Why Wall Street won’t get shrunk

By Felix Salmon
November 22, 2010
8,000 words from John Cassidy on how financiers extract rents from the real economy rather than adding real value.

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This week’s New Yorker features 8,000 words from John Cassidy on how financiers extract rents from the real economy rather than adding real value. His article features not only The Epicurean Dealmaker, star of blog and Twitter, but also Paul Woolley, a former fund manager who now runs the Woolley Centre for the Study of Market Dysfunctionality, a man who knows how to give great quote:

“I realized we were acting rationally and optimally,” he said. “The clients were acting rationally and optimally. And the outcome was a complete Horlicks.” …

“Mispricing gives incorrect signals for resource allocation, and, at worst, causes stock market booms and busts,” Woolley wrote in a recent paper. “Rent capture causes the misallocation of labor and capital, transfers substantial wealth to bankers and financiers, and, at worst, induces systemic failure. Both impose social costs on their own, but in combination they create a perfect storm of wealth destruction.”

Cassidy is good at focusing on excessive pay in the industry:

Perhaps the most shocking thing about recent events was not how rapidly the big Wall Street firms got into trouble but how quickly they returned to profitability and lavished big rewards on themselves. Last year, Goldman Sachs paid more than sixteen billion dollars in compensation, and Morgan Stanley paid out more than fourteen billion dollars. Neither came up with any spectacular new investments or produced anything of tangible value, which leads to the question: When it comes to pay, is there something unique about the financial industry?

Thomas Philippon, an economist at N.Y.U.’s Stern School of Business, thinks there is. After studying the large pay differential between financial-sector employees and people in other industries with similar levels of education and experience, he and a colleague, Ariell Reshef of the University of Virginia, concluded that some of it could be explained by growing demand for financial services from technology companies and baby boomers. But Philippon and Reshef determined that up to half of the pay premium was due to something much simpler: people in the financial sector are overpaid. “In most industries, when people are paid too much their firms go bankrupt, and they are no longer paid too much,” he told me. “The exception is when people are paid too much and their firms don’t go broke. That is the finance industry.”

Cassidy concludes with an ode to an earlier era:

In 1940, a former Wall Street trader named Fred Schwed, Jr., wrote a charming little book titled “Where Are the Customers’ Yachts?,” in which he noted that many members of the public believed that Wall Street was inhabited primarily by “crooks and scoundrels, and very clever ones at that; that they sell for millions what they know is worthless; in short, that they are villains.” It was an extreme view, but public antagonism toward bankers and other financiers kept them in check for forty years. Economic historians refer to a period of “financial repression,” during which regulators and policymakers, reflecting public suspicion of Wall Street, restrained the growth of the banking sector. They placed limits on interest rates, prohibited deposit-taking institutions from issuing securities, and, by preventing financial institutions from merging with one another, kept most of them relatively small. During this period, major financial crises were conspicuously absent, while capital investment, productivity, and wages grew at rates that lifted tens of millions of working Americans into the middle class.

Since the early nineteen-eighties, by contrast, financial blowups have proliferated and living standards have stagnated. Is this coincidence? For a long time, economists and policymakers have accepted the financial industry’s appraisal of its own worth, ignoring the market failures and other pathologies that plague it.

Cassidy’s view is a clear-eyed and straightforwardly reported version of, say, this, from Noam Chomsky:

The capitalist class in the ’50s was sort of part of a social contract. It was part of the tenor of the times… Changes have taken place since then… In the financial institutions, which by now dominate the economic system, the management level repeatedly acts in ways which will destroy their own institutions if it’ll increase their benefits, and benefits are not small. You know, you take a look at the revenue of, say, Goldman Sachs – a very high percentage of it just goes to payment of management and bonuses. There was a time traditionally – say, GM in the 1950s – it was trying to develop a consumer base that would be loyal and lasting and they were thinking in terms of an institution that would remain and grow and thrive in the society. By now, a lot of the investment firms – bankers, hedge funds – are perfectly happy to destroy what they’re in and come out with huge, tremendous benefits. That’s a new stage of capitalism.

Chomsky praises Yves Smith’s book as being “really good”, and says nice things about Simon Johnson, too; I’m sure if asked he’d be equally complimentary of, say, Joe Stiglitz or Jamie Galbraith. Elsewhere, he praises Dean Baker, and dates the beginning of the end to the dissolution of the Bretton Woods system:

In the mid 1970s that changed. Bretton Woods restrictions on finance were dismantled, finance was freed, speculation boomed, huge amounts of capital started going into speculation against currencies and other paper manipulations, and the entire economy became financialized. The power of the economy shifted to the financial institutions, away from manufacturing. And since then, the majority of the population has had a very tough time; in fact it may be a unique period in American history. There’s no other period where real wages — wages adjusted for inflation — have more or less stagnated for so long for a majority of the population and where living standards have stagnated or declined.

There’s clearly a large and appreciative audience in the blogosphere and in middlebrow magazines for this kind of analysis, which has even now become a feature-length documentary. But equally clearly it doesn’t even begin to play with the electorate as a whole. Look at what happened in the mid-term elections: insofar as Dodd-Frank was an issue at all, it was criticized for going too far — for being too much of an incursion by government in private industry — rather than for being too weak.

What has changed since the 1940s and 1950s, when popular mistrust of Wall Street was more than sufficient to constrain its ambitions and dangers? When even well-heeled investment bankers are on pretty much the same page as Noam Chomsky (or, for that matter, Eric Cantona), why is it that such sentiments still seem confined to the chattering classes? Maybe it’s just that this stuff is complicated, and that there’s little incentive for most people to put in the work needed to begin to understand it.

It’s certainly a lot more complicated now than it was in the 30s and 40s. As I noted in my review of Michael Perino’s book on Ferdinand Pecora, the Wall Street excesses of the 1920s were far simpler and more obviously egregious than the Wall Street excesses of the 2000s. Unless and until we see a parade of bankers in handcuffs being convicted of serious crimes, I suspect it’s going to be impossible to persuade the public at large that Wall Street is out of control and needs to be brought down to size. Even when former Wall Streeters like Woolley are clear of what needs to happen:

“The amount of rent capture has been huge,” Woolley said. “Investment banking, prime broking, mergers and acquisitions, hedge funds, private equity, commodity investment—the whole scale of activity is far too large.” I asked Woolley how big he thought the financial sector should be. “About a half or a third of its current size,” he replied.

That would be nice. But it’s not going to happen.

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Comments
22 comments so far

Whoa, did you just call The New Yorker “middlebrow”? Oh no you didn’t!!!

Posted by infirm | Report as abusive

Two critical questions left unanswered:

If banks are making so much money from trading, who is on the losing side of all those trades? It seems as if there is a huge pot of money being transferred from some group (actively managed 401k accounts?) to proprietary trading desks.

Where’s the competition? With so much money to be made, you’d think that new investment banks would be popping up every day looking to offer the same services for much less money.

Posted by FrancisL | Report as abusive

I honestly don’t think that there’s that much difference in popular sentiment towards Wall Street since 1940. Certainly, there’s a question of degree — 2008 was no 1929. But I doubt there’s much qualitative difference: widespread antipathy towards bankers or banks is always going to be inchoate and poorly grounded in policy critiques.

The key difference is the way the political system translates public anger into policy. Part of the difference is that Hoover’s Republicans were obliterated in a way that Bush’s Republicans were not. (Do you honestly think anyone would be criticizing Dodd-Frank for being too harsh if there were 17 Republicans left in the Senate?) But a bigger part is that pro-Wall Street factions within our government now have a superior understanding of the dynamics of public frustration, and the way that formless anger tends to align itself against incumbents, policy be damned. It’s this knowledge that allows the American right to shamelessly co-opt hatred of Wall Street into votes in support of Wall Street.

When a politician thinks voters chose him so he can fight Wall Street, you get 1940. When the same politician learns that voters chose him simply because he was the other guy on the ballot, you get 2010.

Posted by WHS | Report as abusive

FrancisL: Did you miss the explosion of hedge funds, private equity funds, and HFT/market-making shops over the last two decades or so?

From the quoted New Yorker article, one quote was ridden with errors and I will correct it:

“For a long time, economists and policymakers have accepted the financial industry’s appraisal of its own worth, ignoring the market failures and other pathologies that plague it.”

It should read:

“Over the last few decades, economists and policymakers have been well paid to endorse the financial industry’s appraisal of its own worth, willfully blinding themselves to or actively assisting in the obfuscation of the market failures and other pathologies that plague it.”

Posted by najdorf | Report as abusive

Excellent comment from WHS. But Felix, let’s consider what it might mean for you to take the article seriously. First, does Reuters’ business model not require quietly dismissing this view of Wall St.? It can still have an in-house heretic, but said heretic will be necessarily ineffective (or maybe I misunderstand — I assume “investment news” implies “allied with Wall Street”, but maybe not). At a social level, when you meet say a GS employee off hours, do you treat them they way you would treat the owner of a really vile if perhaps quasi-legal business, like say a gun dealer who specializes in cheap hand guns sold where laws are laxest, or a “massage parlor” where the employees are obviously powerless immigrants? And if you don’t, then what does it really mean that you are posting this? When you sit next to a Reuters senior executive at the company Xmas party, will you be sharing your plans to help spread the truth about Wall Street and effect real change that will destroy their ill-gotten profits?

Posted by SamPenrose | Report as abusive

The best contemporary non-fiction writing in the world today is in New Yorker and Vanity Fair. If that’s middlebrow, what’s highbrow? The academic journals, which are quite literally unreadable?

Posted by maynardGkeynes | Report as abusive

I think that the real driver of the financial sector is the amount of debt outstanding or, more precisely, the interest flowing from it. The financial sector intermediates between the borrowers and lenders, transforming maturities, etc., and ultimately captures as revenues much of the interest paid by borrowers.

Debt also represents assets to investors and the financial sector charges fees of 1% or so for managing portfolios and rolling debt as it comes due.

So the financial sector does not have to be smart or even greedy to make money. It will unavoidably be a large part of the economy as long as the debt levels remain high, particularly private debt, which I guess is more profitable than government debt. But if deleveraging continues, the financial sector is likely to shrink gradually over the next decade or so.

Posted by BlackBoxx | Report as abusive

“Since 1980, according to the Bureau of Labor Statistics, the number of people employed in finance, broadly defined, has shot up from roughly five million to more than seven and a half million.”

So what? Is he saying finance employment outpaced the country’s general population growth since 1980?

“But wagers on credit-default swaps are zero-sum games. For every winner, there is a loser. In the aggregate, little or no economic value is created.”

I disagree. Markets “discover” prices; and prices are a signal to the rest of the economy. I’m with Robert Shiller who advocates in his “New Financial Order” (2003) that there ought to be MORE tradable markets on everything under the sun, not fewer.

Or is there a better, non-market-trading means by which prices ought to be determined?

I’ll stop there.

Posted by dedalus | Report as abusive

The difference is there are not (yet)as many people on the street and those that are have social nets and soup kitchens, AA. There is something about down and out that makes one’s thought go darker and anger swell. Depression, stress, too much drink, suicidal thoughts, violence were the order of the day.

I think people very much care, but sadly assume that the bad boys and Wallstreet would be punished, whereas they are rewarded with business as usual. Little did they know there was method in the madness having so many wall-streeters in Government to provide cushioning. IE:

http://www.bloomberg.com/apps/news?pid=n ewsarchive&sid=a7T5HaOgYHpE

Because there were no failures, nothing has changed and you truly can expect more of the same… but until that time they will be raking it in any way they can… skirting the laws or unethically is fine and dandy.

There will be pushback if unemployment,taxes and debt rise. The people are in a bit of a shock right now and still quite well off for the most part. Once that changes and there is no one left to help the down and out, what ensues will get their attention, and it won’t be pretty.

Never totally underestimate the will of the people. Runs on banks truly will still bring some down…

@najdorf thanks for the correction.

Posted by hsvkitty | Report as abusive

Interfluidity is highbrow.

Posted by FelixSalmon | Report as abusive

Why Wall Street won’t get shrunk?

Why should it?
Who will employ the next generation of Americans? General Motors? The Army? US Steel?

A mature world means an ever increasing mass of savings. Regulation and proper incentives are a positive debate.

Destruction promoting would be just childish, if it were not so damaging

Posted by amateur30 | Report as abusive

The US financial sector doesn’t simply provide services to the US economy. Companies based in the US operate globally (and companies based elsewhere also avail themselves of US financial services). Thus it definitely makes sense for the US to have a disproportionate number of jobs in the financial sector (at least compared to 50 years ago).

The salary structure in finance is borderline outrageous (50% of profits going to bonuses?), yet as noted in another article an investment bank IS its employees. You can’t patent financial innovations. The capital equipment is comparatively cheap. Customer relationships are fluid, and often tied as closely to the individual as they are to the company. People bring their business to GS because it has the best and the brightest in the business (albeit not the most honorable). So what else should GS spend its profits on to maintain its position?

I worry, however, that there may be a distinction between legitimate banking services and unproductive leeching off the system. HFT in particular serves no purpose. The “liquidity” provided is not needed under normal conditions, and we’ve seen how rapidly it evaporates under stress. Moreover, the volume of HFT serves to obfuscate trading patterns (including the length of the buy/sell queues) which can trick people into thinking the markets are more resilient than they truly are. Gates and Ballmer insist that dumping 50 million shares of Microsoft on the market has no impact on the share price (since it is only a small fraction of the trading volume), but we all know that the vast majority of that trading volume is HFT “churn”. If you winnowed it down to just those buyers who hold for months or years, you would find that the effective volume is much lower — and a 45 million share dump is significant.

So think about it… HFT would be easy to eliminate with a 0.25% transaction tax. (And a tax that size would have no impact on longer-term trading.) Such a move might not significantly shrink Wall Street, but it could make it less of a self-enriching leech on society, freeing GS to “do God’s work” or whatever they do when they aren’t testing the boundaries of securities regulation.

Posted by TFF | Report as abusive

>

Wiping out the savings of the American middle class by restricting their practical investment options to savings accounts legally prohibited from paying more than 2% when inflation was running in double digits.

>

While encouraging them to recycle petrodollars, make crazy loans to unstable and dictatorial foreign governments and fund shaky development projects run by the people on their boards of directors.

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Which made every bank a one-branch local monopoly that could ignore customer satisfaction (business hours 10 to 3 on weekdays only, and take every holiday ever conceived) and make huge profits without work (like the famous 6 – 3 – 1 rule, make mortgage loans at 6%, pay 1% on deposits and be on the golf course by 3). These institutions were mainstays of local political machines funneling cash and loans to politicians and their favorites, while enforcing explicitly racist and sexist lending criteria. Oh, and in the end the government had to come up with hundreds of billions of dollars in bailouts.

>

Let’s see, the value of the dollar fell by a factor of 50 in terms of gold, and came perilously close to becoming worthless entirely. Neither stocks nor bonds kept up with inflation over periods longer than ten years and American industry went from leading the world to being completely uncompetitive. Pollution soared unchecked and innovation was forced to get funding outside the financial system. The banking system nearly collapsed twice.

I’m not saying things are perfect now, or were completely terrible from 1945 to 1980. There were good and bad things from that era, and good and bad things today. But this whitewashing of history is absurd.

Posted by ObamaDonor | Report as abusive

“Economic historians refer to a period of “financial repression,” during which regulators and policymakers, reflecting public suspicion of Wall Street, restrained the growth of the banking sector. They placed limits on interest rates,”

Wiping out the savings of the American middle class by restricting their practical investment options to savings accounts legally prohibited from paying more than 2% when inflation was running in double digits.

“prohibited deposit-taking institutions from issuing securities,”

While encouraging them to recycle petrodollars, make crazy loans to unstable and dictatorial foreign governments and fund shaky development projects run by the people on their boards of directors.

“and, by preventing financial institutions from merging with one another, kept most of them relatively small.”

Which made every bank a one-branch local monopoly that could ignore customer satisfaction (business hours 10 to 3 on weekdays only, and take every holiday ever conceived) and make huge profits without work (like the famous 6 – 3 – 1 rule, make mortgage loans at 6%, pay 1% on deposits and be on the golf course by 3). These institutions were mainstays of local political machines funneling cash and loans to politicians and their favorites, while enforcing explicitly racist and sexist lending criteria. Oh, and in the end the government had to come up with hundreds of billions of dollars in bailouts.

“During this period, major financial crises were conspicuously absent”

Let’s see, the value of the dollar fell by a factor of 50 in terms of gold, and came perilously close to becoming worthless entirely. Neither stocks nor bonds kept up with inflation over periods longer than ten years and American industry went from leading the world to being completely uncompetitive. Pollution soared unchecked and innovation was forced to get funding outside the financial system. The banking system nearly collapsed twice.

I’m not saying things are perfect now, or were completely terrible from 1945 to 1980. There were good and bad things from that era, and good and bad things today. But this whitewashing of history is absurd.

Posted by ObamaDonor | Report as abusive

The real reason the financial sector is large is nothing to do with trading. The dominant revenue to the financial sector ultimately comes from interest payments on our record amount of debt. By intermediating in various ways, transforming maturity and liquidity etc., as well as managing portfolios and rolling over expiring debt, the financial sector captures as revenue much of the interest paid on all the debt in the system.

Since we currently have a record amount of debt, it is no surprise that the financial sector is at a record size. And, since the debt is not going away in a hurry, the financial sector will continue to be large for the foreseeable future. The bankers don’t need to be smart, or even greedy.

In the longer run, as deleveraging continues, the financial sector should shrink along with the debt, but that process could take many years.

Posted by Hayes | Report as abusive

That was a great foil to amateur’s response, TFF.

There was a time when banks were banks and everyone knew their purpose. Now we are back to thinking that all bankers are snidely do-littles (stereotypical villain) and fatcats. Wallstreet seems to relish that they are unproductive leeches and are ever looking for more and faster ways to spit out the dough.

Your comments on high frequency trading churning trades and money are so true and the SEC can’t keep up or perhaps even grasp. Hopefully the derivatives and the investment banks be reigned in with regulations.

Otherwise wallstreeters will be thought of as white collar bank robbers who haven’t been caught. This spate of insider trading busts are not going to appease anyone who knows that it isn’t the heart of the problem.

TFF< how can the salaries and bonuses be only borderline outrageous when the big 6 banks are $100B short of capital, yet have $145B in the bonus pool. Flat out outrageous!

Posted by hsvkitty | Report as abusive

Are the big 6 banks still $100B short of capital? Where do you get that figure?

As best I can tell, the “traditional banking” lines for the major banks are still unprofitable. Their loan books, whether mortgage, commercial, or consumer continue to sustain a high rate of defaults. Cost of funds is so low that you can’t even pad your margin by taking deposits — the cost of servicing the accounts is greater than the cost of acquiring funds through other avenues. And there is push-back from consumers and regulators on their fee income.

The trading desks turn a regular (daily) profit, however, which is what is keeping them afloat right now. And it is that activity that is generating the bonuses.

Posted by TFF | Report as abusive

“Chomsky praises Yves Smith’s book as being “really good”, and says nice things about Simon Johnson, too; I’m sure if asked he’d be equally complimentary of, say, Joe Stiglitz or Jamie Galbraith.”

In an interview with Cenk Uyger, Chomsky actually praised Joseph Stiglitz and (even) Paul Krugman.

Posted by GHIDS90 | Report as abusive

Basel III shortages between $100 and $150B, of which 90% is by the 6 largest US banks

http://www.reuters.com/article/idUSTRE6A L0A220101122

I don;t care what desk generates the bonuses… it is still exorbitant. ludicrous. Outrageous. Gluttonous.

Posted by hsvkitty | Report as abusive

Well, yes. Absolutely gluttonous. Still hard to see how anybody can change that system. The real losers are the corporate stockholders who take ALL the risk for only HALF the profits.

Posted by TFF | Report as abusive

hsvkitty, it has actually been a very good year for me. Perhaps that is because tutoring is a service business for the upper middle class? Perhaps it is the local economy? (Bouncing back stronger and faster here than elsewhere in the country.) But last year I was struggling to book clients and this year I filled up in early October.

I’m not quite ready to throw a $100,000 party, though!

Posted by TFF | Report as abusive
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