Johnathan Ford, writing in Prospect Magazine, argues that the financial industry has grown far beyond its rational economic size. It’s no longer entirely a service so much as a separate organism whose survival needs do not necessarily coincide with the economy it ‘serves’.
The enormous growth of the financial sector is one of the wonders of our age. In the 1960s the business of banking, broking and insuring accounted for just 10 per cent of total corporate profits in most developed economies. By 2005, this proportion had swelled to nearly 35 per cent in the US and roughly the same in Britain—the two countries that host the world’s largest financial centres. Last year a staggering one in five Britons earned their living in finance.
Of course, the profitability of the financial sector is declining on account of the credit crisis. But the politicians and financial authorities have felt obliged to plug the holes that have appeared in a deflating system with vast public support, and now even direct capital injections. Finance is now not only big, but worryingly unstable.
It’s a well known historical fact that great powers prefer to deal with each other because it makes deal-making and the division of spoils easier. Attempts at cartelizing power often precedes a fatal rivalry. Barabara Tuchman, describing the roots of the Great War in the Guns of August wrote:
Germany might have had an English entente for herself had not her leaders, suspecting English motives, rebuffed the overtures of the Colonial Secretary, Joseph Chamberlain, in 1899 and again in 1901. Neither the shadowy Holstein who conducted Germany’s foreign affairs from behind the scenes nor the elegant and erudite Chancellor, Prince Bülow, nor the Kaiser himself was quite sure what they suspected England of but they were certain it was something perfidious. The Kaiser always wanted an agreement with England if he could get one without seeming to want it. Once, affected by English surroundings and family sentiment at the funeral of Queen Victoria, he allowed himself to confess the wish to Edward. “Not a mouse could stir in Europe without our permission,” was the way he visualized an Anglo-German alliance. But as soon as the English showed signs of willingness, he and his ministers veered off, suspecting some trick. Fearing to be taken advantage of at the conference table, they preferred to stay away altogether and depend upon an ever-growing navy to frighten the English into coming to terms.
Ford argues that big finance needs a big government to provide it with rents because the market alone would never sustain such a bloated thing.
Paul Woolley, a former academic, policymaker, IMF economist and fund manager, argues that efficient market theory falls down because of the “asymmetric information” problem. This, simply put, is the difference in the quality of information enjoyed by agents—the banks, fund managers, brokers and so forth—and the principals, or end investors. The agents know more than the principals, and they exploit this to maximise their own wealth—setting aside the risk and reward objectives of the client. While this worry isn’t new, critics have in the past focused on banking and corporate finance and on abuses such as insider trading. Woolley’s new emphasis, which he has investigated through academic institutes he has established at the London School of Economics and Toulouse university, has been to apply it to investment management. He argues that asymmetric information, especially in this area, has far graver consequences for the functioning of finance.
Perhaps the best example of asymmetric information is the famous “wallet auction,” in which an auctioneer offers to sell his wallet to the highest bidder, while reserving the right not to sell. The asymmetry arises because only the vendor knows how much money is in his wallet. Rationally he will only sell if the bidders overpay. To the jaundiced eye, financial markets often appear like a series of wallet auctions.
This “agency” problem leads on to two bleak conclusions. First, that capital markets do not necessarily price assets efficiently and capital can get misallocated. When the misallocation gets big enough, as it has now, it can lead to substantial macro-economic dislocation. Second, it allows banks and financial intermediaries to capture too big a share of the economic gains from capital investment, and thus from growth itself. And this share (the “croupier’s take” in the celebrated phrase of Warren Buffett’s partner, Charlie Munger) has been going up as financiers have become ever more cunning about exploiting their advantage. Woolley argues that big and unstable capital markets make it likely that we will suffer more and potentially bigger upsets in the future.
Open thread.
Tip Jar
Granted. But markets are still better than any other mechanism for allocating capital.
Yes, but only the regulated entities have this problem. Regulated entities are forbidden from entering into contracts that solve this weakness.
Unregulated “private equity” funds solve this problem by with the 2 & 20 rule (which Main Street mutual funds are forbidden from using); the manager collects a small (2%) fee for managing the fund and a large (20%) fee on profits over a long period of time. That plus long lock-up periods which restrict panic selling allows for very efficient management because all of the incentives are aligned and the perverse incentives are removed.
The Dow drop -486.01 today. I know the Dow has been bouncing around lately but wonder if today’s drop has anything to do with electing a crypto-Marxist as President?
So how do we strink the sector back to an efficient size? We’d like to see the income to the financial service industry shrink while still providing the necessary services AND no effect on the total capital in the system.
Seems like a tall order. Look at GE. About half their profit comes from the finance arm – should they divest?
Or just we just gut it out? In either case, the bailout looks like the wrong answer.
As Brock said, of course some capital is misallocated, and anyone who thinks that is a fatal flaw in markets is a damn fool who is letting the perfect be the mortal enemy of the good. Recessions are essentially what happens after the buildup of misallocated capital gets too big to ignore and everything comes to a halt while the markets realloc.
Depressions are what happen when government refuses to let the market reallocate.
But Ford is right when he says Wall Street has gotten too big. If the economy was a great big balance sheet, Financial Services would go under the G&A category (General and Administrative). As any half-decent businessman would know, growth in G&A as a percentage of expenses is a bad sign, because it’s pure overhead. Increasing overhean means you’re getting less efficient and if you don’t do something about it, you’ll eventually go broke.
Is it too big? When there is a 13 trillion economy, and everything is leveraged as much as it is, there will be a huge financial services sector.
It will shrink of it’s own accord. A whole generation of common and intelligent financial practice has caused losses. Is it smart business now, if you have a company with a short term cash influx to invest it in short term money market paper? Quite a few companies got caught when it’s value went below the buck. Maybe bank accounts are a good idea after all. I know, let’s try to sell mortgage securities. And if the hundreds of companies aren’t doing that short term investment stuff, there won’t be a need for brokers.
This is a common theme; a sector forgets it’s core asset. Financial services core asset is a feeling in people’s minds that if they put money in, they will get it out in a timely way, with a bit of profit. Expertise, computer models, sophisticated slicing and dicing of assets, complicated risk models, etc., are only an asset if used to maintain the core asset.
Derek
The financial sector is only large in comparison to the country in which it resides.
It seems like global compartmentalization is full steam ahead. Anglos doing the finance and weapons, Arabs the oil, third world the natural resources, Asians mass production…..
The real answer was to let the bubble burst, pushing cash into the system just sustaines the beast a while longer and leads to a bigger problem down the line. Now we have a weak and unstable banking sector with worries about long-term credit stabilty AND a trillion dollar bill to pay off the last bit of government meddling.
If the bubble had been allowed to pop the fuctioning portions of the failed businesses would have been picked up by the smarter companies and the failures would have been penalized. Rewarding failure is counter-productive, let the bloated portions die.
Whitehall,
We do require a system for financing our proper monetary needs. However, the existing system is built upon un-even weight and measures. The bankers don’t _have_ most the money they loan, but we must pay them back with _real_ money and interest. All the rest of us would be imprisoned if we tried to get away with this sort of pogram.
Around this subtle crime is arrayed a host of businesses who funnel this strange money into use.
I maintain this: the disporportionate ratio of our financial system, is primea facia evidence of the un-even weight and balances. The visualization of this, is an inverted pyramid, where all of the wealth of the nation/world is the point at the bottom; the bankers represent the bottom layers; all the layers above represent the rest of the financial system & therefore the bankers hypothicated wealth.
I’ve been thinking about this lately.
I believe that not just the financial services sector but the whole U.S. ECONOMY is overloaded with more college graduates than it can rationally utilize.
The “need” for a college degree for everyone has (in order to absorb them all) forced our economy OUT of the productive mode and into the employability mode. Our economy is not geared to maximize productivity but to provide our glut of college graduates with someplace to work.
And we’re still obcessed with creating more!
Dave, I would not hire most of my undergraduates in the two classes that I teach as a professor in a large medium level state university. The kids are immature for any job that requires responsibility. Our university wide class attendance is 45%. Sometimes I only have nine out of thirty students in my class.
I friend of mine in engineering has an attendance rate of 60% for a required senior level course.
Minyanville has a good take on the destruction of credit and its impact on inflation/deflation in the world economy.
http://www.minyanville.com/articles/index/a/15975
twas ever thus
The stock market is down today because the employment figures are catastrophic, and the car-makers are threatening to flatten the economy of the mid-west.
And the market was down yesterday because the financial markets had access to this information before it was publicly released. See ‘Asymmetric Information Problem’ above.
Crypto-Marxist my *ss.
I’m personally waiting for the stock to crash completely, because it’s coming. Especially since the left-wing illuminati have control, people will be pulling out in a hurry.