The Price of Casino-Like Finance Is Higher Than We Think

With the New Year, I have been thinking about old problems: banks, risk management, prices and wages as signals in well-functioning markets, and the efficient allocation of capital. I've been marveling at the disconnect between what my economics textbooks assert and the realities I have observed lately.

Things that have been especially salient are the misallocations that have resulted from very distorted signals in financial markets. Remember that one of the foremost advantages of capitalism and well-functioning competitive markets is the wonderfully efficient way in which prices and wages (at least in theory) signal profits to be made and value to be added to the economy and to us all.  When they work, the signals coordinate a large complex economy far better than any central planner (aka government) could do and they assure that resources are diverted to sectors and productive enterprise that most closely match people’s preferences. To the extent that individual preferences correspond to individual and societal well-being, both individual and societal well-being is also improved. (For an example of a case in which individual preferences do not necessarily correspond to individual or societal well-being, think "drug addict" or "alcoholic." For an example of a case where individual preferences correspond to individual well-being, but not in all cases to societal well-being, think "investment banker who required a bailout.")

Over the last several hundred years, as capitalism and commercial enterprise have come to dominate, there have been a series of cyclical downturns usually brought on by “irrational exuberance” or “animal spirits” in some market. Casino-like behavior aimed at capturing high short-term gains replaced sober, sound, long-term business investment supporting long-term corporate growth and survival. Notice that including “survival” rules out Enron-like "growth."

Economic theory is pretty specific about the characteristics of investors, producers, and consumers that will prevent animal spirit-induced bubbles: reason, self-interest, and full-information. It is not often explicitly stated, but reason and self-interest are taken to mean that the individual is rational and self-interested enough to take a long-term view of their own well-being, their reputation in the market, and their own or their firm’s survival. Full-information means that there is no uncertainty or risk, such as one might find in oh, say, futures markets, mortgage and health insurance markets, stock markets, bond markets. One could go on and on, but you must get the point.

Unfortunately, an entire cottage industry called the economics profession sprang up, firmly anchored on the shores of Lake Michigan, aimed at creating cultural narratives and myths about how “markets” (meaning some abstract aggregation of semi-rational, often ill-informed, but definitely self-interested points of light) would magically “know” and act rationally and with perfect foresight. In many ways, the birth of the cottage industry known as freshwater economics is a testimony to the power of markets. There was and is a lot of money to be made in that cottage industry, especially if one was willing to drink the “business as usual,” “just ignore the man behind the curtain,” “the business of business is business” kool-aid that until recently has characterized my profession.

One under-recognized effect of distorted price signals in a frothy economy is the distortion of intellectual curiosity and endeavor. While a course correction, championed by Keynes, Robinson, JK Galbraith and others in the past and now led by such notables as Paul Krugman, Brad Delong, Joe Stiglitz, Mark Thoma and many others is underway, I believe that considerable damage has been done. Not least because most non-economist Americans are unwittingly under the sway of several "defunct economists." The defunct economists have provided a convenient narrative in which government of, by and for the people can never act as a countervailing force against large corporations, but instead is viewed as promoting individual freedom only when allied with and strenuously promoting the financial well-being and increased power of those very same large corporations. Thank you, Milton and Friedrich and all the others who have piled on that beneficial for a few bandwagon.

Another effect of distorted price signals that is obvious to us all is the way in which trillions of dollars were siphoned away from alternative productive, life enhancing activities and diverted into housing; housing that now stands abandoned on overgrown lots throughout the US or that is siphoning off yet more consumer income to the banking and finance sector in the form of mortgage payments on principal that is now higher than the current market value of the property. Money that would otherwise be available to spend and stimulate other sectors of the economy.

However, I suspect that the longest term and most severe damage from the finance casino will not be from government deficits required to shore up too-big-to-fail banks and insurers. It will be from two powerful, long-standing price distortions that have distorted the composition of our labor force and the mix of human capital within it. The first distortion is the past diversion of some our best technical and mathematical minds away from physics, engineering, biology, chemistry, and, yes, even economics, to financial modeling, risk analysis, and all the other marvelous tools of speculation and gaming. Over the last 20 years or so, the financial sector has been diverting our future scientists and mathematicians into creating new derivatives aimed at managing risk (ha!) and into developing creative investment instruments aimed at obscuring risk.

The second long-term distortion is similar to the first. I'm thinking of all those bright, young, energetic non-quants who came out of some of our best universities and opted to go to work for investment banks, not in technical jobs, but as traders, ratings specialists, analysts, again to support the conversion of trillions of dollars into chaff.  Many of them might have gone on to graduate work in psychology, sociology, English, history, political science, and public health, where they would have added more value than destroying wealth across the globe. Instead of a workforce that gained diverse skills that might one day transform the world in positive and substantive ways, we have a surfeit of MBAs with concentrations in finance and empty houses on overgrown lots.

But there were no jobs in public health, English, political science, etc, you say? Of course not, the financial sector distorted financial capital, which in turn distorted physical and human capital. You have to imagine what the world would have looked like without the casino siphoning resources into real estate. You have to imagine a world without a dot.com and a real estate bubble. Where would the dollars and people have gone? That is what we have lost.

In the long run, the present and future productivity losses from labor force and human capital distortions may well dwarf the more obvious losses from distortions in real and financial capital markets, both in magnitude and scope. At the very least, they add to them in ways that are important to counter if we are to have a solid economic recovery.

Market forces did this. In fact, free market forces did this. Prices and wages signaled money to be made. Rational, self-interested people did the rational, self-interested thing: they went to work where the pay was highest and the jobs were plentiful. Even had they been fully informed about the ultimate downturn (and even if they had believed that the ultimate downturn would not be cushioned by the (bad, intrusive) government) what rational, self-interested person would have behaved any differently with all that easy money to be made?

Don’t get me wrong. I'm not making a case for central planning. I remain committed to capitalism: free markets when they function well, regulated markets when they don’t.  The above are simply additional arguments for reining in and regulating casino-like behavior and casino-like rewards in any market, not just capital markets. In the long run, we will all be dead, but as long as someone will be alive, they deserve a better world and a better life than one gets in a casino where the odds are disproportionately in favor of the house and the house is an unholy combination of corporate power and wealth backed by government laissez faire and largesse. 

Comments

[Norman]

We used to see estimates of the notational value of derivative contracts but I haven't seen an estimate in a long time. Has anyone?

[rjs]

norman: the notational derivatives are reported by the bank of international settlements quarterly, if you can find that...as i recall, they have been increasing again, after a lull during the height of the crisis...

[rjs]

i found these:
http://www.bis.org/publ/qtrpdf/r_qt0909f.pdf

from point 2 in this:
http://text.broadbandreports.com/shownews/Weekend-Open-Thread-105812
US Commercial banks now hold an all-time high of $203.5 trillion in derivatives.

i believe the amount held in europe is quite a bit higher...

[Rick]

Well, I picked up my graduate degree in engineering in 2008 and found there simply weren't any jobs available. So it's more than creating the degrees, it's also having a place to use them.

As to why:

http://web.cecs.pdx.edu/~rc/index.html#Manufacturing

we don't make stuff much anymore.

Rick

Other graphs:
http://web.cecs.pdx.edu/~rc/index.html#econ

[Daniel Rosenblatt]

Another aspect of this (or maybe its a related problem) is the damage done by income inequality: Casino-like finance ends up putting some people in a position where they can extract money from the economy in a way out of proportion to the value of the work they do for society as a whole. This is not only unfair, but it distorts career choices. In a more balanced society it might be worth making a little less to do something rewarding like teaching, or research, or green engineering, but in a sharply differentiated society it gets harder to make that choice, especially when to do so might limit the opportunities ones children have to compete in a supposedly meritocratic system increasingly vulnerable to "gaming" by those with money.

[maynardGkeynes]

"It will be from two powerful, long-standing price distortions that have distorted the composition of our labor force and the mix of human capital within it."

Sorry, but I don't get the distinction between the two distortions. They look the same to me. What am I missing?

[Maxine Udall (girl economist)]

Daniel, Yes, I quite agree with you. I've been thinking more and more about it and may well blog on that topic soon.

Maynard, You may well be right. I was trying to make a distinction between techies ending up on wall street instead of in other private enterprise or in academia and less-technical workers drawn to wall street who might otherwise have ended up in social work and other do-good professions. Probably not an important distinction and I'm not sure I made it very clear. :-)

[Coises]

Daniel:

I’m no economist; but intuitively, it seems to me there must be a connection between income inequality and casino finance.

As income inequality increases, a larger part of the money in a system is held by people with greater personal worth. Now, a family with an income of, say, $25,000 per year probably spends about $25,000 a year. A family with an income of $25,000,000 doesn’t spend $25,000,000 — it looks for ways to invest a large part of that income. And the whole point of investment is to earn money.

A classic investment earns money because it enables a new business, or an expansion of an existing business, that makes a profit. The owners and the investors share in the profit until the investment is paid back, and everybody wins. That profit, of course, directly or indirectly comes from consumers who buy products. But as more money is concentrated in fewer hands, more capital seeks a profit on an ever smaller proportion of consumer spending. What happens when the amount of money seeking to make money through investment exceeds the “carrying capacity” of the underlying “real” economy?

Well, you could stuff $25,000,000 in your mattress, but that’s not a very attractive option. And you could invest it in “real” business, except that the pool of good borrowers is shrinking, because there’s not enough demand to support further expansion of consumer-fronting business. Since there is no “real” investment worth pursuing, the gap is filled by speculation — the casino economy.

I hope I don’t sound too much like an ignorant version of Karl Marx... but it seems to me that if capitalist economies can’t find a way to mitigate this problem, they’re doomed to ever-increasing cycles of boom and bust, until one is so bad that it leads to a total collapse.

[Mike Lawlor, Economics, Wake Forest University]

Dear Maxine,

I think you are right on target with your critique of how the "casino-like" aspects of the current American-style capitalist economies have led to system-level irrationality, even if at the same time they are "individually" rational for some members of those systems.

I also agree with you that the current training and configuration of American Economics is partly to blame for this state of affairs being acceptable to so many.

I also think you are correct that a large dose of history, particularly the history of Economics, is a proper inoculating antidote.

What you say of Keynes, though, while largely true, does not go far enough. He did, as you say, warn of the dangers of casino capitalism. But more importantly, he showed that even unfettered, individually rational, full-information, market systems might not always generate sufficient aggregate demand to employ all of the available work force. To argue otherwise in the 1930s seemed stupid or willfully ignorant to many observers.

But JMK's great intellectual achievement was that he managed to convince enough of the economics profession of this, when economics seemingly had nothing to offer that would explain the Great Depression.

Today, when that message is again glaringly obvious to many thinking observers outside of economics, we are in even worse shape. Thas is because the very training you properly excoriate has for the last thirty years abandoned both history and Keynes. Two results: generations of economists hostile and badly informed about history and an economics profession that has not even learned the basics of Keynes's most important message.

[Maxine Udall (girl economist)]

I could not have said it better, Mike.

I have been thinking recently about the political and economic forces that shaped the abandonment of both history and Keynes within economics. The returns to the "cottage industry" built around non-Keynesian econ that I describe in my original post had something to do with it. I suspect that the emphasis on math over substance in econ may have also contributed. But

I find myself also wondering if some of this goes back to political forces that peaked in the late 40's early 50's when Joe McCarthy and others were harassing academics. The same forces persisted through the cold war years and have continued to pervade and sidetrack intelligent discourse about the proper role of government in economic growth and unemployment (e.g., Obama's "socialist" health care reform). Some of our tribal elders must have felt pressure to avoid appearing to advocate expanded govt roles in the social safety net and in promoting employment for fear of being accused of being too far to the left. Many of them were writing textbooks, some of which have had continuing influence on how new economists are trained and how they think. As a result, there has been an under-supply of understanding much less useful theoretical work in public and welfare economics IMHO. Speculation on my part, but something I want to investigate and think about this further.

There is also tremendous peer pressure within the profession itself. It has altered dramatically within the last 18-24 months as more prominent economists have taken Keynesian positions and made Keynesian arguments. But there are still a lot of economists out there who came through the math or physics department. I find myself wondering if they are a bit like the math whiz modelers in the financial sector who ignored the fat-tailed distributions that most empiricists take for granted. Do they lack the historical, philosophical, and empirical perspectives necessary to break new theoretical ground quickly? Will they be resistant to it because if we move away from existence proofs the math is messier, the conclusions murkier, and promotion and tenure may take longer?

[Maxine Udall (girl economist)]

Daniel,
Your thinking is very similar to my own, especially your last paragraph. I'm also intrigued by your fear of sounding like a Marxist. That is the fear that I believe has constrained much of the profession, at least in the US, from contributing in meaningful ways to public discourse about public welfare and the public interest. I've been saying for years that Marx's economics and his dialectical framework are limited, but what he got right was that there is a problem. It matters how income is distributed. Fairness matters. That's why he keeps getting a hearing and it's (again IMHO) why most people recognize his name, but few recognize Adam Smith's name. It's why if, God forbid, the revolution ever comes, his ideas are likely to resonate popularly: they're easier to summarize in 25 word soundbites that evoke strong emotions and, if we continue to become more unequal, they will resonate with more of the people. We need to start paying attention to income inequality and doing something about it within a regulated competitive capitalist framework.

FWIW, I think your logic is right wrt investment versus speculation in an increasingly unequal society, but as I said in an earlier post, I want to think about this a bit more. The wealthy may just be hunting short-term returns as you say, but we have provided them with a narrative in which that is the socially optimal thing for them to be doing. For one thing, we have allowed the word "investment" to be used interchangeably with "speculation" for a very long time. No it's worse than that, we have allowed investment to mean specualation for a very long time. It's possible that if they had a different narrative and understood the long-term risk to their own incomes, they would search for lower longer term returns, i.e., they would develop a preference for investment over speculation. Unfortunately, human nature may be against us in this, but I would still like to see the narrative changed.

[Maxine Udall (girl economist)]

Sorry. That last post should have read "Coises" not "Daniel.

[Coises]

Thank you for responding, Maxine.

I have doubts about the “narrative” angle; when narratives and incentives don’t coincide, either the narrative changes, or it becomes a hypocrisy. I don’t think narrative leads to behavior leads to conditions... the order is the reverse.

At some point — probably around the end of the Bretton Woods system — conditions for investment changed. Speculation became more attractive relative to “real investment,” and the ways in which financial agents used their wealth changed accordingly. As the demand for speculation grew, politicians were pressured to relax the rules surrounding finance, and as part of this process we developed a revised narrative that explained the changes.

Consider why performance-enhancing drugs are forbidden in competitive sports: were they permitted, the competition would soon cease to promote the things we value (such as the dedication and discipline to develop extraordinary control of ones body) and degenerate into testing which athletes were prepared to take the greatest risks with their health and well-being. Sure, there would be some hold-outs... but they would cease to be competitive, and hence would be soon forgotten. I think the parallels to recent economic history must be obvious.

Any competition is bounded by rules; some the result of nature, some the result of historical development (there was no need to forbid performance-enhancing drugs at the ancient Olympic games — effective ones didn’t exist yet) and some chosen by people. Always, the net effects of the boundaries of a worthwhile competition must be maintained so that the incentives for competitors ultimately promote the things for which we value the competition in the first place. This is not the job of the competitors, but of those who make the rules.

I think you’re getting at a similar thought with the idea of “narrative”; but I don’t think narrative replaces incentive in the minds of competitors. Instead, it tends to be a way of distracting people from the frequently politically unpalatable task of assessing how well incentives match the presumed social value of the competition — a fairy tale that explains why everything is as it should be. What’s missing isn’t a good story for the competitors, but realistic evaluation and action, not limited by the competitors’ perspective, from those who make the rules.

[Denis Drew]

FEMALE Maxine Udall, Ph.D. in economics quick (is she a new Ph.D?) ability to discern the distortions of a planet wide economic view supports my (cabdriver) sociobiological theory that females are able think for themselves -- think in the FIRST-PERSON -- while males (NO MATTER HOW HUGE THEIR IQ'S) cannot; males must by profound evolutionary imperative (PACK hunter) reflexively think in the THIRD-PERSON; must check in with the whole planet before they will discuss a novel approach to a communal problem.

If the new idea is not found in the planet wide discussion -- it goes in one ear and out the other making no interaction with their brains.

Maxine gives me a further extension of my cabdriver theory (Ph.D.: NY, Chi, SF): the first to produce a planet wide theory (assuming there is not one) automatically wins -- with males.
***********
Maxine complains in her essay that America's best brains have been diverted from useful fields to complex and ultimately productivity-less financial strategizing. The true tragedy is that American labor has forgotten all about the need to effectively withhold its contribution from the workplace to get all the market would be WILLING to pay -- which has led to a disappearance of the middle class as the effective and powerful political core in this county which in turn ALLOWED the predominance of finance in the warped political economy. Being a superbly intentioned and educated progressive economist she of course is completely out of touch with everyday labor market life which would have told her that in the clearest terms.

Now we just have to get some progressive economists to hatch their own bargaining power restoring planet wide theory (THIS WOULD BE THEEE PERFECT OPPORTUNITY WHILE THE OLD THEORIES ARE WANING).

Myself, corporeally representing impoverished American labor -- I found, discovered, accidentally came upon the perfect modality to re-balance America's labor market about 5 years ago which I could not -- IN MY DESPERATION FOR AN ANSWER -- fail to recognize the moment I saw it -- the answer all around the better paid majority of the OECD world and even places in the second and third worlds: sector-wide labor agreements.

Maybe we need to pay -- male -- economists half or only a third as much until they see the perfect solution to their own dire need and hatch a perfectly timed new theory for the planet to win the day for it -- with males anyway.