Tuesday, September 24, 2013

How the financial sector swallowed up the economy (continued)



That cancerous growth of the financial sector has been, and remains, a big and multi-faceted problem. Brad DeLong directs us to a brief but illuminating piece by economist Robert Shiller, "The Best, Brightest, and Least Productive?", that deals with one aspect of this larger pathology.

Shiller's piece is written in a scrupulously balanced way, almost to a fault, and its strongest points are hedged with careful qualifications and some excessively tentative formulations.  But the central thrust of the analysis comes through clearly enough:
Are too many of our most talented people choosing careers in finance – and, more specifically, in trading, speculating, and other allegedly “unproductive” activities?
The short, and basic, answer to that question is yes. But Shiller's discussion works up to it.
In the United States, 7.4% of total compensation of employees in 2012 went to people working in the finance and insurance industries. Whether or not that percentage is too high, the real issue is that the share is even higher among the most educated and accomplished people, whose activities may be economically and socially useless, if not harmful.

In a survey of elite US universities, Catherine Rampell found that in 2006, just before the financial crisis, 25% of graduating seniors at Harvard University, 24% at Yale, and a whopping 46% at Princeton were starting their careers in financial services. Those percentages have fallen somewhat since, but this might be only a temporary effect of the crisis.

According to a study by Thomas Philippon and Ariell Reshef, much of the increase in financial activity has taken place in the more speculative fields, at the expense of traditional finance. From 1950 to 2006, credit intermediation (lending, including traditional banking) declined relative to “other finance” (including securities, commodities, venture capital, private equity, hedge funds, trusts, and other investment activities like investment banking). Moreover, wages in “other finance” skyrocketed relative to those in credit intermediation.

We surely need some people in trading and speculation. But how do we know whether we have too many?  [....]

[A] 2011 paper by Patrick Bolton, Tano Santos, and José Scheinkman argues that a significant amount of speculation and deal-making is pure rent-seeking. In other words, it is wasteful activity that achieves nothing more than enabling the collection of rents on items that might otherwise be free.  [....]
In retrospect, it seems clear that one of the factors which helped restrain these tendencies for four decades between the New Deal and the Reagan administration (a period when, for the first time in American history, the US had no significant financial crises) was the Glass-Steagall Act of 1933. Glass-Steagall was part of a remarkably intelligent framework of regulations enacted to cover banking and the rest of the financial sector, and it worked. Then, starting in the 1980s, this valuable and highly successful framework of financial regulation was increasingly dismantled—not sensibly updated and adapted to new conditions, but heedlessly dismantled—in a process that combined free-market-fundamentalist ideological illusions with substantial amounts of irresponsibility, plutocratic muscle, political corruption, and simple greed. And it so happens that during the same period, starting in the 1980s, we have once again experienced recurrent financial crises (and massive bailouts), escalating most recently into the great financial crash of 2007-2009 from which we are still recovering.

The repeal of Glass-Steagall was part of that dismantling. It was a mistake, and one that should now be rectified.
In a forthcoming paper, Patrick Bolton extends this view to look at bankers and at the Glass-Steagall Act, which forbade commercial banks from engaging in a wide variety of activities classified as “investment banking.” Ever since the Gramm-Leach-Bliley Act of 1999 repealed Glass-Steagall, bankers have acted increasingly like feudal lords.  [JW: That is, like robber barons—in ways that are predatory, unproductively wasteful, and socially harmful, but highly profitable until an excessively risky gamble goes wrong.]  The Dodd-Frank Act of 2010 introduced a measure somewhat similar to the Glass-Steagall prohibition by imposing the Volcker Rule, which bars proprietary trading by commercial banks, but much more could be done.

[JW:  Instead, of course, the financial industry, along with its lobbyists & propagandists & political allies, is doing everything it can to insure that even the half-measures included in Dodd-Frank are blocked or watered down.]

To many observers, Glass-Steagall made no sense. Why shouldn’t banks be allowed to engage in any business they want, at least as long as we have regulators to ensure that the banks’ activities do not jeopardize the entire financial infrastructure?

In fact, the main advantages of the original Glass-Steagall Act may have been more sociological than technical, changing the business culture and environment in subtle ways. By keeping the deal-making business separate, banks may have focused more on their traditional core business. [....]
Over the last generation, on the other hand, a business culture of casino capitalism has prevailed.  For some further explanation and elaboration, read Shiller's whole piece (which, again, is concise).

—Jeff Weintraub

P.S.  And for some further discussion of some relevant issues, see here.