Friday, November 15, 2013

Evidence is optional with Finance cynicism

finance.jpgBryan Caplan had a disappointing post about the Finance Industry.  I hate to pick on him, because he's had tons of great posts recently, most of which I haven't commented on.  His post included this graph:

And, he seemed to be under the impression that (1) much of the finance sector's activity involves active stock trading for clients and that (2) active stock trading is a sucker's game.

As a thoughtful intellectual concerned with markets, I would have thought that Bryan would at least entertain the idea that the level of active trading is somewhat related to its usefulness in creating a properly priced market.  I have been meaning to do a post that references this recent FAJ article, (follow up here) which finds that highly active funds beat their benchmarks, even after fees.  On the margin, there may be a little bit too much trading, and there is certainly some trading that seems to be clearly useless, but to think that most active trading could be removed with little cost to market efficiency seems bold.

Besides this fact, other commenters mentioned that secondary equity markets are a small part of the finance sector.  And, Patrick Sullivan pointed out in the comments that:
I notice from the graph that the growth in share of GDP of finance is steady from 1950 til 2000, then it flattens. Should make the 'It was the repeal of Glass-Steagall that caused the financial crisis.' crowd unhappy.
 One of the commenters mentioned that much of the measured value-added of financial firms is due to compliance costs.  I would agree that there is some rent-seeking and some over-selling, but compliance costs and the growth of legitimate services could certainly explain this growth.  Compared to the 1940's, there is massively more need for saving and consumption smoothing today.  Has anyone tried to quantify the level of rent-seeking and over-selling in finance?  My radar goes off when I see sweeping claims made to roused audiences with eager narratives, with little evidence and no concern for scale.  I'd love it if someone can link to any research about this in the comments.

What is this strange tendency for even market-oriented economists to become jaded when they talk about the Finance industry?

There was an op-ed in the Wall Street Journal recently from Andrew Huszar, which begins, "I can only say: I'm sorry, America."  His bio with the article reads:
Mr. Huszar, a senior fellow at Rutgers Business School, is a former Morgan Stanley managing director. In 2009-10, he managed the Federal Reserve's $1.25 trillion agency mortgage-backed security purchase program.
You'd think he'd know what he was talking about.  His piece has been roundly criticized by many more capable than I, so I don't want to rehash the whole piece.  But, the piece strikes me as the sort of writing that has been common in popular finance publishing since the crisis - the story of a former insider who just couldn't take it any more and left finance in order to write an apology to the American people.  Despite their credentials, these authors sometimes seem shockingly ignorant of legitimate arguments for the value of the work they were engaged in.

Here is a portion of a passage from the article:
Despite the Fed's rhetoric, my program wasn't helping to make credit any more accessible for the average American. The banks were only issuing fewer and fewer loans. More insidiously, whatever credit they were extending wasn't getting much cheaper. QE may have been driving down the wholesale cost for banks to make loans, but Wall Street was pocketing most of the extra cash....
Trading for the first round of QE ended on March 31, 2010. The final results confirmed that, while there had been only trivial relief for Main Street, the U.S. central bank's bond purchases had been an absolute coup for Wall Street.
It took me all of about 2 minutes to check this out.
Here are US mortgage rates since 1972.  That last little part after 2008, where the rates are really low, is the part where rapacious banks were pocketing cash from excess mortgage profits.
FRED Graph

Here is the spread of US mortgage rates minus 10 year treasury rates since 1972.  That last little part after 2008, where the spread is bouncing around its narrow long term range, is the part where rapacious banks were pocketing cash from excess mortgage profits.
FRED Graph

Here is the mortgage-to-10-year treasury spread, compared to the Fed's QE programs.  Fed mortgage security purchases are in red and treasury purchases are in green.  Where the red and green lines are rising elevated, those are the QE periods.  Notice how the mortgage spread shrinks during those times?  So, not only were the banks lowering mortgage rates during the rounds of QE, but they were lowering them even in relation to their cost of capital.
FRED Graph
You would think that Mr. Huszar would have been familiar with these spreads when he was managing the Federal Reserve's $1.25 trillion agency mortgage-backed security purchase program.  But, if you picture the Fed as the Interest Rate Wizard of Oz, it must be difficult to construct a narrative about interest rates when they regularly move in the opposite position direction from the Fed's claimed target.

Mr. Huszar is not the first person to float this idea that the Fed has been flooding the banks with cash, and that the banks have been pocketing the cash instead of performing their patriotic duty by loaning it out to good Americans.  But, leaving empirical evidence aside, how do these people think the world works?

Have the banks always had this monopoly power over mortgage profits?  Why did they choose now to pocket extra cash?

There must be 50 banks within 50 miles of my house that I could shop for a mortgage.  Do these people think the local Credit Union is somehow part of a shadowy cabal of tuxedoed fat-cats secretly setting excessive mortgage rates?  Are banks run by underwear gnomes who are raking in billions by NOT issuing mortgages, even while the Fed begs them to?


  1. Nicely done. Huszar got away with some self-promotion, I'm sure (in the WSJ!), but it was obviously full of sound and fury, signifying bubkis.

  2. If the overall economy was prospering you might have a point. But what have we got in return for sending our best and brightest to Wall Street to make billions creating complex financial products and high speed algorithms. Seems to me we have one of the worst economies since the last time speculators were taking such a large share of the pie. If just look at what it is we need done in this country do you think we need more bankers and high speed traders or do we need more health care providers, road builders, jet mechanics and basic researchers?

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