How the Financial Industry Get's So Much Money
There has been some buzz around a recent article by Tyler Cowen, The Inequality that Matters. It is a decent article and makes some good points, but ultimately it misses the mark in my opinion.
The most obvious error made is a semantic one, one of my pet peeves, in which Cowen continues to use the term "top earners" and to talk about the super-rich "making" their money, even though the point of the article is that the super-rich aren't actually earning their incomes, or at least this is one "possibility" that Cowen "considers".
Cowen rightly points out that the highest income receivers in America disproportionately come from the financial sector.
"In that same year, the top 25 hedge fund managers combined appear to have earned more than all of the CEOs from the entire S&P 500. The number of Wall Street investors earning more than $100 million a year was nine times higher than the public company executives earning that amount."
But when he tries to provide explanations for their over sized incomes he comes up extremely short. Firstly, Cowen focuses on the financial sector in relation to other high income receivers implying that the incomes of other high receivers are themselves justified, which they are not. The incomes of corporate executives and celebrities are not justifiable either, as I discussed in the article How Reagan Sowed the Seeds of America's Demise.
But when Cowen tries to explain how those in the financial industry get such huge incomes he falls flat. Cowen's big answers are that investors "go short on volatility" and they use other people's money to gamble. These things are true, but hardly revelations and they don't get to the heart of the issue.
First, when it comes to "going short on volatility", Cowen compares betting against the housing market (which is what many of the biggest hedge fund managers did in 2007 and 2008) to betting that a bad sports team would win a championship, it's not the conventional wisdom so it pays off big etc.
But this really isn't a good analogy. Cowen implies that betting against the housing market was some kind of huge risk or that it took genius to do it or that or that the big payoffs outweigh the losses, etc. This is all nonsense. First of all, it didn't take a genius to figure out that the housing market was going to crash, this was obvious, the only challenge there was having a sense of the timing. But having a sense of the timing isn't so difficult if you are a financial insider who sees the books of banks and knows what deals are being made and is managing the money of the biggest financial institutions. After all lets not forget that John Paulson, one of the biggest profiteers of the housing market crash, is acknowledged to have been involved in picking the the assets going into investment pools setup by other firms, which he was then betting against.
Even though neither Paulson nor the firms that created the toxic Abacus CDO were ever charged with anything, it points to the level of involvement and knowledge that these financial insiders have. They can much more easily time the market than your average guy because they have a far different level of information and are much more closely monitoring the situation, and that's being generous and assuming no funny businesses.
But even that isn't the point and totally fails to get to the root of the matter. The real question is this, why is it that firms like Goldman Sachs are able to reap such huge profits and to pay their employees so highly? In a competitive market profits should be driven down, yet profits for "Wall Street" have been going up dramatically over the past 30 years, most dramatically over the past 10 years. Well, what that tells us right off the top is that we aren't dealing with a competitive market.
What does Goldman Sachs do? Goldman Sachs is an investment bank; their primary function is ostensibly to help clients bring companies public, i.e. to manage IPOs, and to manage mergers and acquisitions, etc. Now, they also do a lot of stuff on the side, like trading and investment banking, etc. The function of the stock markets is supposed to be to help companies raise money via IPOs. That, really, is the sole "economic good" provided by stock markets, the "sharing of capital". However, that isn't where most of the money is made in the stock market, most of the money is made simply trading stocks around, which doesn't generate any real revenue and provides no direct benefit to the corporations whose stocks are being traded.
Now, when it comes to a company like Goldman Sachs, their revenue comes from two main sources: fees paid by clients and profits from trading. The first issue to address is the "fees paid by clients". Based on the level of the profits, the question is, why do clients agree to pay these fees, since clearly Goldman Sachs is skimming a lot off the top? In a competitive market we would predict that competition would come in a drive down prices, but this doesn't happen on Wall Street, the big players are the big players, they have been the big players for a long time and they remain the big players today, and there is very little real competition. Why? I suppose that there are multiple reasons, some of which are based on economic principles and some of which I suspect have to do with the laws on the books, collusion, backroom dealing and personal relationships, etc. I can't speculate on the latter issues, so I'll just stick to the issue of economic principles.
What exactly are stock exchanges? Well actually stock exchanges are the original "social networks". The stock exchanges are essentially the first major predecessors to the internet, and specifically they are the predecessors to social networking sites like Facebook. The value of all social networks and social networking platforms is predominately a product of membership in the network. The networks become more valuable and more attractive the more people join them.
In fact, social networks tend to create natural monopolies, however, our legal system doesn't recognize dominant social networks as monopolies. As discussed in this article Zuckerberg: Non-Evil Non-Genius, sites like Facebook benefit hugely from being the first in the market and then once a slight dominance is established in terms of membership, the membership itself become the most valuable aspect of the platform. People don't join Facebook because Facebook has better features than other alternatives, in fact Facebook sucks in terms of its implementation and user interface and user friendliness. As an application Facebook is horrible, it's horribly designed and it's record on user privacy is deplorable, but people use it and flock to it because that's where everyone else is. The membership is the primary draw, and thus Facebook is a type of natural monopoly, just like Microsoft Windows was a type of natural monopoly by attracting enough users to become a standard. Many people adopted Microsoft not because they loved Windows, but because they wanted to share documents with other people who only had Microsoft compatable documents and they wanted to use programs that only ran on Windows, because that's what was being used at work, etc.
But Microsoft won the court case that attempted to define Windows as a natural monopoly, preventing the operating system from being labeled as such, and thus avoiding the regulation that comes along with the designation. The reality, however, is that virtually all of the super-rich are types of natural monopolists. Celebrities are a type of monopolist. Everyone can't be a celebrity for the same reason that when you go to watch a play you have hundreds of people watching a dozen people perform on a stage. Even if everyone in the audience was as good a performer as those on stage, it wouldn't work if everyone started performing in order to compete for attention, it only works when a few people have the attention and the majority observe.
If incomes and profits get very high for auto-mechanics then more people will become mechanics, increasing competition and driving down profits and incomes. Celebrities have huge incomes, so why don't market forces result in more people becoming celebrities, thus driving down the profits of celebrity? Because celebrity is a form of natural monopoly, and so is social networking, and and stock exchanges are a type of social network and so are investment banks.
Goldman Sachs reaps huge profits, so why don't market forces result in there being more investment banks who compete against Goldman Sachs and drive down prices, thus reducing profits, which, as Adam Smith outlined so long ago, is the whole point of markets in the first place, to drive down profits and thus increase the social good?
Because a part of investment banking is social networking and once dominant social networks are established their momentum can be nearly unstoppable and the barriers to entry for competition are nearly insurmountable. The problem is that these types of businesses aren't widely acknowledged as natural monopolies, but they are. Most acknowledged natural monopolies today are things like utility companies and toll roads.
But that isn't the whole story. In terms of revenue from clients companies like Goldman Sachs have an advantage because they are natural monopolies, or natural oligopolies, and are thus able to extract rents for their services due to the power of the social network that they are able to tie clients into. However they also receive a large portion of their revenue from trading. People greatly misunderstand the revenue generated from trading by large institutional traders and investment banks.
The biggest misconception is the fact that most people don't understand just how unlevel the playing field is between professional traders and the average guy. This isn't like the difference between professional athletes and the average guy, the biggest advantages of the professional trader, especially today, have nothing to do with the natural abilities of traders and have everything to do with the information and tools at their disposal.
First lets take the example of the old school floor trader for the New York Stock Exchange. Floor traders are able to trade on their own accounts, and before various rule changes, including the adoption of decimal pricing instead of fractional pricing, floor traders were able to essentially make no lose deals. Floor traders were, and are in the NYSE, responsible for making the transactions when someone wants to buy or sell a stock (or whatever instrument these days). Let's say that you put in an order to sell your stock at $23.25, and the floor trader got this order, and they saw someone who wanted to buy that stock for $23.75. The floor trader could use his own account to buy your stock from you at $23.25, and then turn around and sell it to the other guy for $23.75, pocketing 50 cents a share on top of his commissions in the process.
Doing this wasn't a matter of being any kind of market genius, it was simply a matter of being able to see all the cards on the table, and it was an easy way to make money. Technically they aren't supposed to do that type of stuff anymore, but we are in a new era of sophistication now. Even without engaging in those types of obvious abuses, traders have a level of understanding of the market activity that the average person doesn't.
But, that was the New York Stock Exchange, which famously had/has all of those traders down there on the floor yelling and making deals. Then came the NASDAQ, and what sets the NASDAQ apart from other exchanges is that the NASDAQ is an all electronic exchange. There are no floor traders, all of the trades are executed electronically, which eliminates middle-men and thereby reduces the overhead cost of executing trades, and it also was supposed to address issues like traders gaming the system.
Ahh, but it hasn't. Now we have something called high-frequency trading, which effectively does the same thing as what the guys on the NYSE used to do, but now it is in fact much much worse, for now it's automated and essentially constant and automatic and all of the investment banks do it.
When you submit an order to buy or sell a stock on the NASDAQ your buy or sell price is supposed to be hidden information that the other party cannot know. If you submit an order to buy 100 shares at $23.75 for example, and there is also an order out there to sell 500 at $23.25, then the way it is supposed to work is that you buy 100 of those shares at $23.25, you get the best price available. The "person" selling at $23.25 doesn't know your price and thus doesn't know that they could have changed you more, etc.
This is where high-frequency trading comes in. Investment banks have computers that do nothing but sit there all day submitting bogus transaction requests. They submit orders to buy and sell stock every fraction of a second basically probing the asking prices in the market, which they aren't supposed to be able to know, but what they do is they submit fractionally higher and lower bids very quickly and then when one is accepted they cancel the transaction, this lets them know the asking prices of the bids in the market. Then once they have determined the spread on selling and buying prices of different bids, they step in and buy a block of shares at one price then sell it immediately to the other person at the other price. So, in the case of someone wanting to sell for $23.25 and someone wanting to buy for $23.75, computers would submit transactions to find those limits, then buy at $23.25 exactly and sell at $23.75 exactly, keeping the 50 cent spread themselves. It's a no lose transaction, there is no speculation taking place, there is no risk, and there is no real allocation of resources. The investment bank just steps in and extracts a fee for doing nothing and its stepping in benefited neither side of the deal, it's purely parasitic. And these large institutions have these programs running all the time, they are unmanned, there is no real strategy or anything it's just a pure profit machine that provides no benefit to anyone other than those running the programs and it serves as an added tax on the investors making the trade.
And this is just one aspect of how these banks are now using computers to engage in trading systems that are effectively just gaming the whole system. And make no mistake, the recently passed financial reform legislation that was passed by the Democrats does nothing to address these issues and doesn't tackle high-frequency trading at all.
But what really makes all of this work and makes the profits for those in finance so high, is the giant pool of money that they operate on. That giant pool of money is what has been created by the rest of society, including Americans and foreigners. Those in the financial institutions are getting hugely wealthy because the giant pool of money produced by the rest of society has grown rapidly and those in the financial institutions are getting a cut out of it, largely by using "heads we win, tails you lose" techniques both in terms of high-tech trading systems and of course in terms of government backed subsidies, in addition to the natural monopolies enjoyed among the various components of the financial system, from the stock exchanges to the highly connected investment banks. It is the collective production of society that has produced the wealth, not these bankers, hedge fund managers and traders, and yet they are the ones reaping the rewards by extracting massive rents on the system.
There are theoretical ways that the entire financial system could be radically changed however, in ways that would effectively eliminate the rent seekers. First is the stock exchanges themselves. As I said, stock exchanges were really the first major social networks, the first major predecessor to the internet, but guess what, now we have the internet, we don't actually need stock exchanges anymore. The whole point of a stock exchange is to serve basically as a giant chat room that allows all of the buyers and sellers of stocks to transact in a single market. Technically when you buy stock you have a certificate. You could go out on the street and sell that certificate if you wanted to, but we don't do that because out on the street you have no idea what other people would be willing to pay for it and you may not find anyone that wants to buy it, so we have exchanges, where everyone who wants to buy or sell "chats" in the same room. The exchange model is over a hundred years old, it made sense when we didn't have the ability to individually connect the way we do now. Now it is a fact that stock exchanges are functionality obsolete, they are totally unnecessary, but they still exist out of moment and regulation. Also note that stocks and other assets only trade on specific exchanges. Companies pay to get listed on a given exchange, and their stock only trades on that exchange. That could all be eliminated with open standards and the development of full market internet based direct trading where buyers and sellers interact directly with each other without middle-men. It's technically possible now, but clearly there are powerful interests, indeed some of the most powerful and wealthy people in the world, who would not let that actually happen. In this case, protecting the interest of the financial industry and the stock exchanges requires preventing the rise of a freer market system. A freer market without exchanges would benefit stock owners at the expense of the middle-men currently in place who graft off the top of every transaction.
As noted by Lord Adair Turner in What Good is Wall Street, investment bankers and traders are really just glorified utility operators. The objective of financial institutions is to channel capital from individuals and institutions to the places where it can, theoretically, do the most good. You put money into the pot and in theory the activity of those on Wall Street is to allocate your money to the businesses that can make the most use of it, allowing them to produce a return on that capital. That's the theory, and that's describing the activities of Wall Street in the best possible light. In reality most of the activity on Wall Street is just outright gambling with no real economic benefit.
But granting the utility of Wall Street activity, it is effectively equivalent to an operator at an energy company who has to rout electricity and turn on and turn off various power plants in order to optimize electricity usage throughout the day, to rout the electricity to where it is most needed. But do we pay such operators by the amount of electricity that flows through the system each day, are they paid by the kilowatt? No, they aren't, they are paid a wage like any normal worker. Do we pay operators at facilities for large cities exponentially more than operators for smaller areas that use less electricity? No, we don't. Operators for larger regions may get slightly higher pay, but its double or triple the pay of smaller operators at most, we don't pay operators 10,000 times more who work for New York city power companies than ones who work in Arkansas, but when it comes to finances it's a different story.
The scale of the income in the financial industry is directly related to the scale of the economic activity, even though we don't pay power grid operators or water management operators in direct proportion to the scale of the flow through the networks they manage. Given that the financial industry is really a glorified utility, and that they benefit from monopolistic characteristics, the industry should bemuch more heavily regulated, including the use of price controls and major compensation restrictions.
There really is no question that the financial industry is extracting massive rents for, at best, providing no real value, and at worst the financial industry is in fact profiting from causing real economic damage. To argue that the events of the last 5 years, with the near collapse of the financial system and the housing bubble isn't an example of profiting from real and massive damage is to just plain ignore reality.
The massive profits in the financial industry are certainly only made possible by the large amount of real value created by the rest of society, which creates the massive pool of money that the financial industry extracts profits from, but the real question of why it is that competition doesn't drive profits down is the more complicated one. The only answers appear to be that players in the financial industry benefit from forms of natural monopoly, while not being regulated as monopolists, that there is indeed nefarious activity taking place both technically illegal insider trading as well as technically legal forms of insider trading, and the rise of computer driven trading schemes has created true virtual money machines that produce essentially risk free profits throughout computerized trading, which is a complete corruption of the markets. All of this in association with the virtual guarantee from governments that major losses will be propped up by tax payers has resulted in a no lose environment where the big players are able to extract massive rents unchallenged by either competition or the law.
See also: Wall Street by Doug Henwood