naked capitalism

A new and welcome front may be opening in the efforts to rein in an overly powerful and now explicitly state-backed financial services industry: challenging its claims that its activities are good for society. While the provision of credit is important to any economy beyond the barter stage, finance should be the handmaiden of commerce, not its master. But the perverse (and disproved) logic of financial economics, that markets are efficient (and by extension, virtuous) means that those associated with them can assert that their services are vital, even if what they are really doing is tantamount to looting.

One salvo comes tonight in the Financial Times, in “Overmighty finance levies a tithe on growth,” by Harvard economics professor Benjamin Friedman,

The crucial role of the financial system in a mostly free-enterprise economy is to allocate capital investment towards the most productive applications…

If a new fertiliser offers a farmer the prospect of a higher crop yield but its price and the cost of transporting and spreading it exceeds what the additional produce will bring at market, it is a bad deal for the farmer. A financial system, which allocates scarce investment capital, is no different.

The discussion of the costs associated with our financial system has mostly focused on the paper value of its recent mistakes…The estimated $4,000bn of losses in US mortgage-related securities are just the surface of the story. Beneath those losses are real economic costs due to wasted resources: mortgage mis-pricing led the US to build far too many houses. Similar pricing errors in the telecoms bubble a decade ago led to millions of miles of unused fibre-optic cable being laid.

The misused resources and the output foregone due to the recession are still part of the calculation of how (in)efficient our financial system is. What has somehow escaped attention is the cost of running the system…..

For years, much of the best young talent in the western world has gone to private financial firms. At Harvard more than a quarter of our recent graduates who have taken jobs have headed into finance…. we are wasting one of our most precious resources…..much of their activity adds no economic value.

Perversely, the largest individual returns seem to flow to those whose job is to ensure that microscopically small deviations from observable regularities in asset price relationships persist for only one millisecond instead of three…

In the US, both the share of all wages and salaries paid by the financial firms and those firms’ share of all profits earned have risen sharply in recent decades. In the early 1950s, the “finance” sector (not counting insurance and real estate) accounted for 3 per cent of all US wages and salaries; in the current decade that share is 7 per cent. From the 1950s to the 1980s, the finance sector accounted for 10 per cent of all profits earned by US corporations; in the first half of this decade it reached 34 per cent…

What makes a more efficient financial system worthwhile is not just that it allows us to achieve greater production and economic growth, but that the rest of the economy benefits. The more the financial system costs to run, the higher the hurdle…

Economic decisions are supposed to turn on weighing costs and benefits. It is time for some serious discussion of what our financial system is actually delivering to our economy and what it costs to do that.

A second effort is being mounted by French president Sarkozy is proposing international standards to rein in bank pay. This is a bold idea, since only international coordination can work to constrain pay, but the countries controlled by the financial classes are certain to reject or dilute any such idea.

From Linda Beale:

French President Sarkozy has seen how banks have responded to the financial crisis of their own making with extravagant bonuses for the very employees responsible for huge losses that led to central bank interventions and much taxpayer funding at stake. To put it starkly, he doesn’t like it. So he has proposed a solution.

According to BNA’s Daily Tax RealTime, he has announced plans for a proposal for bonuses modelled on the recent coordination among countries in dealing with tax havens and banking secrecy. The proposal, to be fleshed out at the September meeting of the G-20 governments, calls for a coordinated effort by the G-20 governments to reign in bonus behavior. Each country would agree to impose a tax on bonuses, to be levied at the same rate across the group. In addition, each country would agree to an overall limit on bonuses, calculated as a percentage of the bank’s revenues. The tax would be dedicated to financing guarantees of deposits.

The idea I like the best is restricting bonuses as a percent of revenue for any state-backed organization. That will lead all the people in safe fee businesses to decamp and eliminate the incentives to swing for the fences for the activities supported by taxpayers. I wish that this could serve as a shot across the bankers’ bow. However, a horde of professionals (lawyers, accountants, lobbyists) benefits from outsized Wall Street pay and will also fight tooth and nail to beat back any pay restraints.