At the end of this post, you’ll find an embedded a lively, thought-provoking speech by economist and Financial Times writer Jphn Kay made at a Bank of International Settlements conference last month. Kay discussed how the claims made by people in the financial services industry, that it was special, in terms of its role in the economy and its mode of operation, are made by just about every industry and don’t hold up to scrutiny.
There were two parts I particularly liked. One was when Kay debunked the notion that financiers play an oh-so-importnat role in allocating capital to its highest and best use. We’ll put aside the fact that if that were true, why did we have such a spectacular blowup in 2008 and why are central bankers working so hard to intervene in that process?
Kay explains that real-economy investment decisions are made by real economy players, like major corporations who make capital budgeting decisions. And the overwhelming source of investment funding for companies is retained earnings, not external funding. Similarly, we’ve pointed out that the role of venture capital in start ups is deminimus. Only 1% of new companies get funding form VCs. Even with among the highly successful enterprrises that these investors target, only a minority get funding from them. Professor Amar Bhide has found that only 25% of the Inc 500 had brought in venture capitalists. And some of those came in shortly before an IPO, with their main role thus validating the company to help it get access to better underwriters rather than playing a critical role in its growth.
Another good discussion was on a pet topic, how Big Finance makes a great deal of fuss about the importance of liquidity and goes all hair-a-fire if liquidity falls. We’re long been of the view that the ability to sell large amounts of securities on a hair-trigger is a very recent convenience that didn’t impede successful investing in the stone ages of the 1970s and 1980s.
As Kay put it:
A paradox of financialisation is that the need for an active share market has diminished at the same time as the volume of trading has grown exponentially….
The word liquidity is widely – almost obsessively – used in financial markets, but often without any precise or particular meaning. A casual search of investment dictionaries and encyclopaedias for definitions of liquidity will reveal as many definitions as sources.
The concept of liquidity I will use draws on a homely analogy. In the Edinburgh of 50 years ago, fresh milk was delivered daily. Except at Christmas. The milkman would make a double delivery on Christmas Eve. My father would ask each year how the cows were persuaded to produce twice as much milk. This feeble joke was part of our family Christmas ritual.The dairy’s problem was not, in fact, very difficult. The fresh milk was not so fresh: it had not come from the milking shed that morning. Stocks could be built up, or run down. In the days before Christmas, milk which would normally have been sent to manufacture other dairy products was diverted to household use.
At ordinary times, our demand for milk was stable. But sometimes we would have visitors and need extra milk. My mother would usually tell the milkman the day before, but if she forgot the milkman would have extra supplies on his float to meet our needs. Of course, if all his customers did this, he wouldn’t have been able to accommodate them. But that was never likely to happen – except at Christmas, and the dairy made contingency plans for that.
The ready availability of everyday produce is, in this sense, an illusion. An illusion widely, and productively, employed in modern economics. Liquidity is the capacity of a supply chain to meet a sudden or exceptional demand without disruption. This capability is achieved, as it was by the milkman, in one or both of two ways: by maintaining stocks, and by the temporary diversion of supplies from other uses. When the supply chain lacks liquidity, consumers need to maintain stocks for themselves – they keep a spare pint of milk in the fridge. The financial analogue of the spare pint is the necessity for businesses and households to maintain monetary balances. In extreme cases of illiquidity, households end up hoarding cash under the bed. These supply chain inefficiencies may be costly, in both the milk supply chain and the money market.
Nothing illustrates the self-referential nature of the dialogue in modern financial markets more clearly than this constant repetition of the mantra of liquidity. End users of finance – households, non-financial businesses, governments – do have a requirement for liquidity, which is why they hold deposits and seek overdraft or credit card facilities and, as described above, why it is essential that the banking system is consistently able to meet their needs.
But these end users – households, non-financial businesses, governments – have very modest requirements for liquidity from securities markets. Households do need to be able to realise their investments to deal with emergencies or to fund their retirement, businesses will sometimes need to make large, lumpy investments, governments must be able to refinance their maturing debt. But these needs could be met in almost all cases if markets opened once a week – perhaps once a year – for small volumes of trade….
The need for extreme liquidity, the capacity to trade in volume (or at least trade) every millisecond, is not a need transmitted to markets from the demands of the final users of these markets, but a need, or a perceived need, created by financial market participants themselves.
Kay also discusses robustness versus efficiency that will be familiar to readers of this site (or of Richard Bookstaber’s A Demon of Our Own Design, or Nassim Nicholas Taleb, who we’ve cited regularly).
Again, this is a very accessible speech with a lot of meaty material in it. I hope you’ll read it in full.
John-Kay-BIS-speech
John Kay BIS speech
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OK, I get the point that cows don’t produce twice as much milk on Christmas by themselves, but if the double delivery came from inventory in milk sheds, that means there must have been twice as many sheds!
Fuk that’s hilarious, what a waste (unless you’re a contractor, lumberyard, painter, doorknob maker, roofer, shingle maker, window maker, architect, electrician, light bulb maker, a maker of nails and hammers, a dude who makes the leather tool belts craftsmen put their tools in, bootmaker for workmen, and milk shed delivery driver, among other “economic actors”)
It would have been easier just to milk the cows twice.
This is hilarious stuff. Economic theory twists the minds of the money-hack industry with ludicrous notions like “liquidity” into such contortions that common sense itself seems jarring.
(OK, I’ll admit it. Mr. Kay’s father’s ‘feeble joke’ is hilarious. At least I thought so! pretty funny iMO.)
Yep, the ‘feeble’ joke is in my genes too. The real, ‘meta’ joke is that this obsession with super liquidity almost guarantees that some financial actors take the joke seriously. By validating the ‘feeble’ joke, those supposed “Masters of the Universe” take another step along the road to Infinite Regression and delve deeper into absurdity. I’m now seeing jobs going begging that include the admonition that part time workers must needs be on call 24/7 for mediocre wages. One tell is when an ad for the same job pops up every six or eight weeks. Some people must learn through bitter experience that, in some circumstances, having no job is better than what’s on offer. I wonder if a real education shouldn’t include an explication of the Theory of Limits, both mathematical and applied.
Twice as many sheds?
That doesn’t make any sense.
They don’t need extra sheds to store the milk for the one day.
They store it in the trucks.
They have to keep the truck coolers running overnight. The dairy owners hate it because they have to pay for the extra gasoline.
The reference to electrical grids was nice to but Kay didn’t expand on the analogy.
Electric circuits have capacity, every chunk of conductor can store some charge for some period of time. A large circuit stores more charge longer. And circuits (even small ones) actually pick up charges from the environment. So charges that were not considered during a circuit’s design can appear and move through the network; that means that charges can also “disappear”, cancelled out when an environmental charge opposite from the expected charge is (passively) induced. Many circuits also operate at one or more internal frequencies, and environmental factors can interfere with those as well. There are strong correlations between capacity and frequency in all systems, as Kay notes of financial networks.
And in the dairy model, extra capacity is right there, in the trucks. But the frequency of that capacity is more limited (and expensive) than the frequency of the capacity of the sheds.
Some of the analogous factors in financial systems might be changes in the actual value of non-financial components in the economy, divergences between perception and actual value (frequency can generate these), and fraudulent inputs and outputs. Modelling that doesn’t seriously consider the inevitability and incident rates of these kinds of events can’t construct reliable financial systems.
Systems analysis and design are interesting because they can address the predictability of unpredictable patterns. We can’t exactly model all future states, but we can anticipate that some states will occur that are not part of the design concept. And we can also design systems that degrade (relatively) gracefully when completely unforeseen factors profoundly disable or change component operation. Non-systems people have a hard time with this, they think that designs are intrinsically complete, and that they don’t have to invest in unknowns, or that the risks of doing so are greater than the risks of not doing so.
Financial systems are so abstract that they are difficult to verify (or even explain) outside of their immediate contexts. So people feel free to ignore or misconstrue unexpected behaviors. And then there’s the fact that some financial constructs are complete bullsh*t.
The think that gets me about the discussion is that there is endless yammering about the “market” and how terrible, bad, no good thing regulation is….but when it collapses they all come beseeching the FED* for liquidity…..aka a bailout. And the loss part of “profit and LOSS” system is all forgiven – even though losses are suppose to be the stick part of carrot and stick. Funny who gets the carrots and who gets the stick (i.e., shaft) in this system.
*Now, I was going to say the government. But it seems to me the FED is MUCH more private than public, and IN FACT works for the benefit of the richest in the private sector much, much, much more than the interests of the vast majority of citizens. What is amazing is that we have been carefully indoctrinated to believe that that is the only way to do it…
Kay concludes, “It is possible to have a smaller, simpler, financial services system that is better adapted to the needs of the non-financial economy an efficient payments system, effective capital allocation, greater economic stability, security in planning and managing our personal finances, and justified confidence in the people who advise us. We will not wake up tomorrow, or next year, and find such a reality. Is it therefore pointless to articulate that vision? I do not think so…”
State of the World Economy: The Emperor Has No Clothes
http://www.triplepundit.com/2011/09/state-world-economy-emporer-clothes/
“… an efficient payments system”
Don’t get me started. For years, Europe and even some developing economies have offered universal electronic payments.
Just yesterday, someone I know wanted to transmit funds to a broker … and learned that, yes, she had to snail mail the form to authorize such transfers. So she visited the bank and paid $30 for a Fedwire (a whole other story of an antiquated, user-unfriendly system).
The slow rollout of e-payments is what paved the way for middlemen like Paypal to make a fortune, raking off exorbitant commissions for sh*tty service.
Our Model T financial system is the way it is, because it’s run by a bank cartel. Smash the Fed.
It gets even funnier: the sending bank and the recipient broker got on the phone. Together, they were unable to decipher how to fill out the bank’s Fedwire form (which is different at every bank), with its “intermediate financial institution” (prolly needed for a credit union sender) and “For further credit to” options.
So they just gave up and mailed a paper check. Yes, we can’t.
I would make the case for manufacturing because there are unique technologies for each type of product.
Paul Woolley is on record from 2010 ( http://www.newyorker.com/magazine/2010/11/29/what-good-is-wall-street) saying the financial industry should be “About a half or a third of its current size”.
He is suggesting at least half the employment in the financial industry is unproductive, and perhaps harmful, for the economy.
Here is another quote from the New Yorker article:
“Why on earth should finance be the biggest and most highly paid industry when it’s just a utility, like sewage or gas? It is like a cancer that is growing to infinite size, until it takes over the entire body.”
Woolley has his own center at the London School of economics, appropriately titled “Paul Woolley Centre for the Study of Capital Market Dysfunctionality”
One rather successful business (Hewlett-Packard) was largely self financed for many years and certainly did not rush to IPO, as it was founded in 1939 and IPO’ed in 1957 so it largely avoided the financial industry in its early years.
For years after that, HP growth was financed by retained earnings and by selling its stock to employees.
One could argue the financial industry should shrink dramatically as information flowing in the internet helps aggregate/allocate capital to the “best” use inexpensively and quickly.
Instead we see the industry growing in size and political power, warmly embraced by both American political parties.
How much, if any, of the bloat of finance is attributable to its weaponization? How big would say, garbage collection be, if the trucks rolled into neighborhoods looking like MRAPs, the workers dressed like soldiers on a night raid and accompanied by platoons for “force protection,” etc.?
How much of the activity of the TBTF institutions is for “war by other means”? I’m assuming it’s non-zero, but is it significant? Did the bailouts have anything to do with compensating covert “defense” contractors?
Too tin-foily?
Or the other way around; How much were the wars and weapons about piling up government debt, in order to issue more bonds to store wealth and issue more money?
It is very simple why finance is more highly paid. In its more complex functions (investing and investment banking) requires highly trained and experienced individuals who benefit from scale. Pay is a red herring. One could argue doctors and lawyers are overpaid relative to their global counterparts. ‘Engineers’ who worked on social media (an arguably useless activity) are well compensated.
Regardless, the industry is probably too large relative to the economy. Banking, securitization and OTC derivatives are probably the biggest threats while HFT firms unnecessarily siphon wealth from investors. Leverage at hedge funds is probably way too high injecting unnecessary risk to markets. The abuses in retail insurance and investment brokerage are beginning to be addressed.
but what are they ding with the complex functions that they are highly paid to perform? I think the point is that liquidity at the current scale is only necessary for the securitizations, not for the economy, so your crafty, highly paid securitizers are not irreplaceable, they’re unnecessary
High Finance is nothing but a den of grifters……..that’s all they are.
When they first started building these paper edifices, back in the 90’s, it should be noted that instead of accountants, they went to physical theorists from MIT for the math. Was that because these mathematicians were so much smarter, or was it because physical theorists are under the impression entire universes spring from every thought bubble, while accountants supposedly know that too much funny math will get you in trouble?
It is very simple why finance is more highly paid.
When bank robbers are asked why they rob banks, it’s because that’s where the money is.
. . . In its more complex functions (investing and investment banking) requires highly trained and experienced individuals who benefit from scale. Pay is a red herring
I used to watch the financial blarney shows and wonder what all those people behind the person being interviewed were doing, peering at three screens at once.
Typically the interviews went like this.
Joke Blerman: We are with Slicky Greedo, the head trader of the Bank of Screw em Blue em and Tattoo em. Tell me Slicky, ‘is it a good time to be in the stawk market’?
Slicky:I tell ya Joke, it’s never a good time to be out of the stawk market. Ya know, it always up up and away, and if you don’t buy now, the prices get away from you and then you never catch up. Bad move Joke, being out. It means eating dirt in old age. . . . . . .
So, what are those people in the background doing? What is so valuable that they ‘earn’ mid six figures and seven figure wages?
Are they using a CAD system to design one of Trumps buildings, or designing an assembly plant for a manufacturer to bring a new product forward? Are they scientists using the power of computers to develop new theories, because if the amount of money being paid is a reflection of complexity of the task at hand, and all they are are stawk floor traders, their pay makes no sense at all.
Another thing, it is bizarro world whereby banks can ‘trade’ on any market they choose, keep the winnings and when the losses are massive, hand those to taxpayers. From my point of view, banks shouldn’t even have a trading floor, or be permitted to own aluminum warehouses and play the aluminum shuffle, or store oil in a fleet of tankers anchored offshore. The big reason for this is that banks see their customers cash flows and balance sheet, and can determine profitability and then jump in and out as they see fit to steal from customers. They are an effing bank. Make loans to people and businesses, operate a payments system, store customers stuff in safety deposit boxes, do stuff that banks do, and that’s it.
Outside of that, they aren’t banks anymore, and should be left to fail when they screw themselves up.
We treat money as both medium of exchange and store of value. In your body, the medium is blood and the store is fat. We need to get away from trying to store infinite amounts of notional value. Much of which is by the government running up excess debt and then borrowing it out of the economy.
Money is a contract, not a commodity. Every asset is presumably backed by a debt. So if we are going to have a system where the public, not private banks, are responsible for maintaining the value of the money, then we need a fully public banking system.
This current hybrid system has the public responsible for the risks and the private sector taking the rewards. Either go back to the old system, where banks issued and were responsible for their own currency, or move forward and make banking a public utility. Otherwise the masters of the current system will use the profits generated to buy up more and more of the public properties, from highways, to parks, to police departments.
Government was private once. It was called monarchy. Do we want to go back?
John Kay has made an excellent argument for reinstating the Glass-Steagall Act and disintermediating those who have held our payments system and savings hostage to their secondary markets trading and manipulations, massive derivatives issuance, and securities frauds. Role of the central banks and current primary dealer structure also merits broader discussion.
Twelve people were officially recognised by Bezemer in 2009 as having seen 2008 coming, announcing it publicly beforehand and having good reasoning behind their predictions.
Two of them, Steve Keen and Michael Hudson, think finance is special.
But, it’s special because it is a cost of doing business and that is why it is not like other businesses that make real things and provide real services in the real economy and make real, unparasitic profit.
Finance is best when its feeding abroad and bringing the profits home.
In a global economy it is spectacularly useless, where can it feed outside the global economy?