to allocate capital, shouldn't the rise in the assets of the financial sector show up as increased performance of the real world economy?

      But part of the rise might be very difficult to measure. For example, what if improved markets simply led to everyone living in bigger houses. You could measure the economic impact of building the bigger houses, but measuring the benefit of living in bigger houses would be difficult. Another problem could be the law of diminishing returns - that the increase in financial assets is, on average, invested in much less productive investments than the first investments that were made.

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    3. I think a good place to start might be to look at international capital inflow and outflow, such as in the Scandinavian banking crisis, what with all those trillions of dollars sloshing around offshore and elsewhere. It would seem that the capital is not being invested in capital producing businesses overseas, but rentier speculation on overseas based financial instruments and attempts at arbitrage of relative performance of such instruments. (such as the stupid German bankers who believed the AAA ratings as described in Michael Lewis, "The Big Short".

      How much of the rise of the financial sector was caused by capital investment, and how much by derivatives being used to reify and sell risk by trying to spin VARs into gold, such as the whole sub-prime fiasco?


      Or, maybe Stiglitz, Sen and Fitoussi are right, and we need something other than GDP as a measure, but that's a whole other debate. See their "Report by the Commission on the Measurement of Economic Performance and Social Progress" at http://www.stiglitz-sen-fitoussi.fr/documents/rapport_anglais.pdf

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    4. Anonymous7:58 PM

      Noah

      A few days ago we exchanged comments about the mafia in Japan

      Crime is clearly non-productive, begging the question, in an economic sense, what is crime and are we witnessing "economic crime"

      Delete
    5. Crime is clearly non-productive, begging the question, in an economic sense, what is crime and are we witnessing "economic crime"

      Probably quite a bit more than has been made public, I'll bet...

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  12. Another place to look would be where the increase in values show up on income distribution. Looks like the 1% again,especially when one sees how much of their earnings depend on financial instruments.

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  13. Anonymous7:58 PM

    I don't understand why there's so much discussion over this question. It's obvious that the financial services industry doesn't *create value*.

    A rather big clue is in the name; It provides "financial services" - i.e. does things to / with money - for a fee. That money has to actually *be created* somewhere in the first place (usually by processing of raw materials into goods, or by creating non-physical saleable things like art, music etc...etc...).

    It is really frustrating just how many people have become employed in rent-seeking (i.e. non-value creating) activities nowadays. And not just in the obvious places like banks & debt management firms; All these insurance comparison sites are also rent-seekers, as are recruitment agencies.

    *They* are strangling the economy. These industries are putting time and effort into grabbing as much of a finite pie as they can. What should be happening instead is those people should be out in value creating companies, increasing the size of the overall pie.

    Therefore, saying that the FS industry "is crucial because it accounts for x% of the economy" is a fallacy, because it is siphoning that percentage off from other industries, and inhibiting the ability of the rest of the economy to increase the size of the overall pie itself.

    All this for the profit of 1% at the expense of 99%. Its absolutely scandalous, and has been allowed to happen by government after successive government.

    ReplyDelete
  14. The missing question is "who benefits?". It's not as if increasing the size of the financial sector spreads more wealth around for all (and don't give me the bit about compensating losers - I'm too old to believe it). And one may also observe that parasitism and predation are perfectly good stable evolutionary strategies. Not weeded out at all.

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    1. Anonymous9:18 PM

      I wonder if the insight that the financial industry primarily tends to benefit the wealthy and not ordinary citizens isn't strong evidence that finance isn't actually increasing the real productive capacity of the nation. The reasoning being that the point of production is consumption, and if consumption isn't rising then it is highly unlikely that the financial industry is actually doing a good job of allocating capital to productive enterprises.

      Delete
  15. Anonymous11:57 PM

    "the bar for policy intervention to curb value-destroying industries should be pretty high here"

    here there be lousy equilibria. trust collapses.

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  16. Anonymous2:36 AM

    A few points.

    You say -
    "...it would be foolish to say "I don't see how this finance industry is adding value, so let's regulate the heck out of it." We start with the presumption that things are there for a reason - in biology, because evolution put them there, and in economics, because...evolution put them there."

    Well, this is not quite right. Money, by definition, is the construct of regulations. As is private property. As are almost all facets of 'free markets'. So regulating the heck out of something is essentially meaningless, and merely panders to a single ideology. What you mean to say is change the regulations that allow the market to operate the way it currently is, with regulations that allow markets to operate they way society deems appropriate.

    The above quote also brings an assumption to the table - there is a reason things exist. It sounds like you mean a good reason, when in fact the reason can be very bad. If you take this approach, anything that exists is good - war, crime and so forth. It must be made clear that things exits often for private gain at the expense of others, simply because they had the power to make it happen.

    Further, you note that "Eventually, swindlers, hucksters, and useless rentiers will be driven from the market." Which is an assumption, rather than an empirically derived rule of thumb. How long is eventually I don't know. And why isn't the current angst about the size of the financial industry a cooperative way of overcoming the rentier nature of the finance industry. By what method should the swindlers be removed? Rarely does the 'free market' cleanse itself. Usually it takes regulation and enforcement of standards.

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    1. I'm glad to see somebody point this out. It seems to me this assumption that "Eventually, swindlers, hucksters, and useless rentiers will be driven from the market." is the basis for Alan Greenspan's assumption that "the markets will regulate themselves, because rational businessmen must protect their reputations." I think this is an information asymmetry problem. Here in Thailand we have essentially two prostitution markets; one for the Thais and one for foreign tourists. The ladies who work in the market for foreign tourists may deliver poor work, because they know their customer base is an essentially infinite pool of people who have never been here before, are going to leave, and will never return. They don't have to worry about repeat customers. It seems to me the market for financial services may have some similarities.

      Delete
    2. Here in Thailand we have essentially two prostitution markets; one for the Thais and one for foreign tourists. The ladies who work in the market for foreign tourists may deliver poor work, because they know their customer base is an essentially infinite pool of people who have never been here before, are going to leave, and will never return.

      Actually, I think prostitution is very bad for men...it makes men quite inept at attracting women...Real men don't need money to buy sex...

      Delete
  17. "If large parts of finance are valueless, why would people, especially rich people who are probably pretty savvy, pay for these things?"

    Could it be that they *extract* value, rather than creating it?

    "This highlights an interesting point that often gets lost in discussions like this: Value-destroying activities often get naturally eliminated over time. This is evolution at work."

    After sucking large amounts of money out of the economy and imploding it. History suggests that the financial industry can create activities like this just as fast - if not faster - than they are destroyed.


    ReplyDelete
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    1. Could it be that they *extract* value, rather than creating it?

      But from whom? For them to extract value, someone has to pay them to do something that turns out to be worth less than the person paid for (a few moments of careful thought should verify that this is the case).

      Could a predatory finance sector keep tricking people forever and ever? Maybe it could...but each individual type of trickery would only have a limited shelf life, making it difficult if not impossible for regulation to keep up with the proliferating tricks.

      Delete
    2. Scams keep on coming back in various guises, but in the past few decades, they all seem to relate to excessive leverage, insider trading and saddling companies with debt, from which the scammer extracts huge fees. Overvaluation (facebook and the previous dot.com mania anyone?) and resultant fads are also part of the picture. Many companies were ruined in the 70's and 80's by the activities of Drexel Burnham Lambert and other takeover artists, most of whom, as with the essentially identical current private equity situation, have kept their ill gotten gains, mostly obtained only by their ability to leverage with low cost money, which of course, comes from the financial sector.

      This is a regulatory issue, but when the financial sector has largely captured the responsible agencies, it would be difficult to stop, but it is essential to do so.



      Delete
    3. Anonymous2:58 PM

      >But from whom? For them to extract value, someone has to pay >them to do something that turns out to be worth less than the >person paid for (a few moments of careful thought should >verify that this is the case).
      hedge fund buys company with large pension fund. Uses fund as collateral to borrow money to pay itself a dividend/management fee. Company goes broke. Pensioners get screwed. They never had any input into the transaction decision.

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    4. "But from whom? For them to extract value, someone has to pay them to do something that turns out to be worth less than the person paid for (a few moments of careful thought should verify that this is the case)."

      cf Goldman Sachs telephone calls to each other saying that they are "really fucking these mugs [their affectionate term for clients] over."

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    5. Exactly. Eventually the clients will either realize that Goldman (or broker-dealers in general) are not to be trusted, or the clients will lose all their money. The broker-dealers will move on to new fools, but eventually they'll run out of fools.

      Delete
    6. Not exactly, if you game the system right. The lack of regulatory control causes much of the collateral damage. In Anonymous 2:58 example, the pension fund money has effectively been transferred to the private equity players, and the burden shifted to the public. http://www.pbgc.gov/ A prime example of this is the Bain Capital $44 million bail out of its Kansas City steel mill investment.

      http://graphics.thomsonreuters.com/11/12/Kansas_City_Steel.pdf

      "What’s more, a federal government insurance agency had to pony up $44 million to bail out the company’s underfunded pension plan. nevertheless, Bain profited on the deal, receiving $12 million on its $8 million initial investment and at least $4.5 million in consulting fees."

      Essentially, if Bain had been held responsible for its contractual obligations to the pension holders, it looks like the federal bailout changed the venture from being a huge loss to a nice profit.

      As long as regulators allow this type of gaming of the system, it will go on, and different variations of the same theme will repeat. Junk bonds/private equity....private gains/public losses...same circus, different tent.

      Delete
    7. bjdubbs5:08 PM

      The same argument would apply to state lotteries, redistribution from the foolish to the more deserving. (If anybody has bothered to make the case for lotteries). (Last comment, promise).

      Delete
    8. Anonymous9:28 PM

      I think that the financiers would be extracting value from ordinary investors, through all of the sorts of fees they charge public companies. You would think that management of the publicly traded companies would wise up, but maybe they too are in on the graft. One example would be an IPO; an investment bank sets an IPO price so that it will experience a pop in the first day of trading, and then goes and sells all of the shares to the CEO's of important clients. In this way the investment bank pays kickbacks to executives of public companies for using shareholder money to pay the investment bank ridiculous fees for financial services.

      Delete
    9. Argosy Jones10:03 PM

      "eventually they'll run out of fools"

      'There's a sucker born every minute.' -Tyler Durden

      It could be that instead of evolution we're seeing a predator/prey population dynamic.

      Delete
    10. That's true, but it's a tricky thing to model how conventional wisdom about financial firms ("Goldman Sachs will just try to cheat you") is passed on to new generations even before they enter the market...

      Delete
  18. "stopping rich people's capital from sitting trapped in big stacks of gold bars in their basements. "

    Isn't this clearly a fallacious argument. If rich people kept their capital in gold bars in their basements, then the people who sold them the gold bars whould have capital to invest. There are big problems with gold (particularly that it is wasteful to invest in digging it up to then store it in basements - not to mention the envirnomental damage of extracting it), but that is not where the waste is.

    ReplyDelete
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    1. No, I think you're wrong about this. The people they buy the gold from will hold some of their wealth in gold, and so on. (It's similar to the calculations you do to find the amount of money created by fractional reserve banking in Econ 101.)

      Delete
    2. Maybe I've been reading too much MMT stuff, but I'm still not convinced. This still just seems like redistribution to me - (some people convincing the rich to waste some of the their purchasing power, so they can have it instead). It's not difficult to create more money if not enough money is circulating, using gold bars to flush it out is just another way.

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    3. No, the point is not that rich people keeping their money in gold lowers the amount of liquidity in the economy. That is a very different topic.

      Imagine Scenario A: U.S. households hold all their wealth in gold (with a bit in cash, for the purposes of liquidity).

      Now Scenario B: U.S. households hold all their wealth in stocks (with a bit in cash, for the purposes of liquidity).

      And in both these scenarios, foreigners don't exist (It's not difficult to add them in, btw). Also, in both these scenarios, corporate bonds don't exist (It's not difficult to add them in either).

      Now, realize that in Scenario A, companies can't raise money by selling stock. So corporate America crashes and dies for lack of funding. That is very very bad for the economy.

      In Scenario B, corporate America does not crash and die for lack of funding.

      Hence, Scenario B is a lot better than Scenario A.

      Now, yes, these are reductio ad absurdum scenarios. But they are meant to illustrate a general principle. Stocks represent investments in long-term, risky, high-return projects. If people misperceive the risks associated with those projects, the amount of investment in those projects will not be optimal.

      Does this make sense?

      Delete
    4. bjdubbs5:03 PM



      This a version of the Juncker fallacy.

      Delete
    5. bjdubbs5:05 PM

      Oder Junker.

      Delete
    6. This comment has been removed by the author.

      Delete
    7. Noah - I think you are here assuming that the total amount of financial wealth is fixed - so a given bit of wealth can be gold, or money or shares. But isn't that why there is a central bank? To ensure that the amount of money circulating is large enough. Your scenario only works if money is destroyed when people buy gold (i.e. they are buying it ultimately from the central bank). Why would the central bank sit around and allow that to happen?

      Delete
    8. Found this discussion on the Junker fallacy:

      http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/08/the-grain-of-truth-in-the-junker-fallacy.html

      Delete
    9. Noah - I think you are here assuming that the total amount of financial wealth is fixed - so a given bit of wealth can be gold, or money or shares.

      No, that's not true. In fact I'm explicitly assuming the opposite; when people hold more wealth in stocks and less in gold in my simplistic example model, the total amount of wealth is higher than when people hold more gold.

      But isn't that why there is a central bank? To ensure that the amount of money circulating is large enough. Your scenario only works if money is destroyed when people buy gold (i.e. they are buying it ultimately from the central bank). Why would the central bank sit around and allow that to happen?

      Hmm, maybe you are reading too much MMT...No, my scenario works without a central bank even existing. Think about it. Whenever you have the urge to say "X is entirely determined by the central bank", imagine a world with no central bank, and how that world would work. Then go add in a central bank and see if that changes your conclusions.

      In the real world, a central bank can certainly induce people to buy risky assets by printing money. That definitely works. BUT, if people have a behavioral impediment to risk-taking that prevents them from maximizing their utility, then no matter how much money the central bank prints, the amount of risky asset holdings will be sub-optimal, relative to people's true risk preferences.

      I could easily show you this with math. The problem with MMT people is that they insist on explaining and describing everything with no-math English sentences. This means that conversations with them generally devolve into huge reams of sloppy word-salad, in which all of the important assumptions are disguised and hidden.

      Delete
    10. OK Noah,
      to clear this - I have to have the answer to two questions:
      1. Where does the gold come from?
      2. Where does the money used to buy the gold go?

      I have a model in my head where rich people can either have money hidden under the mattress or gold in their cellars - and if they choose the latter their is chance that money that wasn't circulating will start circulating. You have a model in your head where rich people swap gold for shares - but who do they do the swap with? There is something missing here. If the gold is dug up and processed in their own country - I'm with you - producing gold is wasteful - I admit that. But if the gold is just changing hands - people are melting down grandmas gold rings - I'm not with you.

      If you introduce a foreign sector it becomes more complicated of course (then it could really be a question of buying gold as against buying investment goods). But you explicitly excluded a foreign sector. So I'm confused by your answer.

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    11. Where does the gold come from?

      Originally, it came from nuclear reactions in the heart of the Sun. Or so we think.

      Where does the money used to buy the gold go?

      Actually, the Universe does not know the difference between one dollar and another, much like electrons. It can count the number of dollars but not keep track of where the individual dollars go. Dollars are fermions.

      I have a model in my head where rich people can either have money hidden under the mattress or gold in their cellars - and if they choose the latter their is chance that money that wasn't circulating will start circulating.

      Well first of all, since your model doesn't include long-term risky projects, it doesn't have much of anything to do with the model I was talking about earlier. It has no hope of fruitful comparison with my model. Which is perfectly fine! Just realize that you're modeling something entirely different from what I'm modeling.

      You have a model in your head where rich people swap gold for shares - but who do they do the swap with? There is something missing here. If the gold is dug up and processed in their own country - I'm with you - producing gold is wasteful - I admit that. But if the gold is just changing hands - people are melting down grandmas gold rings - I'm not with you.

      Oh, in my model, there is a fixed amount of gold. No matter how willing people are to invest in stocks, the total amount of gold remains fixed (though its price changes). The important part of my model is how much resources get invested in long-term risky projects. My simplistic model was used to demonstrate the fact that behavioral impediments to risk-taking can lead to a sub-optimal amount of resources invested in long-term risky projects.

      This result is independent of the actions of a central bank.

      Delete
    12. Sigh - this is not getting very far is it. There being a fixed amount of gold makes it worse. SOMEBODY has to own the gold - so if it is not rich people owning it to store in the basement - who will it be? A central bank - a depository bank as reserve - a government? I'm seriously puzzled - endowment gold seems to me to be just a red herring - except for the effect caused by a wealth effect related to it's price that Nick Rowe pointed to. I still don't understand your point. I offered you a way out with imported gold - and a terms of trade effect, but you didn't take route. Are you saying that only rich people invest - and if rich people are keen on hoarding gold then no investment can be done? I thought the joint stock company solved that one.

      Delete
    13. Sigh - this is not getting very far is it. There being a fixed amount of gold makes it worse. SOMEBODY has to own the gold - so if it is not rich people owning it to store in the basement - who will it be? A central bank - a depository bank as reserve - a government? I'm seriously puzzled

      No, the rich people will still own it. In one scenario, that's all they own. In the other scenario, they own all of that gold plus stock as well; there is more total wealth to own, so they hold all that gold, plus stocks too.

      I offered you a way out with imported gold

      A way out of what...the crushing grip of your inability to understand my simple example? ;-)

      Delete
    14. OK OK, that was mean. Sorry.

      Instead of trying to harp on this example I was making (which is a perfectly good one, but we can go over that some other time), let me make my point a different way.

      Suppose there is some amount of risk that people would choose to take.

      However, suppose that some emotion prevents them from actually pulling the trigger and taking that risk, even though they'd be happier if they just went ahead and did it (imagine someone who would like to be in the pool but is too afraid of the cold to jump in).

      If this happens, the amount of risk taken by society as a whole will be sub-optimal.

      Of course, the government could just induce people to take more risk. But doing this would raise not just the level of risk actually taken, but also the desired level of risk. so the gap between desired and actual would still exist.

      And "money doctors" may help the situation by holding people's hand and helping them take the risks they want to take. In a way that an impersonal institution, including a central bank, government, etc., fundamentally cannot.

      Does this make sense?

      Delete
    15. Instead of talking about gold - let's talk about something similar - ranches in Arizona. It's desert - not much use to anyone (like gold), but the rich like riding their horses or motorbikes on big stretches of spectatular looking countryside. And it is endowment - fixed amount, nobody made it. Let them invest in ranches in Arizona instead of gold. Now do your conclusions change? If so why?

      Delete
    16. Sorry, I missed your reply - OK I sort of see what you are getting at, but I don't think that is actually what happens. I think what banks do is take money from risk averse people and give it to gamblers. The people are actually different people.

      Delete
    17. And in the current situation with both:
      a. Financial profits very high
      b. rates of return very low
      I don't understand how that matches with the story. Why aren't these profits being competed away? How can be people be happy taking risks for little return?

      Personally, I think financial enterprises de facto (if not necessarily on paper - but via leverage) OWN an increasing amount of th economy and are extracting rents from it.

      Delete
    18. Sorry, I missed your reply - OK I sort of see what you are getting at, but I don't think that is actually what happens. I think what banks do is take money from risk averse people and give it to gamblers. The people are actually different people.

      Well, the more risks the banks take, the more risky your bank deposits become...

      Delete
    19. And in the current situation with both:
      a. Financial profits very high
      b. rates of return very low
      I don't understand how that matches with the story. Why aren't these profits being competed away? How can be people be happy taking risks for little return?


      Rates of return are low historically, but not compared to "safe" assets like Treasuries. Finance companies make money on the spread.

      Delete
    20. "Finance companies make money on the spread."

      Yes - but why is the spread not competed away? And yes I agree the bank deposits become riskier - but they are insured - so now we come to the real point - or do we? And perhaps the risk is not so easy to measure or perceive as the risks would have been with direct investment. So it is not so much a case of sweet talking as pulling the wool over the eyes. If that is de-facto a good thing or not - I'm not sure, but it sure goes against the grain if you think transparency is a good thing.

      Delete
    21. Yes - but why is the spread not competed away?

      That's a good question.

      One possible reason is that finance companies are paid to gather information. Gathering costly information = being able to make money on a spread.

      For banks, the spread comes from liquidity transformation. This of course carries the risk of bank runs.

      Some finance companies just make a spread by finding a way to extract rents from markets, by guessing what people are going to do before they do it, and "winning the tournament".

      There are other ways too.

      Note that the question of "why is there a spread" is just as good a question when rates of return are very high overall as when they are low...

      And yes I agree the bank deposits become riskier - but they are insured

      Yes, but in exchange for deposit insurance (FDIC), banks agree to limit their risk-taking.

      Of course, you have shadow banks and quasi-banks, who have de facto insurance through implicit bailout guarantees and then take lots of risk, but that is a somewhat different issue...

      And perhaps the risk is not so easy to measure or perceive as the risks would have been with direct investment. So it is not so much a case of sweet talking as pulling the wool over the eyes. If that is de-facto a good thing or not - I'm not sure, but it sure goes against the grain if you think transparency is a good thing.

      Agreed. The flip side of the "money doctors" idea is that money managers - or banks! - might be bad money doctors, encouraging people to take too much risk, much like a doctor who over-prescribes treatments.

      Delete
  19. "This highlights an interesting point that often gets lost in discussions like this: Value-destroying activities often get naturally eliminated over time."

    Yes but isn't the problem the collateral damage. Once you realise adjustments aren't costless, it becomes clear that smoothing the process can have value. Isn't there a danger that the argument becomes like an argument against regulating speeds on roads - "well if you let them go as fast as they want, the idiots will kill themselves". Unfortunately they won't kill just themselves.

    ReplyDelete
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    1. Yes but isn't the problem the collateral damage. Once you realise adjustments aren't costless, it becomes clear that smoothing the process can have value.

      Of course. That's part of the cost of the value-destroying activities.

      Delete
  20. A timely piece?
    http://www.spiegel.de/international/business/investment-banking-faces-massive-layoffs-and-identity-crisis-a-877710.html

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    1. Yes, I strongly suspect that the "investment banking" industry (which is a total BS name, it's really the broker-dealer-trader industry with a rump of investment banking to keep up appearances) had much too high a percentage of value-destroying activities to survive in anything resembling its pre-crisis form. In particular, I bet that "face-ripping", or acting as middlemen for trades in which the middleman knew that one side of the trade was a bad deal, was the biggest source of profits for these institutions, and that just can't go on past a certain point. Also, "prop trading" at these institutions was basically a bank trying to be a hedge fund, and it's way too big to be a hedge fund.

      Delete
    2. sorry, no. layoffs are a result of Europe in recession and sticky wages. The broker dealers never die, they just move on to the hottest sector of the economy. Once the economy returns to growth you'll stop seeing layoffs and generally see a return of those activities. my prediction is that in late 2013 and 2014 you will see the "private label securities" market return in the US (because housing will be back in growth mode), along with the jumbo mortgage market. You will see lots of stories about how "we're smarter about risk" and we "built out our risk management" and "we price the risk better."

      the trouble with the "evolutionary" theory of value-destroying activities being killed by a recession is that its just another flavor of Schumpeter, which has proven to be wrong over time.

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    3. it iS ALIVE!!!!

      http://www.reuters.com/article/2013/01/22/us-markets-forex-quants-idUSBRE90L0F220130122

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    4. The broker dealers never die, they just move on to the hottest sector of the economy. Once the economy returns to growth you'll stop seeing layoffs and generally see a return of those activities. my prediction is that in late 2013 and 2014 you will see the "private label securities" market return in the US (because housing will be back in growth mode), along with the jumbo mortgage market. You will see lots of stories about how "we're smarter about risk" and we "built out our risk management" and "we price the risk better."

      I'm not sure about this. If pension funds and insurance companies realize that broker-dealers rip their faces off, we could see the permanent winnowing of the entire broker-dealer industry. In fact my guess is that a lot of this is already happening. You will see those things you're talking about come back a bit, but my guess is that the heyday of the broker-dealers is over (at least, for the next few decades, til we all die and new fools are born).

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    5. "If pension funds and insurance companies realize that broker-dealers rip their faces off, we could see the permanent winnowing of the entire broker-dealer industry."

      Since my first job out of graduate school i've had to analyze lots of Goldman Sachs deals. First rule: Everyone knows they are trying to rip you off, its a question of how (much). Nobody is naive (they have their "big boy pants" on). Most people use poker analogies, and if you dont know who the sucker is its you.

      Second rule, you might do the deal anyway. I ate at Five Guys yesterday even though I know its bad for me. That's because CFOs have other objective functions. Refinancing debt or swapping it out is generally a negative NPV deal (because of fees and the bid ask). So why do you do the deal? Current year earnings; tax benefits; help the "relationship" (so they send you 102 page decks with market information or "competitive analysis" insight). And when the trade goes "awry," too far out of the money for comfort, Goldman will be there to help you terminate it too... for a fee of course (
      also a negative NPV transaction). 50% of all derivatives trades end up out of the money, for somebody. huh.

      Having your face ripped off is a cost of doing business, because a broker dealer is ultimately a source of information and advice. Don't believe everything you read about "innocent" pension managers. Do you really expect to hear a pension manager say "oh yeah that was my fault I should have known?" haha. Anyone who says "i dint know" is hiding behind highly paid attorneys, whose job is to build the best case they can to obtain as much money as they can in a settlement.

      Like I said, this is a highly cyclical industry with lending a function of investment. It will rebound with the economy.

      Delete
    6. and actually if you look at the statistics on ABS and CDO issuance, you'll see that CDO issuance is up 10x since 2009 and auto and equipment ABS issuance is going strong. Credit card and home equity issuance is down from 2005 levels... but not zero. Auto and equipment ABS are solid because those sectors of the economy are strong. Credit card ABS is not back to 2007 levels, but has doubled in the last year. Once we get a few solid years of home price gains and normal unemployment, expect home equity and credit card ABS to rebound as well. I would not be shocked to see credit card ABS issuance up 50% again in 2013 from 2013, back to 2007 levels before 2016.

      see structured finance section:
      http://www.sifma.org/research/statistics.aspx

      The non-agency RMBS and CMBS is the one to watch as the housing market rebounds ("private label", see "U.S. Mortgage-Related Securities Issuance").

      Delete
  21. "Eventually, swindlers, hucksters, and useless rentiers will be driven from the market. "

    I strongly doubt it. As long as there is a niche for astrologers and life coaches, there will be a niche for hucksters and swindlers. As long as there are rules, there will be people looking for loopholes to game them. After Amaranth lost 5 Bn on natural gas futures, the founder started a new hedge fund (Verition Fund Management LLC) and is back taking other peoples money...

    The only thing policy can really do is ensure that incentives are aligned and the market is not being manipulated. If I am making a big bet with other peoples money, they I should suffer consequences proportional to the loss if I am wrong. As long as trading and originating financial products is a heads-I-win-tails you-lose payoff, I will continue to make losing bets. But we will need a tyrannical UN world government for that, since a lot of this happens in foreign countries eager to attract "capital," beyond the reach of the USA.

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    Replies
    1. Good point. Also, too, John Corzine.

      Delete
  22. "Also, Japanese consumption is anemic, in part because savings have a very low real yield; "

    Huh? Savings gives a low return, so there is more of it? (I agree it is tricky here, because the low return means that to reach a long term target wealth, you need to save more.) But Japan has an old population. Won't substitution effects eventually outweigh income effects?

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    1. Huh? Savings gives a low return, so there is more of it? (I agree it is tricky here, because the low return means that to reach a long term target wealth, you need to save more.) But Japan has an old population. Won't substitution effects eventually outweigh income effects?

      You're right, and this may already be happening (Japanese household savings rate is down to zero). I was thinking more in the past...but maybe I'm wrong...

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  23. "If large parts of finance are valueless, why would people, especially rich people who are probably pretty savvy, pay for these things? Maybe value is being created and we just don't understand it." I know you're just quoting what someone might say, but it is worth remembering in this context that rich people are not rich because they are savvy. Some are no doubt, but as a rule the way to be rich is to have a rich father. I would suggest that ruthlessness has also more to do than savviness on the origins of wealth.

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    Replies
    1. In this case, the finance industry should facilitate intergenerational wealth mobility... ;-)

      Delete
    2. Anonymous9:41 PM

      It often does Noah. Most hedge funds, and especially those run by quants, are run by first or second generation immigrants. These people pocket vast fees while churning stocks that 2/3rd of the time end up below the index net of fees. Rich people pay them lots and lots of money for the privilege.
      The only real problem is that rich people arent the only ones investing in 'top tier talent' these days. You also see pension funds blindly rush off and hand of huge chunks of money to be destroyed. Someone like John Paulson has grown richer despite his incompetence after 2009 by destroying retirees savings.

      Delete
  24. Anonymous7:12 PM

    Considering that the mammoth amounts of insanely cheap liquidity injected by central banks like the Fed or BOJ directly into the too-big-to-fail banks' coffers are what has made finance into the beast it is today, you would think that might be, ya know, kinda important to mention if one were endeavoring to pass judgment on the industry. Combined with the never-ending bailouts (which did not begin with Bear), central banks have done everything possible to turn the markets into a casino.

    We all know that the too-big-to-fail banks have incredible lobbying power. The natural solution to this is, of course, to give government more power to--ahem--'regulate' their friends in the finance sector.


    Let me guess, you probably think that government spending creates economic growth as well.

    ReplyDelete
    Replies
    1. OK, what's your proposed solution?

      Delete
    2. Noah,
      I'm sometimes really tempted to ask why we have a private limited-liability credit creating banking sector at all. I understand the advantage of not having a monopoly controlling credit. But the idea (which has some advocates) of a government credit card for all citizens + all equity finance for bigger projects has a certain appeal. I wonder if we shouldn't really, really reconsider having a tax system that favours borrowing over equity as a system of raising finance.

      Delete
    3. By the way - it is potentially also possible to use equity to buy houses and land - the financer gets a nominal share of equity and you pay it a rent + purchase some of the equity at an agreed rate.

      Delete
    4. I wonder if we shouldn't really, really reconsider having a tax system that favours borrowing over equity as a system of raising finance.

      This is an incredibly deep question, and in my opinion one that researchers don't ask nearly enough. Debt and equity are not equivalent. We don't really understand all (or even many) of the ways in which they work differently. And we need to understand this.

      Not sure I like the "government monopoly on debt" idea. Seems like that's the ultimate too-big-to-fail lender.

      Delete
    5. I'm not sure I do either (for a different reason). But as regards the ultimate too-big-to-fail lender - that is the central bank anyway. This way just cuts out the middleman and his rents.

      Delete
    6. Anonymous9:44 PM

      Reason - I don't see how your proposed equity arrangement ("the financer gets a nominal share of equity and you pay it a rent + purchase some of the equity at an agreed rate") is really equity and not just debt using different terminology. The way that you describe it sounds a lot like debt - that's basically interest ("rent") plus principal repayment ("purchase some of the equity at an agreed rate"). The financier presumably needs some recourse if these amounts aren't paid - that's the only way the structure works - so in the end this structure is just debt by another name.

      Delete
    7. OK think what happens if the buyer can't pay.

      Now the financer no longer can foreclose - but what he can do is throw the "renter" who can't pay the rent out - or he can buy back some of his equity in place of the rent.

      Now do you see the difference?

      Delete
    8. Another way to think about it - is with a mortgage, ownership changes discretely. With this arrangement it changes proportionally. (The thrown out "renter" would recieve a share of the income when somebody else rents the place).

      Delete
  25. "[C}aution about policy is very similar to doctors' maxim of 'first, do no harm.'"

    It would be have been nice if the neo-liberals had thought of that back in the mid-70s, before real wages were flattened, unions were busted, and all our skill sets -- not just industrial -- were hollowed out, and the bloated FIRE sector started paying itself outlandish salaries, and bought the regulators and the government.

    Just saying.

    ReplyDelete
  26. Anonymous10:29 PM

    None.

    ReplyDelete
  27. Crispy Andy8:52 AM

    Interesting question, but indeed tough to answer...

    What are the opportunity costs of having thousands of physicists and mathematicians employed in finance programming algorithms to send billions of dollars around the globe in split seconds? Would the innovations they could have generated elsewhere have been more useful to society? Probably yes.

    What is the value of financial innovations that benefit those who hold e.g. stocks, but put the burden of bailouts for the financial system on everybody and especially the low-income, few-asset-holders via financial repression?

    ReplyDelete
    Replies
    1. What are the opportunity costs of having thousands of physicists and mathematicians employed in finance programming algorithms to send billions of dollars around the globe in split seconds? Would the innovations they could have generated elsewhere have been more useful to society? Probably yes.

      Could have? Sure. Would have? Hell no. Remember, I've seen physicists. The best physicists (Bob Laughlin, Lenny Susskind, Steve Chu, etc.). A lot of our finest physicists - brilliant people, no doubt - are working on string theory, supersymmetry, quantum cosmology, and other things that, even if they worked, would be totally useless in terms of human technology or improving human life, because these phenomena manifest themselves only over enormous distances or incredibly high energy scales. Even quantum field theory, which works incredibly well (much better than any econ theory will EVER work) has really only led to the creation of one useful technology, and that's the PET scan. OK, and on top of all that, supersymmetry doesn't even work, and string theory can't even be tested.

      So, never underestimate our society's capacity to find useless time-wasters to occupy our brightest minds.

      OK, about those high-frequency algorithms. Yes they are silly. But I'm seeing some research that says they might have major beneficial effects! In particular, high-frequency algorithmic trading seems to drive market manipulators out of the market - the robots drive out the cheating humans. That's very useful.

      What is the value of financial innovations that benefit those who hold e.g. stocks, but put the burden of bailouts for the financial system on everybody and especially the low-income, few-asset-holders via financial repression?

      None. BUT, think for a second. Realize these points:

      1. The bailouts made the U.S. a profit. They did not represent a loss.

      2. The bailouts were paid for mostly by rich taxpayers who own stocks.

      3. Much of the financial liberalization in recent years led to an expansion of the asset-holding class, basically by lowering interest rates so poor people could buy houses (this was an effect of financial engineering, not of government policy as many claim). But that didn't turn out incredibly well. We need ways to let poor people hold diversified portfolios of global equity and bonds for 30-year periods. I personally intend to work on making this a reality.

      Delete
    2. Anonymous10:06 AM

      Noah:

      I appreciate your interest in getting poor people to hold diversified portfolios of global assests.

      Wouldn't it be as simple as allowing people to invest in the TIPs, or mandating that individuals invest in funds (based upon their retirement date) within TIPS?

      I am not trying to bust your glory bro, but I think it may be that simple. I know Brad Delong proposed such a system (via a progressive income tax of some sort) during the Social Security reform debate of the mid-naughts...

      Frank

      Delete
    3. Crispy Andy6:47 PM

      I think your view on physicists is not that representative. :) Of course, there are the academic physicists and I confess I have no clue what they're talking about and how this will ever benefit manking. But I guess working instead in an investment bank was never a realistic alternative to them. If you think of physicists working at the interface with biology, engineering, aeronautics,..., to me the opportunity costs seem quite relevant.
      With regard to HFT: I don't want to disregard the economic research on it (with all its usual flaws we got used to...). But if I'm asking myself, what sort of investment I would prefer, then the answer would be: one that is based on calm economic analysis, one that believes to have detected mid- to long-term profit opportunities based on innovations, efforts, competitiveness,... That's why I'm maintaining my view that sending billions around the globe to profit from tiny, tiny arbitrage opportunities for nanoseconds isn't doing anything good except to the one with the best robot.

      "1. The bailouts made the U.S. a profit. They did not represent a loss."
      I dare to disagree. Unprofitable businesses have not been wiped out, the losses have been transfered to the public balance sheet, now the society as a whole suffers from debt overhang, public services have to be cut, the labor market is still dead. Doesn't seem like a good trade to me.

      "2. The bailouts were paid for mostly by rich taxpayers who own stocks."
      No. There was (mostly) no haircut. Stock markets have been re-flated and are back to old highs. The bill is paid by conservative savers whose real interest rates have been pressed below zero over the last few years. Life insurances today can't guarantee to preserve the value of the money invested into them.

      "We need ways to let poor people hold diversified portfolios of global equity and bonds for 30-year periods."

      I'm working in development, where people kind of try to do the same with agricultural insurances, etc. I mostly don't feel well about these intentions because it's about distorting the people's attitude towards risk. If things go wrong (and academic economic concepts do this sometimes), then there's a lot at stake for these people. Further, I believe that the view that poor people have a) the means and b) the competences to hold portfolios of this kind is quite acedemic already and pretty far from reality.

      Delete
    4. I dare to disagree. Unprofitable businesses have not been wiped out, the losses have been transfered to the public balance sheet, now the society as a whole suffers from debt overhang, public services have to be cut, the labor market is still dead. Doesn't seem like a good trade to me.

      I don't think so, check it out. The bailed out firms paid back the bailout money, plus interest.

      The financial crisis and the recession that followed it were very bad for America, but the bailouts themselves stopped the bleeding and ended up making a profit for the taxpayer.

      The only downside to the bailouts is the bad incentive...the moral hazard.

      The bill is paid by conservative savers whose real interest rates have been pressed below zero over the last few years.

      No, those conservative savers had already bought their bonds, and when interest rates fell, the price of those bonds went up!

      Delete
  28. Anonymous9:01 AM

    Have to echo Lambert Strether here, it's very misleading to inject "first do no harm" after the neoliberal wing of the economics profession has had 30 years of influence restructuring the economy and never once saying "first do no harm."

    Anyway, on to my main point: since economics does not have a coherent theory of value-destruction, it's really hard to respect this kind of analysis. Economists don't even have a workable definition of value-destruction apart from blowing stuff up with dynamite. Start there and we may get somewhere.

    ReplyDelete
    Replies
    1. Have to echo Lambert Strether here, it's very misleading to inject "first do no harm" after the neoliberal wing of the economics profession has had 30 years of influence restructuring the economy and never once saying "first do no harm."

      True, but this isn't a defense of the "neoliberal wing of the economics profession". Far from it. I'm not sure which economists and which policies fit in that wing, but I can definitely think of some that I think did a lot of harm.

      Anyway, on to my main point: since economics does not have a coherent theory of value-destruction, it's really hard to respect this kind of analysis. Economists don't even have a workable definition of value-destruction apart from blowing stuff up with dynamite. Start there and we may get somewhere.

      I also want better theories of value destruction, but this is a little unfair. In game theory there are plenty of examples where one player can act as a parasite, or trick another player, or wield asymmetric information such that markets shut down completely. The problem is that those examples are highly specific, highly stylized, and not easily applicable to the real world. But they're certainly coherent.

      Delete
    2. Anonymous11:41 AM

      I'm not sure I buy that I'm being unfair, because too many economists would argue that in aggregate, parasites or tricksters just move money around the economy - and don't actually destroy value at the system level. There's very little consensus around being able to define rent-seeking, for example. And we all know for economists, if it can't be defined and measured, it ceases to exist.

      Coherent doesn't mean "coherent with stylized rules I wrote" but "coherent with the broad set of theories in use" - and since economist have a lot of trouble with value, let alone value-destruction, I think there's a lot of groundwork to be done.

      Delete
    3. I'm not sure I buy that I'm being unfair, because too many economists would argue that in aggregate, parasites or tricksters just move money around the economy - and don't actually destroy value at the system level.

      There's not any proof to back up such arguments. And there are plenty of game-theory models where value gets destroyed.

      Delete
    4. Economists don't even have a workable definition of value-destruction apart from blowing stuff up with dynamite. Start there and we may get somewhere.

      What about Scroogenomics? If I bought that book for you, but it didn't even come close to matching your preferences, then value would have been destroyed. On the other hand, if it did closely match your preferences, then value would have been created.

      Real men don't need money to buy sex...

      Having served in the infantry...I can tell you with definite certainty...that buying sex matches the preferences of real men. Therefore, it creates value. Therefore, making prostitution illegal destroys value. And by prostitution I mean a completely consensual exchange between two adults.

      When I was extremely drunk in the infantry...and very aware that I was wearing beer goggles, I remember asking my buddies if a lady at the club truly matched my preferences. They would invariably say yes and then the next day I would wake up to discover that she really did not match my preferences. That situation sure matched the preferences of my buddies though. And it sure matched my preferences to put them in the same exact situation.

      How closely does what the government supply match our true preferences? If, as Joel Waldfogel has argued, only the people closest to us know our true preferences, then, given that most of us have never even met a congressperson, it stands to reason that the government is nothing more than "an orgy of wealth destruction."

      "The justification for assigning responsibility is thus the presumed effect of this practice on future action; it aims at teaching people what they ought to consider in comparable future situations…This does not mean that a man will always be assumed to be the best judge of his interests; it means merely that we can never be sure who knows them better than he…" - Hayek

      Delete
  29. Anonymous10:16 AM

    The link to the Robin Greenwood and David Scharfstein paper given in the post doesn't work.
    For anyone interested, what might be the paper can be downloaded here:

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2162179

    ReplyDelete
  30. Anonymous9:52 PM

    I was surprised not to see more discussion from Noah of regulatory and tax gaming as areas of finance that don't add value for society.

    These abound - lots of activities (in housing finance and elsewhere) were designed to create securities with a particular credit rating to meet regulatory mandates. The goal was, of course, to create the highest yielding security that would get that rating, not really to balance risk and reward. Similar regulatory gaming in shadow banking - essentially setting up "banks" not called banks and "deposits" not called deposits to get higher returns than available through related banks.

    In asset management, of course, there is also often a tax management aspect, especially at the high end of the market.

    ReplyDelete
  31. Anonymous11:35 PM

    "Where does the gold come from?

    Originally, it came from nuclear reactions in the heart of the Sun. Or so we think."

    Actually, from the first wave of supernovae. The gases they ejected, which contained heavy elements, eventually gave rise to solar systems with heavy elements. Assuming you mean our Sun by "the Sun" I cannot image a mechanism that would move heavy atoms from the Sun to the Earth.


    "If large parts of finance are valueless, why would people, especially rich people who are probably pretty savvy, pay for these things? Maybe value is being created and we just don't understand it."

    This kind of argument that drives non-economists, such as myself, crazy. I suppose it would be too radical to ask the people paying? (I rarely have trouble imagining possible reasons for almost anything, as long as I'm not required to actually test the idea against the real world.) It comes from being drunk on your own cool-aid (models).

    Another point: as far as I'm concerned, "face-ripping" is fraud. If it's not fraud under the law that's probably because the law has been corrupted by financial interests. I suspect that there is little that would drive this type of transaction out of the market faster than the sight of some of the people who profited serving prison terms.

    Cochrane and co. will of course argue that this would discourage potential efficiency-producing innovation. Yeah, right. Question: how much extra efficiency for how long will it take to make up for the harm done by the last set of supposedly efficiency-producing innovations? Which is how many trillion dollars in lost potential economic activity, and counting, not to mention prolonged unemployment exceeding that in the Great Depression. Etc., etc.. This is your idea of doing no harm?
    Also reference Paul Volker's famous comment that the only financial innovation he could think of that was unambiguously welfare-enhancing was the ATM.

    All things considered, I'm of the opinion that at this point financial innovation is guilty until proven innocent and should be regulated accordingly. "First do no harm" means "First be sure there won't be any more explosions."

    A final note on the subject: in my recollection of the real world, outside the medical context that slogan has been used mostly by right-wingers intent on low taxes for the wealthy at the expense of any action benefitting the non-wealthy. Having witnessed several decades of this I'm throughly sick of it.

    My apologies for the lack of coherence in this rant. I'm too upset to organize it coherently; besides, doing so would take more effort than I'm prepared to exert and probably more expertise than I possess. But you really need to address the question of the other side of no harm.

    ReplyDelete
    Replies
    1. Actually, from the first wave of supernovae. The gases they ejected, which contained heavy elements, eventually gave rise to solar systems with heavy elements. Assuming you mean our Sun by "the Sun" I cannot image a mechanism that would move heavy atoms from the Sun to the Earth.

      Ah, thanks for the tip.

      It comes from being drunk on your own cool-aid (models).

      Evolution - or, really, natural selection - isn't a model. It's a principle. We know that in this case, the selection pressure is "getting people to pay you for stuff".

      Another point: as far as I'm concerned, "face-ripping" is fraud. If it's not fraud under the law that's probably because the law has been corrupted by financial interests.

      Well, you appear to be correct:
      http://www.forbes.com/sites/johnwasik/2013/01/10/wall-street-winning-war-against-investor-protection/

      A final note on the subject: in my recollection of the real world, outside the medical context that slogan has been used mostly by right-wingers intent on low taxes for the wealthy at the expense of any action benefitting the non-wealthy. Having witnessed several decades of this I'm throughly sick of it.

      Well, I kind of disagree with that, but I'm open to being convinced otherwise by non-ranty thoughtfulness...

      My apologies for the lack of coherence in this rant. I'm too upset to organize it coherently; besides, doing so would take more effort than I'm prepared to exert and probably more expertise than I possess. But you really need to address the question of the other side of no harm.

      But the other side of "do no harm" is that sometimes regulation doesn't do harm, it does good!

      Delete
  32. Anonymous11:40 PM

    "Actually, from the first wave of supernovae. The gases they ejected, which contained heavy elements, eventually gave rise to solar systems with heavy elements."

    A little sociological note here: this account was dreamed up by a group of cosmologists of whom the most prominent was Fred Hoyle. But Hoyle managed to so annoy the powers that be in physics that although his collaborators got a Noble for it, he was left out.

    ReplyDelete
  33. I stopped reading at "We start with the first welfare theorem: loosely, supply, demand and competition lead to socially beneficial arrangements."

    Wrong. He left out "in the absence of externalities..." And that's the "assume we have a can opener"/"then a miracle occurs" part of economics. If wishes were horses...

    Joan Martinez-Alier said it best, "Externalities are not so much market failures as cost-shifting 'successes'."

    Every single word Mr. Cochrane wrote after "loosely" is a lie.

    ReplyDelete
  34. Excellent information,this blog is really source of many many information.please keep it up.
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  35. Financial services are the economic services provided by the financial firms which constitutes of a group of accountants Ireland. O'Donoghue Accountants provides a broad range of services to manage money, including tax consultation and tax relief, audit services to companies or individuals, business advisory services and related service.

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  36. "Similarly, it would be foolish to say "I don't see how this finance industry is adding value, so let's regulate the heck out of it."


    Yes it would be foolish to say that....... but no one who is suggesting regulations IS saying that! What we have are people who DO understand the industry as well as anyone, people like Bill Black, Yves Smith, Warren Mosler to name just a few, saying that banking is running amok. Private debt created finance is inherently unstable, that is why Central Banking evolved. Central Banks stand to be lenders and buyers of last resort and are tools of the finance industry to keep their prices from wildly fluctuating in a pure market. Unfortunately, too often recently they are becoming buyers and lenders of FIRST resort throughout the western world.

    While all the VSP wail about govt debt levels which approach 100% of GDP the private debt levels are almost four times that if one includes the shadow banking debts........ and every last cent of this private debt was created BY the financial sector(and then sent to govt balance sheets during crisis so their institutions can "appear" solvent). It is what the financial sector does, it creates debt.

    ReplyDelete
  37. Both should be required reading for any introductory finance class. There is so much in these essays that one blog post couldn't hope to adequately cover the topic, so don't expect this to be anything resembling a complete response.
    gold ira investing

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  38. Anonymous7:31 AM

    ""We know that the free market is always perfect and good and that policy can't help." (That is something that ideological libertarians often say, and I think it's extremely unhelpful for the econ profession when they say it.)"

    This is wrong. Ideological libertarians understand that markets are not perfect. Nice straw man.

    ReplyDelete
  39. MikeW_CA9:44 AM

    "The bar for policy intervention to" _preserve_ "value-destroying industries should be" even higher. "Eventually, swindlers, hucksters, and useless rentiers will" find that they can get a very good return on their investment in government power to prevent themselves from being "driven from the market". That's been a bigger problem than excessive regulation during the past few years.

    ReplyDelete