John B. Judis has a piece in The New Republic in which he argues that the position taken by people like MIT professor and former IMF chief economist Simon Johnson and former McKinsey consultant James Kwak about Wall Street's prominent role in the US's economic problems is misguided. I think Judis is right in much of what he says, but it's about half irrelevant and half straw man. His strange argument seems to suggest that those who place a major part of the blame for the economic meltdown at Wall Street's feet ignore a multitude of other problems.
I think you can boil his claim down to a cause-and-effect chain: Judis thinks that the growth of Wall Street came about as a consequence of the collapse of the Bretton Woods system 30 years ago. With a system of floating exchange rates, the argument went, arbitrage opportunities were created (as price movements could be exploited by astute market participants such as the big banks), and financial institutions were needed more and more to help companies manage risk (for instance, by allowing companies to purchase futures to lock in prices, and developing currency swaps that protected exporters from fluctuations in currency values). So big banks stepped up to design complex transactions for companies, and big banks' trading desks grew, as did hedge funds that could make money by exploiting market inefficiencies and profiting off of them.
Now, I obviously don't think, like the populist left and populist right do, that evil hedge fund speculators and vampire squid banks are doing something incredibly destructive. But I'm also not of the opinion that they're necessarily doing something incredibly productive. I think my argument is that Judis's cause and effect chain is mistaken. The collapse of the Bretton Woods system didn't inevitably lead to the outgrowth of big finance-- the erosion of the post-World War II regulations in the banking sector, of which the collapse of the Bretton Woods system was one, but far from the most significant, drew in smart people enamored with the big money to be made on Wall Street and created a distorted economy that needs to be fixed.
I guess the first thing to point out is that since World War II, finance has become increasingly deregulated. The collapse of Bretton Woods was probably a necessary development, but it was far from the only one, and far from the most signficant one for this story. There was the elimination of fixed trading commissions in 1975, the deregulation of the Savings & Loan industry (followed by an inevitable blowup) in the 80's, and the formal repeal of the part of 1933's Glass-Steagall Act separating deposit-taking banks from securities firms. Each of those developments created profit opportunities for financial companies. The sector grew rapidly until, as Judis points out, it more than doubled in size from the 1950's, to over 20% of GDP by 2009.
This is where some might pause and say, "So what? If finance makes money, why shouldn't it grow? Why do we care about the size of finance?" Well, I think the answer there is that finance is, ultimately, not just a service industry, but a utility. It's absolutely necessary for the economy, but it can't function on its own, and it can certainly get too big. Think of it this way. Producing things like food, clothes, cars, and TVs (things we like and use), and providing services like cutting hair and curing the sick, would be extremely inefficient, if not impossible, without a good power company to provide electricity to where it's needed. Now imagine that the power company is a fifth of the size of the economy, and its employees are the best-paid people in town. Instead of leaving school wanting to produce cabinets, advance science, or start a new business, everyone wants to work for the power company, since that's where the money is. And sure, there are innovations along the way-- power is provided more efficiently, companies can get lights that turn on automatically when they walk into the room, and so forth. But the question then becomes, is that an economy that we want?
For me, the answer is no, because at the end of the day, without places to allocate the power, the power company is effectively useless. And, while you can innovate all you want, there's only so much utility we get as a society from having a whole lot of innovation in how you can deliver power-- at the end of the day, energy is energy is energy. And finance is a pretty good analogy: you can innovate all you want, but money is money is money. In essence, all finance does (even if you believe that it performs all of these functions to the best of their ability, which I don't) is allocate capital to its most "efficient" uses (I put "efficient" in quotation marks because for the better part of the last decade, financial institutions decided that allocating capital to mortgages for high school dropouts and empty office towers was super-efficient). It takes savings (in the form of deposits, mutual funds, pension funds, and hedge fund accounts) and places them into supposedly higher-yielding investments, with the result being that everyone gets paid if the investment posts a good return, while much of the risk of loss is absorbed by the financial institution. As a utility, it is effectively useless if there aren't clients which require their services. In other words, Goldman Sachs can't exist without Procter & Gamble, General Electric, Starbucks, Wal-Mart and Microsoft.
And I think the reason we should care about the explosion of finance is that its fat paydays move talent out of the corporations that produce goods and services directly, and towards a utility. Fifty years ago, if you were a physics Ph.D who built world-renowned models, you dreamed of going to work for NASA and working on getting to space. If you were a bright, innovative Harvard grad, you started your own business. Now, that physics Ph.D is getting plucked out of the lab and handed $10 million a year by Goldman or a hedge fund to design a model which allows them to leverage small discrepancies in prices into hundred-million dollar paydays. NASA can't compete with that salary. But, at the end of the day, all a successful convergence trade based on that physics Ph.D's model means is that the prices of the securities or commodities being traded moved to their efficient level a few minutes (or a few hours) before they otherwise would have. If that physics Ph.D built a successful new rocket for NASA, well, we've got a great new way to make scientific progress. So the profitability of the financial sector actually has negative utility, as the best workers are drawn away from business, engineering and science and drawn toward finance. So what we end up with as a society is a lot of financial innovation, but less technological innovation. You might be able to call up Morgan Stanley and hedge against a fall in the price of corn more easily now than you could 30 years ago, but the cost is that our scientific knowledge is behind where it might otherwise be, and we don't have nearly as many entrepreneurs out starting businesses because they could leave Harvard and pick up a $100,000+ paycheck as a 22-year-old at Goldman.
So how do we resolve the issue? Is the cat already out of the bag? Well, maybe. But I think one somewhat counterintuitive idea is to re-regulate. I'm not smart enough to come up with a comprehensive financial regulatory regime, but if you set up dull, predictable rules that can't be easily skirted, like the ones that existed from about 1945 to the early 1970's, you end up with a financial sector that might be somewhat lazy, dull, and boring, and probably pretty inefficient, but also one that doesn't outdo itself with groundbreaking new mega-profitable opportunities that not only threaten to undermine the entire system, as they did in 2008-2009, but also doens't attract people who have skills that would be better applied elsewhere.
Now, we'll never be able to go back to the 60's, and it would be foolish to try, but the growth of high finance more or less mirrors the end of the improvement in the wages of the average worker. From the time Reagan took office in 1980, median wages stagnated. After 2008, they sank. The economy grew, but it grew only at the top. Hedge fund managers and Wall Street dealmakers got mega-rich. The average worker was left behind. Luckily, Wall Street had an answer for that stagnation so that the average person would keep feeling richer: leverage. Advanced innovations in risk-taking were supposed to allow families to borrow more than they could before, without adding to the total risk in the system. Needless to say, that idea blew up in everyone's face. But to get back to the point, hedge fund managers will continue to exist, but regulations in other places could limit the risk-taking (and, as a result, the profitability) of other financial institutions. And this in turn would put financial salaries back in line with those given to workers in other parts of the economy. Consequently, innovative talent moves away from designing new ways to price options and hedge interest-rate movements and toward designing the next Google, developing the next Starbucks, or inventing the housekeeping robot.
So no, finance isn't the great beast Judis claims his critics make it out to be. But it also isn't the most productive place to lure our coutry's best and brightest innovators.
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