In the November 29th issue of The New Yorker, John Cassidy asks in a commentary:
"What good is Wall Street?" He ends his article with a quote from Paul Woolly: “There was a presumption that financial innovation is socially valuable. The first thing I discovered is that it wasn’t backed by any empirical evidence. There’s almost none.”
Wall Street sustained losses of US$42.6 billion in 2008, but made US$55 billion in profits the very next year - when most people were coping, and many coping badly, with recession, unemployment and declining asset prices. In the first quarter of 2010, traders at Goldman Sachs had their best quarter results ever - US$7.4 billion in net revenue.
In securities trading these days, institutional fund managers and speculative high frequency traders are most of the market. Rarely do they provide capital for new or expanded business enterprise. Mostly they take cash out of the economy through the buying and selling of existing securities which represent the present value of past capital investment.
Big trading houses hardly ever have a day when they lose money. This is not taking a chance on a roll of the dice - this is loading the dice in their favor. It is moving the chips around among the poker players; total wealth is not increased in a trade of securities; cash just changes hands.
If someone buys at five and sells at six to pocket a one dollar profit, what value have they added? Some liquidity to the market for that security, to be sure, and there is a social good provided by liquid markets. But beyond that?
They took the dollar profit in exchange for a legal claim on future income and/or capital - a security. This is rent extraction, not wealth creation. Rents are paid for access to legal or political authority - as when we pay rent to a landlord, we buy a share of his or her legal title to real property. Patents and copyrights provide legal opportunities for rent extraction. Without legal title and the power of government to enforce those property rights, no rents could be charged.
If prices for securities rise, however, there is what is called a “wealth effect.” People then feel a rising tide of economic prospects and their psychology encourages consumption and borrowing, which do impact the real economy.
More realistic economic wealth creation through financial intermediation aggregates existing wealth from some to transfer its buying power to others to finance enterprise, innovation and growth.
This is most often done through new loans to business and new equity investment in companies, or through hybrid investments like warrants, preferred stock and convertible bonds and debentures.
Traditional banking, investment banking and venture capital provided these financial services. Insurance and other forms of risk protection and diversification also add real economic value in encouraging investment in enterprise.
But from 1991 to 2000, some 150 venture capital-backed companies a year took in equity capital through Wall Street. But since 2000, such annual IPO offerings have averaged only about 50 per year.
Capital markets seem to have lost faith in new enterprises and have become captivated by property, derivatives, bonds and every other asset class.
So where will the growth come from to hire workers and pay down national debts?
Lord Adair Turner, Chairman of the UK’s Financial Services Authority, wrote recently that “It is possible for financial activity to extract rents from the real economy rather than deliver economic value.”
If all financial innovation does is create new forms of rent extraction, what good does it do except to take money from the many and give it to the few?
In the United States, six firms - Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo - have assets of US$9.2 trillion - 63% of national GDP.
John Maynard Keynes famously aligned securities exchanges with casinos in their social utility. Did he have a point? Casinos make a lot of money on millions of small transactions. They win every time you lose at their tables. What wealth do they create? They just take your money and move it to other pockets.
So does a poker game, or craps. Money moves among players, but the total pot sees no growth in value. Some go home winners, but others leave as losers to that extent.
The bets made by many securities traders are calculated by algorithms that measure a price as a deviation (higher or lower) from a statistical norm and plot the odds of deviation associated with that price. If you bet that the price will converge towards the norm, you can successfully arbitrage and make profits.
The algorithms that now control most trading in securities began as attempts to beat the odds in casinos. Our financial system’s major profit seeking mechanism owes its life and its profits to the techniques of gambling.
Maybe Keynes had a point after all.
Gambling, I would suggest, is a form of extracting rents from the real economy. Gamblers seek rents associated with their legal rights. Gambling is all about getting power according to the rules. The rules of gambling - poker, black-jack, craps, chemin de fer, bridge, if you will - create legal rights in players. Two of a kind in poker beats any single high card, etc. If the rules come down in your favor, you have a right to collect. You suddenly have a valuable property in how the cards or the dice fell. You can therefore trade in your property for some of the cash money put up by the other players, including the house.
Or, if you gain nothing to trade from the fall of cards or dice, you lose whatever price you paid to join the game. That entrance fee is also a form of rent, paid to those who “own” the game for access to their assets.
All the money that changes hands in gambling is brought into the casino or the game from the outside - from the real economy.
Rent extraction in gambling brings about a kind of "irrational exuberance" on the part of many players that does not exist in normal market transactions where pricing future returns is more realistic.
The more rent extraction is at work, the less market mechanisms can do their job of providing economically efficient outcomes. Where rent extraction is at work, the elasticity of supply and demand curves tightens; free market checks and balances have less effect; prices don't signal true levels of demand or possible supply, and they are artificially high. It is easier to make money through rent extraction than to be subject to market forces.
Monopolies and cartels create opportunities for rent extraction. Adam Smith, in his book Wealth of Nations, noted that business owners and managers love to get together and conspire against the public by setting up rigged markets to increase the returns to rent.
Corruption by officials and politicians is another form of rent extraction: use of state power for selfish gain comes at a price paid to those in charge of state authority. Here, too, market forces are too weak to control prices and economic outcomes.
If it is correct that financial intermediation has more and more become rent extraction, than it should also be correct that we need to give it less and less deference and government advantages.
The profits of financial houses should move back down in proportion to all profits roughly to the proportion that the financial industry contributes real wealth to national GDP.
Disproportionate rent extraction would appear to be highly unethical, in any industry.