Friday, June 28, 2013

J. Bradford DeLong: Is financial sector draining life blood of real economy?

In his Project Syndicate column, Professor DeLong asks the question of whether the financial sector is draining the life blood of the real economy.

To answer this question, he observes

Back in 2011, I should have read Keynes’s General Theory a little further, to where he suggests that “when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” 

Regular readers know that the capital development of all the developed countries has become a by-product of the activities of a casino because the financial regulators, like the SEC, allowed the financial industry to bring opacity to large areas of the financial system (examples include black box banks and brown paper bag structured finance securities).

Our financial system is based on the FDR Framework. This framework combines the philosophy of disclosure with the principle of caveat emptor.

The primary role of government is to ensure that all useful, relevant information is disclosed in an appropriate, timely manner.

Market participants have an incentive to use this information as under the principle of caveat emptor they are responsible for all losses on their exposures.

The FDR Framework supports the three step investment process:

  1. Use the disclosed information to independently assess the risk and value a security.
  2. Solicit prices from Wall Street for buying and selling security.
  3. Make investment buy, hold or sell decision by comparing independent valuation of security with price being shown by Wall Street.
Where there is opacity, market participants cannot go through the investment cycle.  Instead, the act of buying or selling a security is nothing more than blindly betting (Mr. Keynes' casino).

Professor DeLong wonders why there has been no "obvious economic dividends" from the growth in the financial industry.

The reason, I proposed, was that “[t]here are two sustainable ways to make money in finance: find people with risks that need to be carried and match them with people with unused risk-bearing capacity, or find people with such risks and match them with people who are clueless but who have money.” 
Over the past year and a half, .... evidence that America’s financial system is less a device for efficiently sharing risk and more a device for separating rich people from their money – a Las Vegas without the glitz – has mounted....
The first sustainable way to make money in finance relies on transparency.  The second sustainable way to make money in finance relies on opacity.

As Yves Smith observed, nobody on Wall Street was compensated for developing transparent, low margin products.  Hence, Wall Street focused on making money by relying on opacity.

An argument could be made that opacity is not a sustainable way to make money in finance.  After all, opacity caused the financial crisis that began on August 9, 2007.

The counter to this argument is that the bankers used the opacity of their own institutions to their advantage and managed to a) convince policymakers and financial regulators to use taxpayer money to bail them out and b) continue to pay themselves large bonuses.

Four years ago, during the 2008-9 crisis, I was largely ambivalent about financialization. 
It seemed to me that, yes, our modern sophisticated financial systems had created enormous macroeconomic risks. But it also seemed to me that a world short of risk-bearing capacity needed virtually anything that induced people to commit their money to long-term risky investments.
In other words, such a world needed either the reality or the illusion that finance could, as John Maynard Keynes put it, “defeat the dark forces of time and ignorance which envelop our future.” 
Your humble blogger disagrees with Professor DeLong that illusion is needed to induce people to commit their money to long-term risky investments.

For over 5 decades since the FDR Framework was put in place during the Great Depression, the economy had adequate access to capital for risky investments that contributed to growing the real economy.

It is only after illusion was introduced into the financial system through the use of opacity that the financial sector's percentage of GDP increased.  The financial sector made much more money because investors didn't have the information they needed to properly assess risk and over-paid for the risk they took on.
Most reforms that would guard against macroeconomic risk would also limit the ability of finance to persuade people to commit to long-term risky investments, and hence further lower the supply of finance willing to assume such undertakings.... 
I disagree with this statement.  People are willing to commit to long-term risky investments when they have access to all the useful, relevant information in an appropriate, timely manner.  The reason people are willing to commit is that they trust their own assessment of this information.
At that point, it is time either for creative thinking about how funding can be channeled to the real economy in a way that bypasses modern finance, with its large negative alpha, or to risk being sucked dry.
I agree with Professor DeLong that we need to bypass where modern finance siphons off excess return.

The straightforward way to do this is to bring transparency back to all the opaque corners of the financial system. Then the financial system can operate as intended under the FDR Framework.

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