Wednesday, May 27, 2015

If loving finance is wrong...

David Glasner joins the chorus against the finance sector with "Is Finance Parasitic?", mostly with true stories of information asymmetry.  This seems to be a point of view that unites observers from all perspectives.

Think of the international capital flows that I have been looking at lately.  Developing market savers invest in low yield US assets, and US corporations invest in developing economy operations.

This trade is largely facilitated by the liquidity of US equity and debt markets.  Here is my attempt at passing an ideological Turing Test.  Let's look at all the damage finance does through this simple trade.

1) Developing market capital is pulled out of markets that could desperately use it.

2) That capital is parked in Western markets, funding unproductive public debt and inflating real estate values, creating unsustainable asset bubbles.

3) US households binge on this cheap capital, selling their financial futures by borrowing against these bloated assets to spend more than their incomes would allow.

4) Much of this spending goes to imports, so all of this debt goes to killing US jobs and supporting jobs overseas.

5) In the meantime, US firms keep moving operations abroad, selling out the American worker for an addiction to cheap foreign labor.

This is the bubble economy, and it has been facilitated by parasitic finance, who takes its cut at every step in the process.  Does the typical household have higher income because of any of this financial crapulence?  No.  Finance just leaves a trail of debt and excess.

</end of test>

David also references this post with thoughts from Timothy Taylor and Luigi Zingales   These guys are all much smarter, better read, and more reasonable than me.  And, clearly there is as much (maybe more) rent seeking, unfair practices, influence peddling, etc. in finance, as there is in many sectors.  But I am struck by the apparent lack of concern with the difficulty of measuring the social gains of financial activity and the tendency to generalize from specific problems with little concern for scale.

I suspect that a lot of potential readers would read my five steps above without objection.  Isn't that a good description of what is happening?  It's frustrating to me to see so many respectable intellectuals seeming to support the common narrative.  This is a subtle, complex subject, and the subtleties need supporters.

The output of finance frequently can't be measured in spending or production.  Finance is the management of risk.  Sometimes, when finance adds value, it adds value by reducing the denominator in the present value of future cash flows.

When developing market capital flows into the US, driving down interest rates, the owners of that capital earn much lower income on those US assets than US corporations earn on the foreign assets that they purchase in return.  Is the US financial sector actually destroying the potential income of those foreign savers?  If we simply measure the value of finance through the top line income it produces, then the answer is yes.

Or, maybe, Western financial institutions are providing value that surpasses that apparent loss of income, and this is one factor that attracts that capital to Western securities.

When US firms buy foreign productive assets in markets with high local risks, even if those assets don't produce more than they would under local ownership, their nominal values may rise due to the fact that they are pulled into a diversified asset base of a corporation traded in sophisticated and liquid financial markets.  So, there is no increase in production, but American corporations capture increases in nominal asset values due to diversification and liquidity.  American finance, just moving stuff around on paper to create fake paper profits.  Right?

Or, put another way, the owners of those foreign assets are now demanding fewer profits for each dollar of productive assets, and capital inflows into those markets will push up the future wages of local workers as a result.

This is conceptually very difficult to understand.  Even if financially literate intellectuals put on a full on offensive effort toward public education on this issue, it would be a tough assignment.  But, in a world where misplaced concerns about trade deficits and asset bubbles keep steering public policy in damaging directions, it's disappointing to see these concerns supported.

One specific reaction I have to the Glasner piece is regarding his paragraph about active trading.
In earlier posts, I have observed that a lot of what the financial industry does is not really productive of net benefits to society, the gains of some coming at the expense of others. This insight was developed by Jack Hirshleifer in his classic 1971 paper “The Private and Social Value of Information and the Reward to Inventive Activity.” Financial trading to a large extent involves nothing but the exchange of existing assets, real or financial, and the profit made by one trader is largely at the expense of the other party to the trade. Because the potential gain to one side of the transaction exceeds the net gain to society, there is a substantial incentive to devote resources to gaining any small, and transient informational advantage that can help a trader buy or sell at the right time, making a profit at the expense of another. The social benefit from these valuable, but minimal and transitory, informational advantages is far less than the value of the resources devoted to obtaining those informational advantages. Thus, much of what the financial sector is doing just drains resources from the rest of society, resource that could be put to far better and more productive use in other sectors of the economy.
It seems to me that he is doing a rhetorical flip-flop here.  It seems as though he is counting the gains of the winning trader as gains to finance and the losses to the losing trader as social losses.  But, isn't it more accurate to say that, if active trading is a zero-sum game, and passive investing on average earns higher returns, that all the gains are social?  The active investors who are making markets more efficient capture none of the gains of their efforts.  In fact, after costs, they lose. But, the benefits clearly accrue to the passive investor and to consumers who enjoy the products of newly funded firms.

Did Apple, Microsoft, Google, Amazon, etc. just spring from our passive conscience?  Aren't we taking for granted that the internet economy sprang from the American VC industry?  I suspect there are some subtle rhetorical biases going on here, where we separate active asset management into categories.  Where it was highly socially beneficial, as with Apple, the result is (1) huge gains to some traders and (2) unseen consumer surplus.  So, we count the trading gains as a sort of unearned income that leads to economic inequality.  Where it failed, the result is (1) losses to some traders and (2) missed potential consumer surplus.  So, we count the losses as a sort of outcome of information asymmetry - finance luring unsuspecting savers in with false tales of potential gains, pocketing the trading fees in a heads-I-win, tails-you-lose parlor game.

In the model in the Hirshleifer paper that Glasner links to, markets are assumed to be perfect.  So, active trading doesn't add any social value in a model that assumes away the social value of active trading..  And, we make a different category for describing capital that creates permanent changes in productive capacity.  When we describe these activities as earning rents off of "private information", it's easy to underestimate how ethereal information is.  Until the singularity comes, things like "foresight", "intuition", and "courage" are scarce kinds of information.  We are much more willing to credit people who created PC's in their garages with creating a new world than we are willing to credit the people who bankrolled them.  It seems ok that the tinkerer got rich.  He was out there working days and nights, getting his hands dirty, doing real work - innovating.  The financier behind him just got lucky, and her gains are parasitic - rents from private information.

Partly what is going on here is the Ant & the Grasshopper problem.  Is someone who invests savings with the assistance of a financial advisor a consumer of the finance sector or a part of the finance sector?  I think what people tend to do is move the agents around, depending on their place in the narrative.  So, there is a narrative that investors trade too much and are overconfident about active investing.  In this narrative, the financial intermediary plays the part of the finance sector and the saver is a customer - outside of finance.  So, overtrading is a cost finance imposes on others.

But, what if the narrative is that corporations have some sort of monopolistic power and profits keep climbing while wages stagnate?  In this narrative, the saver is a part of finance.  They are accruing gains on their investments at the expense of others.

Finance is parasitic because we define it as parasitic.  And the definition is fluid and self-contradicting where it needs to be.

In any system that is too complex to easily understand, we have a tendency to import our biases as a satisfying source of explanation.  Parasitic financiers are an ancient source of explanatory satisfaction.  I think we would do better to check ourselves.  It is very important for us to undermine and correct specific areas of corruption and influence peddling in an area as important and difficult as finance.  But, a comment like, "a lot of what the financial industry does is not really productive of net benefits to society." which is sort of vaguely defensible while feeding corrosive social misunderstandings, is sort of a rhetorical parasite feeding on our existing biases.  I'm not sure this points us in the right direction.

"Mood affiliation" is very tempting here.  I want to make it clear, the point of this isn't to make a category - "finance" - and to form two teams of arguing advocates and opponents.  My point is that finance, in the current public context, contains (1) a lot of highly regulated, complex, and politically charged activities that are ripe for rent-seeking and abuse by providers and (2) a lot of complex and politically charged activities that are very beneficial - crucial, even - to a world of progress and abundance, and whose benefits are subtle, difficult to measure, and frequently at odds with our dreadful intuitions.  Confusing activities in group number 2 with those in group number 1 is inevitable, because emergent phenomena are too complicated to understand.  This confusion is usually met with mass approval, because of our rotten intuitions and the moral dissonance we feel about deferred consumption - the ant.  Avoiding this confusion may be one of the most important and difficult tasks public intellectuals can undertake.


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