How Wall Street bankers got so rich

Tyler Cowen is an economist on the faculty of George Mason University and the Center for the Study of Public Choice.  He is an advocate of tax cuts and balanced budgets and a critic of Keynesian economists such as Paul Krugman.

Tyler Cowen

He wrote a disturbing article recently for The American Interest recently in which he argued that (1) the financial sector is soaking up increasing an increasing share of the U.S. national income and is likely to continue to do so; (2) by so doing it will put the U.S. economy increasingly at risk; and (3) it is hard to see what can be done about it.

He cited statistics showing how the financial sector is growing in comparison to producers of tangible goods and services.  From 1973 through 1985, the financial sector never accounted for more than 16 percent of U.S. corporate profits; by 2004, it had risen to 41 percent.  From 1948 through 1982, compensation of employees in the financial sector was roughly equivalent to average compensation in U.S. industry as a whole; by the 2000s, it was 181 percent.

Cowen noted that in 2004, the top 25 hedge fund managers received combined compensation equal to all the CEOs of the Standard & Poor’s 500 largest corporations put together.  And the number of Wall Street speculators taking in (I won’t say earning) $100 million a year was nine times as great as the number of public company executives taking in that amount.

How did they become so rich?  Cowen said it is by means of what he calls “going short on volatility.”

By this he means betting against infrequent events, such as a collapse of house prices, as if they were never going to happen.  They are able to get away with this because, when the day of reckoning comes, they are able to walk away from the situation  Wall Street firms are public companies, and so the risk of collapse is handed off to the shareholders.  And they are so large and so entangled with the rest of the economy that the government can’t allow them to fail.  Wall Street executives get to keep gains for themselves, while spreading risk to stockholders and taxpayers (and also to customers who buy securities they don’t understand, an aspect Cowen doesn’t deal with.)

Cowen doesn’t think there is much that can be done.  The problem is not so much that the banks are too big to fail as that the bankers are too clever to be regulated.  Their financial instruments and activities can’t be controlled because they are too complicated to understand.  Whatever regulatory system the government tries to impose, Cowen thinks the so-called financial engineers will find a way to get around it.

For now, he says, the big financial institutions are chastened by the recession, and are inclined to sit on their money rather than gamble with it.  The Federal Reserve System facilitates this by lending trillions of dollars at near-zero interest rates, on which the banks can profit by re-lending in the form of short-term commercial paper (money market funds).  But sooner or later, he says, there will be another financial bubble.

The underlying dynamic favors excess risk-taking, but banks at the current moment fear the scrutiny of regulators and the public and so are playing it fairly safe. They are sitting on money rather than lending it out. The biggest risk today is how few parties will take risks, and, in part, the caution of banks is driving our current protracted economic slowdown. According to this view, the long run will bring another financial crisis once moods pick up and external scrutiny weakens, but that day of reckoning is still some ways off.

Is the overall picture a shame? Yes. Is it distorting resource distribution and productivity in the meantime? Yes. Will it again bring our economy to its knees? Probably.

via The American Interest Magazine.

Click on The Inequality That Matters for Tyler Cowen’s full article in The American Interest.

Click on Tyler Cowen’s Counsel of Despair for Roth Douthat’s comments in The New York Times.

Click on Inequality and Crisis for Rick Avent’s comments in The Economist.

Click on Why Are Bankers So Rich? for Kevin Drum’s comments in Mother Jones.

Click on Tyler Cowen on Inequality and the Financial Sector for Mike Konczai’s comments on his Rortybomb web log.

Click on Who Is Going Long on Volatility? for Tyler Cowen’s response and further discussion.

Click on Marginal Revolution for the web log which Tyler Cowen maintains with Alex Taborrok.

Have things always been this way, or is this something new? Joseph Wechsler, in The Merchant Bankers (1966), described a world in which the world’s financial system was dominated by banks with long histories, many of them partnerships and family firms.  You would think such a world would be more stable than what we have now.

In a partnership, the partners go broke if the firm fails.  In a family-owned firm, the partners generally are concerned with the firm’s reputation, and with having something to pass along to the next generation.  So you would expect the old-time partnerships to have been more risk-averse.

But, as Wechsler reported, the old-time mechant bankers still got into trouble.  And we’ve had nothing in recent decades with consequences equivalent to the Great Depression following the Crash of 1929.  I guess things are the same as they always were, except more so.

Tyler Cowen in his article says that, except in the case of high finance, there is no connection between the stagnation of ordinary folks’ wages and the higher rewards going to people at the top of the income scale.  I have to disagree, not so much on the basis of statistical analysis as on what I see going on around me.

In all kinds of organizations – not just business corporations, but hospitals, universities, philanthropic institutions – there is a pattern of increased compensation at the top and decreased compensation at the bottom.  It is very interesting in this respect how the so-called public school reform movement focuses on breaking the power of teachers’ unions.  The theory is that it is necessary to strip teachers of job security so that administrators are free to hold them accountable for failure, but I don’t know of anybody who questions the administrators’ and consultants’ six-figure salaries or proposes holding them accountable for failure.


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