tag:blogger.com,1999:blog-17232051.post8709259286537038426..comments2024-03-28T03:16:14.104-04:00Comments on Noahpinion: Why did the finance industry get so big? (guest post by Dan Murphy)Noah Smithhttp://www.blogger.com/profile/09093917601641588575noreply@blogger.comBlogger21125tag:blogger.com,1999:blog-17232051.post-77563249238122186282012-07-23T19:36:01.524-04:002012-07-23T19:36:01.524-04:00If we apply the "1920s test" and ask wha...If we apply the "1920s test" and ask what the common feature was, the answer which pops up is rampant fraud, and government tolerance of that.neroden@gmailhttps://www.blogger.com/profile/07475686367097445497noreply@blogger.comtag:blogger.com,1999:blog-17232051.post-65725905872895508752012-07-23T19:35:11.677-04:002012-07-23T19:35:11.677-04:00Drat. This hypothesis seems to fail the "192...Drat. This hypothesis seems to fail the "1920s test", given below -- it doesn't work for the 1920s as far as I can tell.neroden@gmailhttps://www.blogger.com/profile/07475686367097445497noreply@blogger.comtag:blogger.com,1999:blog-17232051.post-52692884426428183792012-07-23T19:32:31.517-04:002012-07-23T19:32:31.517-04:00Here's some econ 101 analysis. (Well, from my...Here's some econ 101 analysis. (Well, from my version of econ 101!)<br /><br />Market making is a natural monopoly -- easier and more efficient if only one firm is doing it.<br /><br />Private monopolies generally extract monopoly profits if they are allowed to.<br /><br />We can see that this is how the VISA/Mastercard duopoly makes bundles of money. Through monopoly power.<br /><br />The classic solution is for all natural monopolies to be provided as public services by the government.<br /><br />In past years many market makers were effectively run as not-for-profits (VISA when it was owned by a bank consortium, NASDAQ when owned by a consortium of dealers), and they've since been converted to for-profits. <br /><br />Also, many (credit cards) were not monopolies yet, and the natural process of mergers to make them into monopolies had not yet occurred.<br /><br />Once they became for-profit monopolies, the increased share of profit extraction was natural and predictable.neroden@gmailhttps://www.blogger.com/profile/07475686367097445497noreply@blogger.comtag:blogger.com,1999:blog-17232051.post-47736896889442593942012-07-02T14:33:08.945-04:002012-07-02T14:33:08.945-04:00Looking back, it is likely that a lot of the profi...Looking back, it is likely that a lot of the profit (and value added) reported by the financial sector in the run up to crash was simply an accounting "error" - the values, the profits and the value added were never real.<br /><br />With advancing technology, and a glut of savings, the margins and profits available to the financial sector as a whole should be declining.Absalonhttps://www.blogger.com/profile/09131268683451462949noreply@blogger.comtag:blogger.com,1999:blog-17232051.post-69303101782817769982012-06-21T22:20:13.465-04:002012-06-21T22:20:13.465-04:00Like, most of that has been around for a couple of...Like, most of that has been around for a couple of generations. IIRC, the massive changes in the financial sector apply to the last thirty years (I.e., after we tore down the New Deal structures, and found out why they were there).Barry DeCiccohttps://www.blogger.com/profile/04735814736387033844noreply@blogger.comtag:blogger.com,1999:blog-17232051.post-67728904618177231932012-06-20T10:03:12.189-04:002012-06-20T10:03:12.189-04:00Well thought out. IMHO the following are roughly t...Well thought out. IMHO the following are roughly the way things happened:<br /><br />(1) The global savings glut requires an increasing "effort" (read compensation and personnel) devoted to scouring out better returns to the capital holders, who are, precisely because of that distinction, not particularly industrious (the median capital owner, that is. This is my conjecture and always has been: basically industriousness does not typically spring from the progeny of multimillionaires but from the lower economic classes).<br /><br />(2) Growing income disparity has caused a global concentration in the hands of very few. This led to crafting of global legislation and regulations that perpetuated and extended the search for higher yields on capital, leading to instruments that allowed incredible leverage on base returns. It also necessarily led to imprudent lending in many portions of the global economy, most prominently in the U.S. housing market. <br /><br />(3) Then came the Minsky Moment<br /><br />(4) Economies will probably continue to swing the same way like a pendulum going forward, unless they (starting with the U.S and Europe), are essentially run by hard countercyclical computer algorithms, on policies, both economic and regulatory :-)Som Dasguptahttps://www.blogger.com/profile/11848089230329819807noreply@blogger.comtag:blogger.com,1999:blog-17232051.post-15047102754795220722012-06-19T22:42:17.663-04:002012-06-19T22:42:17.663-04:00I think it may be of practical importance because ...I think it may be of practical importance because we need questions like those to identify the necessary conditions of an outcome and to weed out unnecessary or even confounding variables. <br /><br />I don't know how to phrase it exactly, but my raw (and maybe inaccurate) intuition says something like this:<br /><br />1. Consider a set of statements S.<br /><br />2. Consider a set of observable phenomena P', which can be described by a set of statements S' together with some logical operators. <br /><br />In this case P' is a set of observable outcomes associated with a generic financial sector expansion- a financial sector expansion that may occur at any time, regardless of any outside factors, as long as the conditions described by S' exist.<br /><br />3. S' is a component of S.<br /><br />4. Now consider observable phenomena P'' and P''' that can be described by sets of statements S'' and S''' where S'' and S''' are both in S and S'' U S' and S''' U S' are non-empty.<br /><br />I think of P' as the "core" of the phenomenon of an expanding financial sector: those phenomena which are always manifest when the financial sector expands.<br /><br />To arrive at S' and therefore describe these universal, necessary features in the most refined way possible, we have to somehow filter S into S'.<br /><br />The danger arises when S' is, for example, inside S''', which fully contains S'' such that there is at least one statement x that is in S''' but not S''. In such a case, we may arrive at S''' and suspect that it is S'. This would happen if we only observe P'''.<br /><br />Empirically, our theory that the logical synthesis of the statements in S''' correspond to observations manifest in P''' will not be falsified, but our theory will also not be as refined as it can be- it will include statements we do not need to describe the necessary (or fundamental) reasons for a financial sector expansion.<br /><br />But if we describe S'' as well (i.e. the 2000 period AND the 1920s) we would notice that there are statement x which are not in S''' and we would therefore be able to refine "a little closer" to S'.<br /><br />If we do this several times and as long as each time we write down sets of statements that produce testable hypotheses with each new set of statements of cardinality lower than that of the smallest set of statements we previously used, we will make progress towards S'.<br /><br />Something like that.Zlati Petrovnoreply@blogger.comtag:blogger.com,1999:blog-17232051.post-69989725701140131602012-06-19T18:53:22.679-04:002012-06-19T18:53:22.679-04:00PS: two real factors might be that trade has incre...PS: two real factors might be that trade has increased much faster than the general output, and that the level of debt has gone up (i.e. creating more volume to earn money on).<br /><br />Also, with respect to the level of competition – in addition to the problem of establishing a reputation (I know of people with their own funds who outperformed the big competitors for years in a row but still live on noodles due to not being able to attract large enough amounts of capital yet) there are generally really high barriers for entry into the financial sector.neminoreply@blogger.comtag:blogger.com,1999:blog-17232051.post-68746728704047081502012-06-19T18:40:13.123-04:002012-06-19T18:40:13.123-04:00“But again, the acceleration in finance’s value ad...“But again, the acceleration in finance’s value added share in 2000 did not correspond to acceleration in idiosyncratic risk.”<br /><br />???<br />The amount of risk that the financial sector transferred from the rest of the economy into their own (or the taxpayers) balance sheets increased a lot over the period.<br /><br />“So yes, I do believe that some of the rising value of the finance industry is in its ability to efficiently facilitate trade and manage risk.”<br /><br />You got to be kidding. Give me one example. As far as I know it is still all value at risk models - and I hope that you are not referring to the credit rating institutes.neminoreply@blogger.comtag:blogger.com,1999:blog-17232051.post-14978568767604514302012-06-19T18:33:54.010-04:002012-06-19T18:33:54.010-04:00"Perhaps we can answer the question by simult..."Perhaps we can answer the question by simultaneously asking "why did the financial sector's value-added share rise so sharply in the 1920s....."<br /><br />Yes , and then why did it decline so much in the 1930's and after , and then why were the post-war decades such a period of both financial stability and unparalleled , and widely-shared prosperity ?<br /><br />What common features did the 1920's have with the past few decades that required a large financial sector with an obscene compensation structure , that distinguished those two periods from the one lasting from WWII to the 1970s , with no such requirements ? <br /><br />It's very curious , but of no practical importance , I'm sure . It might be a good topic for some future economic historian with time to waste.Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-17232051.post-737119056075203952012-06-19T18:16:54.255-04:002012-06-19T18:16:54.255-04:00I wonder about financial innovation.
What is it, ...I wonder about financial innovation.<br /><br />What is it, exactly? To me it seems a definition of degrees.<br /><br />Is a composition of existing financial products financial innovation (i.e. a CDO)? I would argue that it is only if it produces results for the buyer that the sum of the components cannot produce outside of the new vehicle at a reasonable cost. <br /><br />Computer technology differs just this way. A billion transistors is not the same thing as a CPU. The CPU's architecture makes the product's function fundamentally different from that of its components. Hence I call it innovation. <br /><br />The computer engineer's value-added is that he extracted from a billion transistors functionality that they do not have as stand-alone components.<br /><br />Now, we know that some composite financial products produce new functionality through regulatory arbitrage, whereas some produce it through imperfect correlations, for lack of a better description.<br /><br />So we could argue that they do behave like technological innovations.<br /><br />But what if some of these innovations work by creating information asymmetries and thus help sellers sell lemons at higher prices than they would in a less sophisticated, more transparent market?<br /><br />If, in other words, an innovation operates not by producing fundamentally unique and new functionality, which in turn produces value-added, but instead acts as a means to redistribute wealth from buyers to sellers, could it be that parts of the so-called value-added from "financial innovation" are redistributions in disguise?Zlati Petrovnoreply@blogger.comtag:blogger.com,1999:blog-17232051.post-347903525260313102012-06-19T17:57:38.919-04:002012-06-19T17:57:38.919-04:00Perhaps we can answer the question by simultaneous...Perhaps we can answer the question by simultaneously asking "why did the financial sector's value-added share rise so sharply in the 1920s and 1880s?"<br /><br />The same reasons or different? If the same, then perhaps we've discovered something systematic. If different, then we ought to figure out why the reasons differ.<br /><br />Also, rather than asking, "why did the value-added share increase" in total, should we not worry more about deviations from trend growth in relative size?<br /><br />I.e. why did we see abnormal growth in the financial sector's relative size (assuming that normal growth is something that more or less tracks the deepening complexity of a modern economy)?Zlati Petrovnoreply@blogger.comtag:blogger.com,1999:blog-17232051.post-76569289829052702992012-06-19T15:02:37.328-04:002012-06-19T15:02:37.328-04:00Good summary, but I think it misses something abou...Good summary, but I think it misses something about financial asset wealth vs tangible asset wealth.<br /><br />While housing is tangible, "mortgage backed securities", and CDS/ CDO "financial products" (Credit Default Swaps & Obligations) are not.<br /><br />As more wealth is "financialized", the finance industry gets bigger.<br /><br />Similarly, bonds today are a financial product. It makes sense that an economy with $100 trill in total bonds has a much larger financial sector than one with $50 T -- and what is the limit to financial institutions in creating bonds/ obligations? <br /><br /><br />There were too many AAA rated financial products in the pre-Great Recession housing bubble. There should be a limit, perhaps GDP for a year (or two?), on the total amount of AAA rated bonds available -- and once that limit is reached, new AAA bonds would require lower ratings on the worst older bonds.<br /><br />Finally, gov't debt has to be handled by the Finance Industry. Voter desires for "free money" benefits from the gov't, resulting in gov't over-spending, require the gov't to borrow. As gov't borrowing goes up, there will be more GDP in Finance.Tom Greyhttps://www.blogger.com/profile/15046612425809449502noreply@blogger.comtag:blogger.com,1999:blog-17232051.post-11823119890135309842012-06-19T14:04:52.199-04:002012-06-19T14:04:52.199-04:00Financial innovation is a part of making markets (...Financial innovation is a part of making markets (#1), and its value is derived from the value of the trade in goods and services that it facilitates. Financial innovation increases the value of the finance industry, but it does not by necessity increase the finance industry's share of value added.Danhttp://www.umich.edu/~dpmurphynoreply@blogger.comtag:blogger.com,1999:blog-17232051.post-75449567226554244232012-06-19T13:00:56.171-04:002012-06-19T13:00:56.171-04:00Liquidity and market risk are also important parts...Liquidity and market risk are also important parts of #2, not just counterparty risk.<br /><br />Also, you forgot financial innovation. There are many markets (like commodities markets, electricity, renewable energy credits, i could name dozens), that have seen extremely rapid financial innovation in the last 10 years. This has led to the rapid growth in the need for #2 and #1.<br /><br />Also, #5: Accounting and regulatory rules have become ever more complex. BASEL MCMXLVII, or whatever we are up to now, plus OCC regs, is a full time job and now we have models just for regulatory purposes.dwbnoreply@blogger.comtag:blogger.com,1999:blog-17232051.post-74075243428221737922012-06-19T12:50:36.099-04:002012-06-19T12:50:36.099-04:00Are 2 and 3 related? I mean there are risks we ins...Are 2 and 3 related? I mean there are risks we insure against now that our ancestors didn't. For example, we insure against the risk of outliving our ability to work by retirement savings, which in turn go through financial intermediaries. Maybe a lot of saving/investing is some form of risk management (eg against job loss) that previously people did not do (or could not afford).Lukenoreply@blogger.comtag:blogger.com,1999:blog-17232051.post-57915760955516584962012-06-19T12:49:42.291-04:002012-06-19T12:49:42.291-04:00Here's Haldane.
JzBHere's <a href="http://www.nakedcapitalism.com/2011/11/haldanemadouros-what-is-the-contribution-of-the-financial-sector.html" rel="nofollow">Haldane</a>.<br /><br />JzBJazzbumpahttps://www.blogger.com/profile/07337490817307473659noreply@blogger.comtag:blogger.com,1999:blog-17232051.post-75699780123846424542012-06-19T12:43:40.435-04:002012-06-19T12:43:40.435-04:00Would you be able to test your "JUST GIVE ME ...Would you be able to test your "JUST GIVE ME THE MONEY!" hypothesis? <br /><br />If the growth of finance's share of GDP is linked to returns, would the 2nd derivative of finance's share move in tandem with the size of returns.<br /><br />Bigger returns (i.e Bubble time) = Acceleration in finances share of GDP?<br /><br />Or something like that. Finance may follow a trend that has a negative second derivative (concave), but then you you would expect the deviation from trend growth to move with returns?Tom Walshhttps://www.blogger.com/profile/02143064677765352629noreply@blogger.comtag:blogger.com,1999:blog-17232051.post-64400117100023435832012-06-19T12:22:08.292-04:002012-06-19T12:22:08.292-04:00By all three of your criteria, the finance industr...By all three of your criteria, the finance industry is an epic fail for society.<br /><br />1) As market maker, you argue correctly that the finance share should not grow faster than GDP, but it has - and quite dramatically so. In fact, finance has captured an <a href="http://jazzbumpa.blogspot.com/2012/01/where-has-all-money-gone-part-ii.html" rel="nofollow">increasing share of total corporate profits</a>.<br /><br />2) Managing risk. Yes, they managed to socialize all the risk and privatize all the return. That is value subtracting.<br /><br />3) Investment intermediaries. If there were real value here for the alleged services rendered, people's net worths would be rising. The opposite is the case, and financial intermediation via bundling and tranching into derivatives which no one can rationally price or evaluate is a big part of the reason why. As intermediaries, they have reaped enormous profits while impoverishing most of the rest of the population.<br /><br />The real answer is that through lack of regulation they have found ways to extract rents from society, and have given close to nothing back in return. The golden age of the post WW II era corresponded to a finance sector whose share of total corp profits was under 30%. Now it's around 50%.<br /><br />Money and power are fungible, and this leads to a spiral of increasing wealth accumulation at the top. The whole thing is, in Krugman's words, <a href="http://jazzbumpa.blogspot.com/2011/11/what-is-contribution-of-finance-sector.html" rel="nofollow">a giant scam</a>.<br /><br />And it has been <a href="http://jazzbumpa.blogspot.com/2011/09/high-finance-sector-profits-kill.html" rel="nofollow">dragging us down</a> for longer than your life time.<br /><br />Cheers!<br />JzBJazzbumpahttps://www.blogger.com/profile/07337490817307473659noreply@blogger.comtag:blogger.com,1999:blog-17232051.post-13900498991025620942012-06-19T11:28:40.614-04:002012-06-19T11:28:40.614-04:00Nice summary!
However, it should be quantifiable ...Nice summary!<br /><br />However, it should be quantifiable how profits booked at the time trades were made compare to any losses incurred in the trade over its lifetime. I believe Andrew Haldane has some estimates and the losses dwarf any growth in value-added. Therefore, I am a bit surprised you don't give this kind of incentivized time mismatch more prominence in your analysis.aelnoreply@blogger.comtag:blogger.com,1999:blog-17232051.post-56935539784274420342012-06-19T11:28:37.684-04:002012-06-19T11:28:37.684-04:00I think that you need to look at this in the histo...I think that you need to look at this in the historical terms of the rise of the rentier economy, which sequentially lead to the decline of the Spanish, Dutch and English financial empires. Essentially, there is a pattern of trade/technology advantage, followed by the growth of a middle class, followed by wealth following investments in government debt and creation of rent opportunities, followed by decline. For more discussion, please see 'Economics: Repeating Rhymes' at http://somewhatlogically.com/?p=562<br /><br />Essentially, all the countries mentioned failed to invest in their own development and industry, for example, "At their peak, the wealthy of Holland owned one quarter of England’s public debt, along with one third of the shares of the Bank of England and the British East India Company, while their manufacturing mostly peaked in the 1720s. Earlier, travelers had commented on the wealth of the Dutch middle class, but in 1764, English writer James Boswell noted: ”Most of their principal towns are sadly decayed, and instead of finding every mortal employed, you meet with multitudes of poor creatures who are starving in idleness.”<br /><br />Also, the rise of the financial sector pay and services have very little to do with benefit to the economy, and much to do with government policy, as discussed by Bartels, as quoted here. "Projecting Inequality' at http://somewhatlogically.com/?p=254<br /><br />It could well be argued that the two Roosevelt administrations drew us back from the edge of the self-inflicted collapse. Why should one invest in a company that has all those messy employees, supply issues, market concerns etc. when if you're rich enough to be invited to join Madoff's funds, you can get 25% annual return. Crowding out by the financial sector, anybody?<br /><br />JRHulls<br />Somewhatlogically.comJRHullshttp://somewhatlogically.comnoreply@blogger.com