Thursday, October 30, 2008

Is the finance boom over?

At least for a while. Note the dip after the great depression -- is that where we are headed?

This data comes from papers by Thomas Phillippon (MA in physics, Ecole Polytechnique, PhD in economics, MIT -- vive Les Grandes Ecoles!). See here and here; via Zubin Jelveh.

From 1900 to the mid-1930s, the financial sector was a high-education, high-wage industry. Its workforce was 17% more educated and paid at least 50% more than that of the rest of the private sector. A dramatic shift occurred during the 1930s. The financial sector started losing its high human capital status and its wage premium relative to the rest of the private sector. This trend continued after World War II until the late 1970s. By that time, wages in the financial sector were similar to wages in the rest of the economy. From 1980 onward [deregulation!], another shift occurred. The financial sector became a high-skill high-wage industry again.

The figure below (click for larger version) shows the relative incomes of engineers and financiers over time. The data on the right is for those with postgraduate degrees. Perhaps the collapse of the finance bubble will reallocate human capital back into more "productive" activities?


DB said...

With a little re-tooling, I should be ready by next year to analyze LHC data. -- A Finance Guy

Mr. Gunn said...

one could only hope!

Anonymous said...

It sure is over for AIG, whose fortunes continue to head south (NY Times):

The American International Group is rapidly running through $123 billion in emergency lending provided by the Federal Reserve, raising questions about how a company claiming to be solvent in September could have developed such a big hole by October. Some analysts say at least part of the shortfall must have been there all along, hidden by irregular accounting.

Steve Hsu said...

I'm very curious about the AIG story. Perhaps they are having to post huge amounts of collateral to back the CDS contracts they've written? Where are all the good journalists?

Anonymous said...

More on the CDS settlement backwash, probably related to AIG's troubles:
How Credit Default Swap Settlements Are Draining Liquidity From Interbank Market

A comment on the post says:

Each day it becomes clearer to me why Mandelbrot and Taleb are frightened.

If the unwind were to occur over a long time span then governments could cope. It is happening too fast.

Anonymous said...

See this commentary on from the CEO of the International Swaps and Derivatives Association, politely dismissing the significance of credit default swaps as a central villain:

It's also worth noting that, in spite of the failure of Lehman, as well as several other large counterparties, the CDS business continues to function effectively. CDS have proven to be the main - and sometimes the only - way to shed risk or express a view on market behaviour. While cash, securities and money markets have seized up, the CDS business still operates.

DTCC has adopted a similar stance in their public statements. Of course, the organizations heavily involved in the CDS market would hate to see it fade away or subjected to further regulation.

Steve Hsu said...

The CDS market may still be functioning, but that doesn't tell me whether CDS bets have exacerbated the current crisis. Those are separate issues. For exaample, even if counterparty risk *turns out* not to be a problem (we won't know until the crisis is over), people may have *behaved* as if it was *during* the crisis. That might mean selling other assets because I can't be 100% sure my "insurance" (hedge) is going to pay off.

Why does AIG need more and more money from the Feds? Their only exposure to the credit crisis, as far as I know, is in writing CDS contracts. Their (ordinary) insurance business is still cash positive.

Anonymous said...

There are two other reports on right now that throw doubt on arguments for confidence (much less complacency) about the role of CDSs.

It seems that promoting the value of derivatives as a risk management tool, in spite of multiple episodes indicating their potential for increasing risk, is a recurring theme in the history of this class of securities. A cynic (or a realist) would say that whenever a putative risk management tool becomes itself an avenue for making money (generating returns) then this is more or less guaranteed to happen.

The difference in attitude between a lot of people in finance and people in engineering, especially those who design and maintain critical infrastructure (eg, computer operating systems and networks) is striking. There are certainly temptations in engineering to chase profits or surrogates like performance, which require various kinds of optimization. But optimization is often dangerous, because it involves making optimistic assumptions. (Note the common word root!)

The most blunt practitioners of modern finance have been willing to forthrightly say that they are engaged in gambling, and explicitly repudiate a prudent, risk-averse engineering ethic. Through clever marketing this has become more and more pervasive, although most of the participants in the game have perhaps been more like rich suckers who get invited to the table just so they can lose big bucks to the pros.

Anonymous said...

PS: On roping in those rich suckers, see Andrew Lahde's parting shot (upon shutting down his hedge fund).

Sam said...

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