Complexity and rent-seeking in the non-productive industry

The New Yorker has an Annals of Economics article this week on finance's role in the American economy titled "What good is Wall Street?" Lest you have any doubt about the author's answer to that question, the subheading is "Much of what investment bankers do is socially worthless." Some brief thoughts, preceded by what I think is the necessary admission that I was an investment banker (doing albeit nonstandard work) for two years:
  1. I'm glad that the concept of financial work as a fundamentally rent-seeking activity is getting more mainstream. I'd be happier if this were running in USA Today instead of The New Yorker, but still.
  2. I strongly suspect that most people who haven't explicitly had to think about it (by which I mean: most people) still don't understand what finance as an industry 'does'. I think the simple model of what banks do (deposits in, loans out, earn the spread) is pretty widely understood, but how the rest of finance operates, or even what makes up the rest of the financial services industry, not so much. That is a bad thing for a lot of reasons.
  3. LSE has a Centre for the Study of Capital Market Dysfunctionality? Seriously? I know several people who would probably love to post-doc there.
  4. Sol and I were recently talking about Russia since the Soviet collapse (we're required by contract to spend most of our time trying to distract each other from actual productive work) and he mentioned that it was the epitome of elite capture. Every time I hear stats on the perpetually (even during the crisis) increasing gap between top 1% earners and the median, I think about that process.
  5. From my own experience and those of some friends I'd say fresh college graduates' decisions to work in finance are driven by two things. The first is the low option value of a year or two of your early twenties versus the salary proffered; how many people do I know took the hipster / slacker / failed artist route for those years and have little to show for it aside from going to a few more parties? The second is the relative attractiveness of job choice coming out of finance. A first job in finance doesn't drastically reduce one's set of possible careers the way a lot of other fields do because it signals that you're at least passably smart (though probably not brilliant) and you're willing to work like a dog. If we're worried about our best and brightest going to work in finance, which I honestly think is a distraction from more serious concerns like under-regulation, we need to do something about the attractiveness of those two drivers. Since salaries won't likely change soon, I suspect that ultimately means changes in social norms and the social acceptability of going to work in what has largely become a parasitic industry.
  6. The author touches on but doesn't really delve into what I think is the heart of the problem: finance has enormous returns to complexity. Firms don't generate huge returns by focusing on banking; they get it by being early-actors in markets that haven't become efficient yet. If the hot new derivative your firm has developed is either sufficiently new that other firms aren't familiar with it or sufficiently complex that other firms can't muster the expertise to price and trade them, then you can escape the margin-killing slide towards efficiency, at least for a few years, and make bank. That finance's ability to support million-dollar-a-year salaries derives mostly from the exploitation of market inefficiencies is something that I think is lost in most discussions, especially when there's so much rhetoric claiming finance makes markets more efficient.
  7. The complexity rents argument alone is, I think, sufficient to strongly argue in favor of much heavier regulation and reinstating the separation of normal and investment banks. If we add in a political economy / returns to political contributions element to the model it becomes even more pressing.

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