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Friday, July 17, 2009

Against finance

Paul Krugman rails against Goldman's big quarterly numbers in yesterday's Times. He goes as far as to claim that Goldman's success is bad for America!

At the core of his argument is the following observation:

Over the past generation — ever since the banking deregulation of the Reagan years — the U.S. economy has been “financialized.” The business of moving money around, of slicing, dicing and repackaging financial claims, has soared in importance compared with the actual production of useful stuff. The sector officially labeled “securities, commodity contracts and investments” has grown especially fast, from only 0.3 percent of G.D.P. in the late 1970s to 1.7 percent of G.D.P. in 2007.

Such growth would be fine if financialization really delivered on its promises — if financial firms made money by directing capital to its most productive uses, by developing innovative ways to spread and reduce risk. But can anyone, at this point, make those claims with a straight face? Financial firms, we now know, directed vast quantities of capital into the construction of unsellable houses and empty shopping malls. They increased risk rather than reducing it, and concentrated risk rather than spreading it. In effect, the industry was selling dangerous patent medicine to gullible consumers.

This point has not received enough attention in the volumes of analysis produced by the financial crisis. Some comments.

1. Markets and capitalism are good -- overall, they benefit society by providing (mostly) efficient allocation of scarce assets (including human, as well as other, capital).

We've just been through a bubble, with resulting misallocation of resources, but perhaps bubbles are an unavoidable side effect of capital markets, and perhaps their short term negative consequences are compensated by the long term benefits of market economics. Of course, it is beyond our capabilities to address this question with high confidence, so what is left is people arguing their priors. At the bottom of this post are some previous comments of mine on this topic.

2. Concentration of the control of wealth is inevitable, given advances in communications and information technology, the complexity of our economy, and cognitive limits of average people. By control I don't mean ownership, I mean investment and allocation decisions -- think mutual fund investors of modest means, but whose money is aggregated into a billion dollar fund controlled by a few investment professionals.

Given 1 and 2, I doubt Krugman really wants to eliminate the financial sector. His outrage is really motivated by populism, and relates to the following question:

3. How should these professionals be paid? How much value do their decisions actually add to the economy?

This is the fundamental question, also unanswered. Would less extravagant pay for money managers (e.g., as a consequence of more egalitarian cultural values) lead to reduced economic growth? By how much? (By the way, I don't think we can lay all the blame for the current crisis on the professionals -- millions of Americans participated in the housing bubble.)

Personally, I think Wall St. compensation practices need to be changed. I debated this and related points with a hedge fund manager in some previous posts: On the benevolence of financiers , Money talks.

Here's what I wrote in 2008 on topic 1 above. Can anyone do better than these estimates?

Now to my heterodox heterodoxy: always estimate costs and benefits when making a decision. A little calculation is in order: suppose unfettered markets lead to systemic crises every 20 years that cost 15% of GDP to clean up. I think that's an upper bound: a $2 trillion (current dollars) crisis every 20 years. [That $2 trillion was an estimate for the direct housing bubble losses, but I can see now that the collapse of credit markets and of business and consumer confidence is going to increase that number substantially.]

Easy Question: What growth rate advantage (additional GDP growth rate per annum) would savage, unfettered markets need to generate to justify these occasional disasters?

Answer: an additional .1 percent annual GDP growth would be more than enough. That is, an unregulated economy whose growth rate was .1 percent higher would, even after paying for each 20 year crisis, be richer than the heavily regulated comparator which avoided the crises but had a lower growth rate.

Hard Question: would additional regulation decrease economic growth rates by that amount or more?

Unless you think you can evaluate the relative GDP growth effects of two different policy regimes with accuracy of better than .1 percent, then the intellectually honest answer to the policy question is -- I don't know -- no shouting, no shaking your fist, no lecturing other people, no writing op eds, just I don't know. Correct the things that are obviously stupid, but don't overstate your confidence level about additional policy changes.

(Note I'm aware that distributional issues are also important. In the most recent era gains went mostly to a small number of top earners whereas the cost of the bailout will be spread over the whole tax base.)

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