Posts Tagged ‘Going short on volatility’

How Wall Street bankers got so rich

December 20, 2010

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.