Tuesday, January 4, 2011

The Politics and Economics of Finance

. Tuesday, January 4, 2011





Related to my previous post, as well as other recent discussion from Cowen and others. Graph taken from a commenter at Sumner's place (click for larger image).

I've been in a late night Twitter discussion with Steve Randy Waldman over that Sumner post. I summarized much of what I think about it in the post below, but Waldman (and others) think that rent-seeking behavior deserves a much greater role. I disagree, and I also disagree with Sumner on some key points, so here's more fully what I'm thinking right now. I think there are two major shifts, one political and one economic, that does the best job of explaining inequality and finance's role in it:

1. Sumner probably shouldn't've phrased things in terms of "discoverers", nor in terms of "deserve". The former conjures venture capitalists and start-up funding, and that is clearly at least part of what Sumner had in mind originally, but not all. The latter ascribes some normative aspect that i don't think he meant to convey. He would have done better to simply say that finance has done very well at responding to the incentives given them. Those incentives are shaped by a government that wants to please its constituents. Its constituents want funding for houses, for cars, for expensive health care and well-funded retirements. The government incentivizes finance to provide those things at relatively low cost, in exchange for subsidies of various kinds.

Is this capturing of rents? On the one hand, finance has profited very greatly from this arrangement. On the other hand, so have many others, from "subprime" folks who would never have gotten to purchase a home before, to real estate owners/developers, to construction workers, to millions of kids getting student loans. In other words, if there is a "public interest" in having debt spread through the system, can that political economy really be characterized as rent capture by bankers? It seems more nuanced than that.

This is not to suggest that finance doesn't lobby in favor of their interests. They do, as they would be expected to do. Sometimes they win, and their managers and shareholders (including those who invest their pensions and savings in the market) benefit from that. And surely there is some direct sleaziness that goes on, and outright fraud as well.

But that has always been true. That hasn't changed in the past 15-20 years. It hasn't changed in the past 500. It was true in the 1820s, and the 1950s, and the 1980s. What has changed is the rewards going to that sector, and not just in the U.S. You can't explain variation with a static variable. Which makes me think that there is an overarching, dynamic, structural economic story beyond the political dimension, which is my next point.

2. Finance was dealt a very good hand. Technological advances massively reduced transaction costs for capital allocation. Institutional advances -- e.g. the WTO and capital account liberalizations of the past quarter century -- have increased scale opportunities for capital allocation. And, yes, skills investments in things like quantitative finance have also pushed finance's PPF outward. The previously-established financial centers -- New York, London, Frankfurt -- took advantage of those developments. It's not that our generation's financiers on the whole were more gifted than those of previous generations; it's just that the world opened up for finance in a way it hadn't before.

Take an analogy. Professional baseball players make much more money than they used to make. Is this because they are better baseball players? Not necessarily. Is this because society values baseball more than it used to? Probably not, in any normative sense. It's because technological advances have made it possible to watch every game of every team at very low cost. Thus the audience increases, the demand curve shifts right, and the value of a baseball player's labor goes up. Yes, the superstars -- the Jeters and A-Rods and Buffetts and Soroses -- reap much of the reward, but even the average major leaguers and role players make much much more than they used to.

In fact, even if baseball players (financiers) were actually worse than they used to be in absolute terms, their remuneration could still go way up because of advances in other sectors, like technology, that allow them to reach a much larger audience. Going back to finance, there has been a huge global demand-curve shift, and economies that are capable of satisfying that demand (read: first-wave industrialized economies like the U.S. and U.K. that developed large, liquid, robust financial sectors a long time ago) have seen their economies orient more towards finance than in previous generations. We're exporting a lot of that finance as well, in exchange for agricultural and manufactured goods that are often facilitated by our finance sector. And it isn't just the Buffetts and Soroses that benefit, but the typical finance professional as well.

I think that that is what Sumner meant by "deserve" and "discovery" and "capital allocation". At least that's how I read him, and that's what my own thoughts are.

None of this is to say that finance is perfect, or even especially good at efficiently allocating capital to useful purposes. Obviously they mess up, quite horribly at times. Partially because their incentives are screwed up by markets, partially because their incentives are screwed up by public policy, and partially because they just make mistakes. But with the hand they've been dealt it would be almost impossible to not get paid off. And so they have been.

The normative question is whether this shift -- in which more of the economy in housed in finance rather than manufacturing or agriculture, with a concomitant rise in income inequality -- represents a problem for society. The positive question is whether these outsized gains for finance will be competed away once rising economies develop larger, stronger financial sectors of their own, and whether increased competition will lead to increased volatility in the system. This is already too long, so those will have to be the subject of other posts.

6 comments:

Canute said...

"On the other hand, so have many others, from "subprime" folks who would never have gotten to purchase a home before, to real estate owners/developers, to construction workers, to millions of kids getting student loans."

But aren't a significant portion of these people emphatically not better off, as they are saddled with debt they cannot feasibly pay off?

"Take an analogy. Professional baseball players make much more money than they used to make. Is this because they are better baseball players? Not necessarily. Is this because society values baseball more than it used to? Probably not, in any normative sense. It's because technological advances have made it possible to watch every game of every team at very low cost."

Really poor example. Players make that kind of money thanks to free agency, which owners in all 4 sports fought tooth-and-nail to keep in place (until 1993 in the NFL). Only at that point did players begin getting a reasonable share of revenues.

Kindred Winecoff said...

Canute -

Some of them are now in the same place that they were before: unable to afford a house. Not so many are demonstrably worse off.

Regarding baseball, I think it's a fine analogy. Free agency in baseball happened in 1976. Exploding revenues and astronomical salary gains didn't happen until two decades later, when cable tv sports saturated the market. Roughly the same time period as the boom in finance.

Sarah said...

"Some of them are now in the same place that they were before: unable to afford a house. Not so many are demonstrably worse off."

This is a rather bizarre claim. People who are struggling to pay off a house that may now be worth 50-70% of what they paid are not worse off? People paying twice or three times for their house than what they would pay to rent a comparable place are not worse off? People who have been foreclosed upon are not worse off? People who have gone through bankruptcy and now have little access to credit are not worse off? And if they are NOT in this situation it is probably because they, like many minorities, were put into a loan labeled 'sub-prime' when they would have qualified for conventional financing because it was more profitable to the mortgage broker and bank.

I'm baffled by a logic that can look at the whole long train wreck of the housing crisis and find it equally beneficial for bailed-out bankers with their record bonuses, foreclosed on home-owners, and out of work construction workers.

SBD said...

FYI - The above Sarah is not SBD. But, I would say that many people who have been foreclosed on are worse off than they were before (sudden stops in credit for one, Poverty rates went up last year). I'd say your argument that finance was dealt a good hand overlooks the political reasons WHY they were. I'm curious - what do you think about Ragu Rajan's argument about how it was easier for politicians to create opportunities for easy credit rather than deal more directly with stagnant wages and growing inequality?

Kindred Winecoff said...

Sarah -

Not to diminish the real suffering that goes on, but it's not as if were it not for these bankers these hypothetical people wouldn't be struggling to make ends meet. Also, it's not as if there isn't adverse selection on the other side of the market. Moral hazard isn't the only information asymmetry.

My point was that if your mortgage is underwater you can walk away. Yeah, your credit will take a hit, but subprime loans (esp NINJAs) were given to people with fairly poor credit anyway. Hence, SUBprime. The bank gets stuck with the devalued asset, the person/family can essentially walk away having lived in a place they couldn't rightfully afford for a few years, got back to renting like they used to do, no major consequences.

That's not the best state of affairs, I agree. But in the universe of human suffering it doesn't rank all that high in my book. Not to mention that there has to be some personal responsibility for choices made. I didn't buy a huge expensive house in a clearly speculative market. I bought a very small, very inexpensive house that I knew I could afford. Most of my friends didn't buy at all, even though they could have gotten loans, because they knew they couldn't afford it and didn't trust the fact that prices would go up 10% a year in perpetuity.

And I'm not saying bankers have suffered just as much. Read what I wrote: finance was dealt a very good hand. They almost couldn't mess it up. Many of them lost a lot of money, some of them didn't lose a penny. I'm not at all saying we should cry for bankers. I'm just saying there's no need to tar and feather them either.

SBD -

My point is that "sudden stops in credit" is basically the status quo for subprime borrowers in a "vanilla" banking sector. So yes, they are worse off than they were in 2006, but not necessarily worse off than they would have been had finance never gotten so effed up.

I haven't read Rajan's book yet but I've read some of his articles and interviews. I think I'm in complete agreement. And that's really been my point: governments wanted finance to give credit to everybody. For housing, yes, but also school loans and car loans and everything else. They skewed regulatory policy so that would happen. They skewed monetary policy so that would happen. I don't think it was a response to inequality necessarily, but slow wage growth yeah.

That's why I don't think of this as "rent capture". The reason why the gov't did this is because *we wanted them to do it*. Everyone wanted to go to college, everyone wanted to buy a house, everyone wanted a new SUV. Society demanded it, the gov't skewed the incentives of finance to provide, and finance did it. Maybe finance benefited the most; they probably did. But their not the only ones.

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