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5: Why Financial Markets Fail

Financial markets seem to embody the essence of capitalism, enabling the resources of a society to be applied to where they will accomplish the greatest social good. At least, that's how it goes in theory.

In practice, financial markets do embody the essence of capitalism, but its weaknesses as well as its strengths. Markets are subject to "bouts of herd behavior" and can be dysfunctional even for extended periods of time, in a manner that is silently corrosive and comes to our attention only when the problems have become exacerbated and exaggerated and the corrosion becomes evident.

The Great Depression of the 1930s demonstrated the problems of a financial system, and its lessons have been forgotten. We believe such a disaster could not happen again, dismiss it as a unique set of unusual circumstances that are highly likely to recur. Less then a century later, here we are again.

The importance of finance

Financial markets, like any other markets, bring together people who have the resources to solve one another's problems. Those who need finance have ideas and ability, but lack the capital to act upon them; those who furnish finance have capital but lack a plan to make productive use of it.

Finance is also available for consumptive needs - the individual who needs a house but does not have the ability to buy it outright can obtain financing to have it immediately and pay for it over a period of years out of their future income.

The risk inherent in investing in the future, that the productive activity will not yield profit, or the consumptive borrower will fail to repay his debt obligations, is pooled and spread out among investors who are willing to assume some portion of the risk, provided the reward is sufficient.

In any instances, finance enables actions to be undertaken, benefit to be created and consumed, that otherwise would not have been possible for lack of capital resources.

Without finance, the economic growth of the past two centuries would not have occurred, and making would likely be stuck in what is now considered to be the "middle" ages, of stagnancy, desperation, and want.

This is the source of fear when we see the economic system failing. Society, such as we know it, is entirely dependent on the health of the financial sector. Without it, production and spending would plunge - the fuel to the engine of society would be cut off. The financial system is faltering, and so people are feeling the ill effects. If the financial system collapses, society would soon follow.

(EN: I don't buy into the nightmare argument. My sense is that the doomsayers stop short - that is, the collapse of financial markets would not be the end of the planet. Life goes on. Human beings still need things, and still have the capacity to produce the things they need. While there would likely be quite some hardship and deprivation for a time, humanity would carry on producing and trading goods, and the financial infrastructure would be rebuilt, likely more quickly than we assume. In moments of overwhelming pessimism, it even seems to me that a sudden and complete collapse would be preferable to these decades of slow death.)

What makes finance special?

The "financial world" is extremely volatile. Wealth can be created or destroyed in great quantities in a short period of time, and the institution that allows capital to flow from one set of hands to another is "quintessentially fragile."

Consider that all debt is based on speculation and assumption. The lender trusts that his borrower will repay him. The borrow has faith that his future activities will give him the means to repay.

There is absolutely no way to be certain - the faith we place in the future is based on great hope and little evidence. Even when evidence exists in abundance, there are no guarantees that things will work out as we hope, but might turn out as we fear.

And ultimately, the financial system for all its faith in numerology is entirely irrational and emotional: it is the precarious relationship between hope and fear.

The psychological nature of wealth

Our present notion of wealth is problematic. Machines, bridges, factories, and goods are real things to which we ascribe a value - but the ascribed value is dubious and largely imaginary. Ultimately, things are worth what people feel they are worth, which is entirely psychological. Any numerical value is abstract.

The real value of a thing is in the benefit it is expected to provide by its consumption, or that which it is expected to produce by its use to create other things, or that which it is expected to fetch by its exchange for other things. In all instances, its value derives from expectations.

Paper wealth is a step removed from the ownership of the actual items of capital. A share of stock is a claim on a portion of the assets of a company. Its value is derived from the expected value of the corporation's assets, the income the corporation might earn, or the price that might be fetched by selling the share to someone else. What's more, the value of paper wealth can be nullified at a whim, by a refusal to redeem the share.

How wealthy an individual or society is a reflection of its feeling and expectations. It is psychological and imaginary rather than real. As such, it is exceedingly easy for trillions of dollars in wealth to be created or eliminated in the daily fluctuations of the stock market.

When it disappears, no-one can say where it went. In truth, it never existed at all. It is only that we have changed our collective opinions of the imaginary value of things. Ultimately, asking where our wealth has gone is the same as asking where our happiness has gone when we find ourselves in a sour mood.

The speed of finance

Because wealth lacks substance and is based on psychology, financial values can move dramatically in moments on the basis of very little change in the physical world. Fortunes can be made and lost in financial markets far more quickly than in almost any other activity.

A stock market can, and has, doubled or halved in value in the course of a single year - an the value ascribed to real goods and services are likewise subject to surge and retract - while it is their customary nature to follow long and slow trends, the change can take place instantaneously.

By contrast, the value produced by tangible assets proceeds slowly. You can double the value of a house simply by offering double its asking price - but you can not as easily cause there to be two houses rather than one. You must build, and that takes time.

People an countries achieve real wealth - the enjoyment of benefits delivered by assets - through hard work over a great deal of time. Rapidly developing countries may find that personal wealth (the benefits enjoyed consumptively) increases at a pace of 10% per year, more developed ones at more like 2% to 3%.

Conceded, that if one person makes a fortune on the stock exchange, he can consume a disproportionate share of goods and services by virtue of his paper wealth - but on the larger scale, if everyone gains paper wealth all at once, the price of goods rises to nullify their wealth - the gross amount of benefits delivered by tangible assets has not increased in either case, and in the latter case, the nominal value has increased but the amount of goods has not.

Wealth on a societal scale is not produced by financial markets, but by the actual creation of things that deliver benefits, which takes more time.

The power of debt

The effects of the "elasticity of wealth" are exacerbated by the power of debt.

If an individual produces a benefit, his reward for his effort is the enjoyment of the benefit. If he sells his work product to others, he receives the value they are willing to offer in exchange (which he then exchanges for the work product of others in the market).

Within the collective, an individual seeks to make an income by selling his labor to others - he will contribute his effort to achieve goals that others have, and accept in return the payment he has negotiated in exchange for the contribution of his labor - and as previously mentioned, the estimation of that value is at the discretion of the employer, based on but not necessarily derived from the value of the work toward the final output.

With capital, it is different. The interest paid for the privilege of borrowing money is not based on the value produced by that money, but the rate that the lender imagines he might have earned if he had invested his funds elsewhere.

Some people are able to borrow in order to invest. The business owner borrows money to invest directly in productive assets that will furnish the capital to repay the loan. Others borrow to consume. The homeowner borrows the money to purchase a home, which will be paid for from his future income that is not directly connected to the asset.

Still others borrow at a low rate to loan the same finds to others at a higher rate, and make money by using their personal assets to absorb the risk of their investment.

There's an aside about real estate investment - in which "the ordinary punter" can borrow money to invest in an asset with the hope that the asset will increase in value, such that he can flip it, repay the loan, and enjoy a tidy profit. This made a lot of people very wealthy for a few decades, and a lot more impoverished when the bubble burst.

Businesses, particularly large ones, are heavily leveraged and are making money on borrowed money. This works so long as assets increase in value, but fails catastrophically when assets decrease in value, which is why many businesses and investors alike (those who trade on the margin with borrowed funds) were wiped out in the events of 2007-2009.

Sidebar: Six Key Failings of Financial Markets

The author provides a quick list, some of which has been established, and notes that there will be further support of these arguments later.

Being wrong in good company

Until recently, some economists did not believe in bubbles or dismissed them as a largely historical side effect that occurs only in small markets, worthy of no more than a footnote.

Outside of economic theory, it is recognized that people tend to follow the behavior of others who are successful, optimistic that imitation of the activities will lead to achieving the same results for themelves. They do so without much consideration of how the behaviors of others function, or whether the same results can be achieved when many people decide to do the same thing. In this way, "group think" leads to the tragedy of the commons.

Moreover, people value conformity. Few succeed by being original, and most people go quite far in life by imitating others. An executive who does not apply much intelligence or initiative can play it safe, do what others do, and innovate within the narrow confines of standard practices, takes on little risk of making a mistake - and if he does, his defense is that he is following conventional wisdom.

While it is said that economists always disagree, the striking thing is how little their opinions differ. They tend to follow consensus. The same can be said of many though leaders in the financial markets: they learn the tricks of the trade, and employ them with very little variation.

Keynes likened the practice of professional investment to a contest in which each person is to pock out the six prettiest faces in a hundred photographs, the prize going to the person whose choices most nearly match the average. As such, the competitors are not choosing based on their personal opinion of prettiness, but guessing what the mass of humanity will choose.

When the same practice is undertaken in financial markets, the result is that investment is not made in the most profitable pursuits, but in those that an analysts expects other analysts will find profitable, and all gravitate to the same commodities and firms, inflating their price due to demand rather than a rational estimation of their real profitability.

Life cycles

In the age of proprietorships, large companies were managed by their owners over long periods of time. The owners thus were encouraged to take a long-term perspective, to manage the company to be reasonably profitable for the entirety of their lives, and to pass on a successful and strong firm as a legacy to their children.

In the age of corporations, firms are managed by professionals who have a very short tenure. It is not uncommon for a CEO to have a term of only two or three years. It is also in his interests to promote the short-term performance to make himself attractive to his next employer, even if this comes at the long-term detriment of the firm. He is therefore not attentive to the long-term performance of the organization, nor does he care what shape it is in when it passes to the hands of the next chief.

Neither can the board of directors, representing the interests of the investors, be counted upon to encourage the chief executive to consider the long-term welfare of the firm. Most of them are also short-term players, who bought low, will cash out when the stock price rises, and have little regard for what is left in their wake.

Lesser employees, consumers, and long-term inventors, and society at large, meanwhile, operate on a longer scale. They hope to keep their jobs, enjoy a stable quality of product, and enjoy reasonable returns for a longer period of time. Their desire is not for a flash in the pan, but a long and steady source of energy.

This supports the existence of bubbles - which are sources of magnificent wealth for the short-term players who intend to walk away before they collapse. The consequences are much worse for those who remain invested for the long run.

And back to the executives, if any chief executive of a major banking group had stood up in a crowd and declared the housing bubble to be an impending disaster, he would have been lynched. His investors wanted to keep making exorbitant profits for as long as possible, and his peers would not appreciate his letting the secret out. It is in their interest to keep playing along for as long as the party lasts.

Gambling and the human connection

The economy for goods and services can be seen as a mixture of engineering and social organization, the creation of goods for the satisfaction of needs. The economics of finance, however, are more in the nature of gambling: seeking reward by undertaking risk, in a game where winning a profit has nothing to do with producing anything at all, but speculating on how other players will lay their bets.

The author suggests that a great deal of financial theory borrowed examples and mathematical models from the world of gambling. The odds of earning a return on investment were assessed in the same way as winning a bet on the roll of the dice.

To some degree, there are inherent flaws in the mathematical theory: in gambling, there is the certainty that some outcome will produce a winner and the event is purely random; in economics, there is no certainty of success, and the event is not random at all. The author suggests that the nearest gambling model to finance is horse racing - though it would be a race in which there were pitfalls and land mines, such that there was no guarantee that any horse would win.

In is interesting to note that in the early days of modern financial theory, many economists were disdainful for mathematical analysis that seemed to have little regard for economics. Financial theory nonetheless slowly gained acceptance, and the fascination with numbers and the appearance of truth even gave this fringe practice greater regard than approaches to economics whose consideration of supply and demand were supported by fewer and much simpler numbers.

Zero-sum games

The author previously contrasted creative gains (from producing something from nothing) and distributive gains (from transferring something from one party to another). Part of the reason for the gross volume of financial activity is because it is distributive - and as such is not restricted by the facts of reality in the volume of transactions that can be made.

Consider the distributive activity that can surround one bushel of wheat: a certificate of ownership of that bushel can be bought and sold a hundred times over, though the wheat can be sold only once. The financial market can also issue loans backed by the collateral of the future value of the wheat, and can issue a contract giving the right to buy the wheat at a fixed price, both of which can be bought and sold at will. The total value of the financial transactions regarding the wheat can be hundreds of times the value of the wheat itself.

No real value is created by the financial transactions. The certificate may rise in value because of the expected sale price of the wheat at harvest-time, but that value is still on account of the wheat and not the transactions.

But even where the wheat does not change hands, and the owner of the certificate sells it himself, the profit he makes is because the price of the good has risen over time. Specifically, the profit he makes is lost to the producer of the wheat, so it remains a zero-sum game.

(EN: I don't really consider this last bit to be an issue. The producer of the wheat could likely not have enjoyed the extra measure of profit because he lacked the capital to produce the wheat, which is why he sold it at a discounted price before it was even planted. He cannot claim injury if the price happened to rise, any more than he should expect to be demanded to compensate the buyer if the price happened to fall.)

Financial investment is not at all like trading in physical assets, in which there is an ultimate gain that will be shared out with each participant in the distribution chain from producer to consumer. In financial training, the gain of one person is always at the loss of someone else.

Consider hedge funds, which appear to be making money in a down market. They do so by "shorting" securities, obtaining a commitment from another party to buy their holdings at a given price. When the market price of a good goes down and the other party is compelled to pay the price to which they committed, their loss is the hedging investors gained. As such a hedge fund that "makes" billions of dollars has caused others to lose an equal amount.

Even a typical stock transaction "makes" profit by buying low and selling high - as described by the aptly-named "greater fool" theory, as the party that sells cheaply an asset that would have been valuable in future, beyond the interest that would be paid on a loan, has lost that profit to the buyer of his shares.

The suggestion that the wisdom and folly of traders in a market help to establish the "right" price for actual consumers in a market has no connection to the supply and demand of goods in the market - but instead creates an artificial sense of supply and demand by virtue of their trading activity that skews the perception of those who furnish and need the actual good. Because wheat futures traded at a given level, the sellers of wheat expect the value of the future to be the price that is fair for their goods.

As such, what is a zero-sum game for the buyers and sellers of financial instruments translates into a very real gain or loss in value ion the consumers' marketplace.

There's a brief mention of the ethics of profiting from the desperation of others. A person may be motivated to sell an investment out of a present need for the money, and compelled to accept less than it is objectively worth in order to have money quickly. A person who merely wants money, because of a negative expectation of the future value of his investments, is likewise motivated to sell at less than fair value.

Where there is a general state of malaise about the future price of things, the prevailing practice in the market is to seek to cash out, as investments are losing propositions. This depresses the value of the financial markets, with a corresponding effect on consumer markets, and deflation and economic stagnation result.

Consider also the effect on firms that seek to raise money to finance production by selling securities - their future income sold at a loss to have money to earn that income. When prices are rising, the loss is greater; when prices are falling, they are unable to find interested investors.

The cost of liquidity

While it can be argued that the markets originally served a purpose in providing capital to those who needed it, markets have mutated beyond the point of usefulness where trading is done for the profit of traders, with little regard to the way in which capital invested in firms is actually employed in productive pursuits.

The ability to trade encourages trading, and the more trading occurs, the greater the volatility. Volatility increases the incentive to trade for speculative purposes, and as such markets tend to support activity in the market, oblivious to the ultimate consequences to society at large.

More than this, the kinds of activities in a financial market are geared to short-term profit, compared to the application of capital to practical purposes. The underlying productivity may take years or decades to come to fruition, but profit can be made on trading shares on a daily basis, and the success of investment managers is assessed monthly or quarterly.

Similarly, the securitization of debt instruments, chiefly mortgage loans, over the past two decades has had a marked effect on the behavior of banks that originate loans. Before securitization, a bank would have to hold a loan until maturity, or sell it to another bank that would likewise hold it, and much attention was given to the creditworthiness of debtors. With securitization, the loan is merely inventory to be sold as a commodity, with little consideration of whether its face value would be repaid.

However, while individual banks could dispose of toxic assets through securitization, those bad loans were still a burden on the overall banking system, which paid the price when it was found that the paper was not worth the paper it was written on.

Why is there so much distributive activity?

The author suggests there are five main reasons that so much of the activity in the present economy is distributive rather than creative of wealth:

  1. It is a get-rich-quick scheme. There is the ability to make large profits, very quickly, with very little effort or knowledge. Making products is hard and takes dedication and effort, whereas trading stocks is quick and easy.
  2. Everyone feels like a winner. A person who sells a stock feels he has won because he expects the price will go down, and the buyer feels he has won because he expects it will go up. Regardless of how it works out, they are both happy and eager at the moment of the transaction.
  3. There is a veneer of value creation. Some participants genuinely feel that they are creating value and providing a service to those with whom they interact. Like a bank processing checks, they feel they are giving people money rather than merely moving it around. While the customer is served in some way, nothing has been created in the economy.
  4. Gains and losses are distributed evenly over time. A trader feels exhilarated about a 50% win on the heels of a 40% loss (do the math - he has lost 10% not gained it). It's very much like gambling in psychological terms.
  5. The losses that offset investors' gains are taken by unknown parties with "special characteristics" that make them indifferent to the welfare of the losers (EN: the example provided is not very illustrative).

These characteristics are common to most activities in financial markets: investing and trading of all kinds, "financial engineering," mergers and acquisitions, investment management, etc. Any activity in which a profit can be made without creating value is by definition distributive - and when it doesn't support the delivery of value to a consumer, any profit is made at the loss of others.

Why do bankers earn so much money?

The author suggests that the idea that the income of bankers and brokers has anything to do with effort or talent is "so outrageous as to be risible" yet their income is far higher than many professionals who engage in productive work that creates value.

If the benefit of the market system is that people are rewarded in equal measure to the value they contribute to society, then the astronomical pay offered to those in distributive professions is an indicator that the market system itself does not work very well.

The reasons for this are different for different levels and sorts of distributive activity.

Senior Executives

At the top of any organization, it is difficult to determine what someone's true contribution is. Their daily activities have no immediate connection to the product their firm produces, and the result is that their compensation is the result of social factors and politics internal to the organization. This is true in all corporations, bot only banking.

The compensation of top executives is determined by committees of the board, who are member of the same social circles. It is, essentially, an old-boys network, granting one another cash out of the corporate treasury. They may, at times, seek the advice of consultants and other to justify the amounts, but this is seeking legitimacy for a decision in arrears - the consultants are being paid to provide evidence in support of a foregone conclusion.

If the CEO can be said to provide value to the firm by directing the activities of those who do productive work, then what portion of the value is created by merely giving direction? And would not that amount remain stable over time, as the duties of the CEO have not changed much in the past forty years?

It likely should, but it does not: consider the research published by Cornell University, indicating that in 1965, the compensation of the average CEO was 24 times that of the average employee. In 2005, it had ballooned to 262 times.

(EN: This seemed specious, so I checked it. A US department of labor study shows similar, and much more significant disparity, with CEO compensation peaking in 2005 at 411 times average worker pay. Their figures go back to 1980, at 44 times, to 2010, at 325 times.)

Moreover, this disparity is not evident in all cultures. In the US, the multiplier for chief executives is far more than the multipliers in other nations such as Japan and Germany. Clearly, the CEO of a company in one country does not make that much more of a contribution to value than one working in a similar firm in another location.

(EN: I was not able to find a credible source of similar times-average figures for other countries. There was a 2006 study that found American CEOs were paid an average of $3.3M compared to $1.6M in all other countries - but this does not reflect exchange rates or the cost of average workers. However, I don't think the author's suggestion, while unsubstantiated, is unreasonable.)

In theory, the free market offers to participants a reward that is in line with their contribution to the welfare of those who receive the benefit of their work - the more value they generate, the better compensation they receive. This is not true of financial services, in which bonuses paid to executives, on top of their base pay, are based on the income derived by processing transactions: whether the customer gains or loses value, the firm takes its commission. As such, compensation can be very high (for facilitating many transactions) even when the results of their work are poor or even counterproductive (the transactions result in the client losing money).

Lesser Mortals

The compensation of the top executives in a firm affects the compensation of the rest of the organization: the CEOs compensation is at the top, the other C-level executives are a incrementally less, the compensation of their subordinates is incrementally less, etc. Thus the high pay of the CEO requires the pay of any CXO to be elevated, causes the pay of the senior VPs to be elevated, and so on throughout the organization.

(EN: This seems to hold true, but I have also noticed that there are often sharp drops at certain levels. That is, the salary of a senior VP is 10% more than that of a non-senior VP, who gets 10% more than a junior VP. However, the difference between the lowest level of VP to the highest rank of executive, the lowest level of executive to the highest rank of manager, and the lowest level of manage to the highest rank of employee, are much more significant, sometimes on the order of 50%. This is often hidden in salary ranges rather than actual salaries paid.)

On the whole, even the rank-and-file employees in financial services are responsible to the revenue (or loss) that results from their work, and should generally be rewarded accordingly, but it doesn't work this way: they are rewarded for their activity regardless of the results.

Consider that gains and losses occur over long periods of time, but rewards are given for short-term performance. If investments lose value this year, they earn less - but if in the following year investments gain, there are bonuses aplenty. This occurs even if the following-year performance is merely regaining some of the value lost in the previous year.

A quote from Andrew Cuomo summarizes this well: "when the banks did well, their employees were paid well. When the banks did poorly, their employees were paid well. When the banks did very poorly, they were bailed out by taxpayers and their employees were still paid well."

(EN: true, though I cannot entirely agree that it is unjust or counterproductive - the win/loss outcome is the result of the decision to invest in a certain way. It is a misperception, created in part by the employees themselves, that their reward is for the outcome of investing - it is in many cases, and likely should be in more, that they are rewarded for their effort instead of the outcome, and this is just in some instances. When a professional has no input into the decision of what to buy and merely trades what the customer chooses, he has no responsibility for the financial outcome and should be rewarded for this effort. But when a professional is involved in the decision, advising clients or making investment choices for him, then he is culpable and his compensation should be tied to the outcome rather than the activity, but often is not.)

Salary Ranges: The Black Box

The author speaks to ranges of pay in financial professions that are quite wide. The actual salary of the professional exists within a range, which is driven by perceptions, bargaining power, internal politics, corporate culture, and other factors.

As such, so long as compensation remains within that range, the market is not signaled to any change n the actual compensation paid, and it is opaque to the market. Unless a person is promoted, his compensation is known only to be within the broad range of his job classification.

In this way, compensation is a black box. There is no way to precisely know what an employee makes, or what every employee makes in a given job at a given company, or even a whole class of employees across many companies.

(EN: I'm not sure if this is significant, but I can say it's not unique to financial services: virtually every job has a pay range, and there doesn't seem to be the same level of interest in individual compensation in other industries. Moreover, what good would it do, other than to cause resentment and intrusion into private affairs, to disclose the actual salary of every individual employee?)

Lack of Competition

In many cases, the compensation model of financial services is akin to that in an oligopoly. While there may be many firms, a few firms set a lead that others follow, seeing to match compensation to the industry standard. Consider that the top five banks in the US account for more than 50% of banking activity; and the world over, the top ten banks globally account for between 76% and 87% of financial activities, depending on the financial product in question. Al the rest are, by comparison, very small players.

One would expect that the usual forces of competition would come to bear - where exorbitant profits are made, there are more new entrants and more heated competition among existing ones, bringing profits down to a reasonable level. But in the financial services sector, this "hardly ever happens" in practice.

Because size and reputation are critical in attracting clients, it is very difficult for a new financial firm to gain mass. And moreover, the customers of many financial services firms are not very price sensitive: they are attentive to the performance of their portfolios, but don't pay much heed to fees and commissions, which are within a narrow range among the top ten firms.

In the market for labor, employees are highly compensated, and to attract talent a would-be competitor must match or exceed what the top firms are offering, which means that they must grow to gain the same economies of scale in order to offer competitive compensation. Since firms start small, there is not much opportunity for them to achieve the same economies.

At the retail end of financial services, there does seem to be a great diversity of small firms, but as each of these is supported by one of the larger firms, their services are provided in a noncompetitive way.

Apportioning Rewards

In many industries, the argument is made that a disproportional share of income is given to the providers of capital, as opposed to the providers of labor. In the financial services, it is entirely the opposite: most of the profits accrue to the employees rather than to the shareholders.

The author states that "shareholders are themselves weak and supine institutions whose senior executives are on the same gravy train, and hence have little incentive to cause a derailment by questioning levels of pay."

Why is the financial sector so big?

There has been a dramatic growth in the financial sector in the latter half of the twentieth century. In 1950, the sector accounted for less than 3% of the US economy. By 2002, it exceeded 40%.

The author suggests this is normal and healthy: when a person earns more than he consumes, he has excess capital - which can be squandered, set aside, or invested productively, and the latter seems the best use of it. And a small excess per annum amounts to a substantial sum over a longer period of time.

He does, however, suggest that the excess is invested in distributive gains rather than creative ones, so what is good for the investor is not necessarily good for society when it does not result in increased availability of goods.

Second, as previously suggested, people in the financial services sector are paid far too much for his liking. Externally, a lucrative profession draws a great deal of interest from the labor pool. Internally, it enables the firm to offer a livelihood to unproductive individuals.

Supply and demand of financial services has led to compensation of employees in the financial services to be far more highly compensated than other professionals of similar ability.

Consequences of overexpansion

The author suggests high compensation of financial services professionals has incentivized risk-taking, such that the entire economic system is endangered. There's the common perception that variable pay, in the form of bonuses, exacerbates this - but the author is quick to point out that they are not categorically bad, in that a bonus can be used to incentivize productive behavior if tied to the right things.

In particular, if an employee receives a bonus for short-term performance that results in a positive outcome, but suffers no penalty (other than not receiving a bonus) for subsequent negative outcome, the employee is encouraged to take on limitless risk, there being no penalty for failure.

A second consequence of overcompensation in the financial services industry is that it draws highly talented people whose talent is utterly wasted. Succeeding at finance is fairly easy, and does not require much intelligence - but because of the reward, intelligent people are drawn to the profession.

A century or so ago, financial professions such as moneylending were considered disreputable professions and British families would be deeply ashamed if their most worth sons were involved in such distasteful affairs - the most clever people in a society were devoted to activities that created a benefit to the society, and moneylending was (rightly) seen as a dishonest profession that was of benefit to some to the detriment of others.

The chief problem is that the welfare of a society depends on productive activity - and productive activity provides modest rewards for long-term performance, hard work, and reasonable risk. However, productive professions must compete for talent and capital with distributive activity, which provides a much higher return for short-term performance and risk-taking.

Consequently, the brightest and most able people are lured away, in staggering numbers, from professions that produce value for their societies, and instead lead them to devote their efforts to "betting on the price of lottery tickets we call securities."

The author doesn't mean to imply that success in investing activities is determined purely by luck. There is some intelligence involved in making an accurate prediction of future outcomes, and the greatest rewards go to individuals who apply themselves to making the most accurate predictions. But making a prediction is different to making a product, in that a prediction provides no actual value.

Even in the market, consider the kinds of investors who take a modest return over a long period of time, and the way in which their rewards are diminished or stolen altogether by riskier short-term investors. There is in effect an interaction between the real economy and financial markets that can be likened to host and parasite.

Who creates wealth?

The author was aghast upon reading a newspaper article in which bankers and investment managers were "the wealth creators" of society, arguing that they should be praised rather than criticized for their work.

Such sentiments completely miss the point. Wealth is not created by being shuffled around. It is fascinating to some, and horrifying to others, that trillions of dollars are constantly changing hands without producing anything at all that is of benefit.

It cannot be denied that some financial activity facilitates the creation of wealth - capital resources are used to establish a productive enterprise. But once a productive enterprise is established, it requires no further investment to perpetuate its operations, and should profit, grow, and repay its initial investors by virtue of its own productivity.

The majority of activity in financial markets is purely distributive. No new enterprises are created, no existing ones expanded, but money changes hands. The gains of one party reflect the losses to another, some profiting by fees related to the transaction, while nothing of value is delivered to the consumers in the market at all.

The fraud connection

In financial markets, those who know more profit by taking advantage of those who know less. While distasteful, this is completely within the law. However, financial markets are also "uniquely prone" to more egregious activities.

Fraud is especially prevalent because of the intangible nature of securities and the opaqueness of financial structures. One can more easily misrepresent the value of the wheat in a granary than its actual volume, or even its actual existence.

The author notes that fraud is more common in bull markets, likely because it is easier to generate apparent gains and surveillance standards are laxer - where many are legitimately making money, a claim to be making it seems reasonable; when most are losing, it seems suspicious. Fraud is most likely to be discovered when a bull market turns bearish.

The property bubble, particularly, was rife with fraud that is only now being uncovered: the inflated value of properties and "liar loans" to uncertified buyers. More sophisticated forms of fraud take longer to unravel.

A few examples of frauds are given: one in which a small number of British schemers swindled nearly two thousand investors out of millions by a real-estate scheme in which they grossly overestimated the value of dilapidated homes. In the US, Bernard Madoff's epic Ponzi scheme, to the tune of $50 billion, demonstrates the scale on which fraud was perpetrated for many years.

This speaks to the decay in the very roots of efficient markets theory - can we accept that buyers are sufficiently circumspect in their behavior when some of the most sophisticated investors were so thoroughly duped?

As to the attentiveness and effectiveness of government regulators, consider a quote from an auditor who had tried for nearly a decade to expose the fraud: "I gift-wrapped and delivered the largest ponzi scheme in history to [the US Securities and Exchange Commission]. Most officials did not understand ... the 29 red flags that I handed them."

Professional pride and ethics

It's like the suspicion of fraud and the degree to which fraudsters are rewarded that warrants society in general to have a great deal of cynicism about the financial services industry, and the irony is all the more deepened because of the pretension of integrity on the part of the practitioners.

Consider by contrast the trust and respect granted to those in the medical profession. People place their very lives in the hands of doctors, pharmacists, and others because they are aware of and trust in the ethical code of the medical profession, and while they recognize that there are "occasional rogues" in the profession, most practitioners are trustworthy.

The same is true, to a lesser degree, of businesses that provide products and services. While there are some fly-by-night operations and some well-established firms engage in misconduct, on the whole we feel that we get the value we pay for, and that those who provide them act in an ethical manner. A company that has stood for decades is likely reliable.

When it comes to financial matters, we do not expect providers of services to behave in an ethical manner. Even before the misconduct of the recent catastrophe was revealed, people recognized that financial professionals take advantage of their customers to some degree - unlike a provider of goods who earns more by providing more value to the customer, the provider of financial services earns more by taking more value from the customer - and this has been essentially correct of the profession since its very beginning.

Even the best of financial professionals, who feel they are genuinely looking after their clients' interests, earn by taking from those whom they purportedly serve. All bankers seek to pay the least to their creditors, demand the most of their debtors, and siphon what they can from their investors - it is good business, and to do otherwise results in less profit to the bank.

It is sometimes argued that financial professionals work extremely hard to earn, or gain, a profit. They work long hours and give intense mental effort to scrutinizing investment options. This is sometimes true, though less so in senior positions, but working hard doesn't mean that they are delivering any value: devising, executing, and concealing fraud requires a lot of effort.

Culture and values

The author provides a succotash of anecdotes:

The author suggests such incidents are indicative of the widespread culture in corporate America. He concedes that there are executives who take pride in their work, are motivated by their contribution to society, and are remunerated decently but modestly - but most of the attention is given to those who are avaricious and get excessive rewards, even when they run their firms in the red.

The same can be said of financial professionals - the superstars, to which the next generation look as role models, make sky-high returns when they make money by taking it from others in a manner that is entirely legal, but nonetheless ethically questionable.

That is to say that in financial professions, material reward have been divorced entirely from the behavior that achieves something for the common good. And where reward is granted, behavior soon follows.

The triumph of finance capitalism

The author does not deny that the peak of finance capitalism in the 1980s and 1990s coincided with a period of considerable prosperity, but dismisses this as correlation rather than causation.

Must of the prosperity enjoyed by society was financed by mounting debt rather than productive activity, and the consequences of this debt have only recently been felt.

He also chooses this moment to play the race card: suggesting that "the Anglo-Saxon countries" (a term he surreptitiously uses) drained the prosperity of the rest of the world - their economic growth was driven by exports, such that the physical product of their efforts was sent aboard, in exchange for currency and debt instruments. Asian countries, in particular, provided the production for the excessive growth of consumption in the white world.

Meanwhile, the Anglo-Saxon culture was "aped around the world," spreading the distributive behavior to developing nations. Foreign politicians warn their people of the "blind pursuit of profit and lack of discipline" and encourage them to "borrow in moderation, save in earnest, take care of the real economy, invest in productivity" - but the lure of easy money is likely stronger than the appeal for moderation.

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