Wasting a Good Society on Finance

Wed, Aug 25, 2010 | Jared Woodard

Economy, Politics

This is one of those off-message rants that marks, I guess, one of the real differences between “blogs” and “old media,” and if you’re only here for the options stuff, you can skip this post.

From 1990 to 2006, the GDP share of the financial sector in the broad sense increased in the United States from 23% to 31%.
-Már Gudmundsson, Bank for International Settlements, 2008

This point has been made many times before – and better – by others, but while reading a Times article on a recent breakthrough in the analysis of junk DNA, it struck me again how poorly organized our society is. Instead of creating incentives for people to pursue work in genetics and environmental science and all the other fields that might solve urgent, significant problems, we take a huge percentage of the smartest and best college graduates and stick them in the financial sector, where they can – in the absolutely best case – make the portfolios of wealthy individuals and institutions slightly more efficient or more profitable. I’m tempted to agree with Paul Volcker that the only meaningful financial innovation in recent history has been the automated teller machine. I say that as someone who spends a lot of time and effort fiddling with options and futures, and I can do so without fear of contradiction because I’m not foolish enough to equate “meaningful” with “profitable.”

Leaving aside the worst-case outcomes of pushing so much talent into finance – and we’re arguably living through those outcomes now – even an optimal scenario looks like an outrageous failure of that supreme object of American faith, the free market. Even if we imagine a world in which the American credit super-cycle was able to continue indefinitely, and further posit that the collective output of Wall Street wasn’t just to dump everyone into one big ETF – and hey, tack on any other wild counterfactuals you want – I still don’t understand why the size of the U.S. financial sector isn’t prima facie evidence against the rationality and efficiency of a market economy. We’ve got a good society here, with plenty of smart and hard-working people, and we had to go and waste it on something as derivative as finance. (There’s an old, unfair joke that “those who can’t do, teach;” I wonder if, in a similar vein, we can say that those who can’t succeed in maths, physics, economics, or prostitution do finance.)

The disconnect is clear enough, I think: we humans care about things like quality of life, about having breathable air and potable water, and even about things like the arts and humanities. But markets struggle to recognize the value of any of those things: if you strip away all the quasi-religious reverence that the Western world has for markets and remember that they are, after all, just one method for processing information, then it seems much clearer that the needs of human societies are inadequately served by market systems. With enough hand-waving about regulatory capture and political corruption and so on, it might be possible to mitigate the particular example of the over-allocation of “human capital” (a nasty, embarrassing phrase) to the finance sector. But, ultimately, the inability of markets to deal with the major problems we face must be taken seriously: call this or that individual issue a “negative externality” if you want, brush it under the rug, and keep reading your Mises or Friedman or Hayek. But as the problems pile up, pretty soon it starts looking like all externalities.

11 Comments For This Post

  1. Highgamma Says:

    To cite others paraphrase of Winston Churchill, Capitalism is the worst economic system, except for all the others that have been tried. Of course, it’s not perfect. As you point out, the information that is passed through prices is only a filtering of what imperfect humans know and can act upon.

    However, capitalism, when cronyism is minimized, diffuses power. It goes hand-in-hand with freedom, though it does not guarantee it. Giving up freedom for the promise of stability always seems to end poorly.

    So, no brushing things under the rug, there is a fragility created by the free market. We need to remove the incentives, sometimes government-imposed and sometimes not, that feed this fragility, but we will never be rid of it. We certainly need to minimize cronyism which increases as we increase state power.

    Handing enormous economic power to government officials doesn’t have a good track record. (We can talk about Fannie and Freddie, the Fed, public hiring that makes no sense, regulations that aren’t enforced and policymakers who seem to be pushing the market in the precisely wrong direction, but I’m sure you’ve heard that all before.) Let’s make sure that the solution isn’t worse than the disease.

  2. gappy Says:

    This argument has been put forward by Esther Duflo, Calvin Trillin and many others. I think the same once in a while, but then I quickly disagree with myself. Briefly:

    1) It’s true that the financial sector enjoyed disproportionate rents but it’s not true that the smartest and brightest work there. As you noted, the place is littered with failed scientists. Worse, it’s littered with idiot savants. There are once in a while people working there who have trained for the job — Very good PhDs in finance and economics, for example, or good M&A lawyers, and they usually strike me as the ones who offer the best contributions to their organizations.

    2) The term “free market” is vague at best, and a rhetorical construct at worst. Financial markets are heavily affected by regulation. Just to give two examples: the MBS market would not have taken off without tax incentives; and the huge sub-industry of institutional asset management is also very strongly regulated through tax incentives, indirect barriers to entry, etc. All of which increases the incumbents’ rents.

    3) “With enough hand-waving about regulatory capture and political corruption and so on, it might be possible to mitigate the particular example of the over-allocation of “human capital” “. This is a very strong belief masquerading as common sense. There is a ton of theoretical and empirical literature that agrees at least on one point: it’s not that easy. Even if we had an effective mechanism to agree on social objectives, implementing them is hard. Of course, it plays both ways: it’s actually disingenuous to assume that, by renouncing any social objective, we are also renouncing any form of implementation of *something*. As I mentioned, there is no such thing as free markets, and that is fine by me. So, let us regulate and design better (fairer?) markets; let us agree to correct the most obvious mistakes and injustices. But the recurrent call to the better allocate supposedly clever guys strikes me as ill-founded.

  3. Michael Liss Says:

    While I agree that the growth in the financial sector is evidence of something gone amiss, I disagree with the conclusion that culprit is “the free market”. Our financial system is the polar opposite of a free market. It is chartered, regulated, and manipulated by Government. The failure is governmental dallying, not the free market.

    I have started a number of software companies in my time. I am working on another one right now. I never asked anyone’s permission. I have also thought about starting a bank – but that would be nearly impossible due to the chartering and regulatory process. Banking (Finance) is not a free market.

    But back to your point regarding the mis-allocation of talent towards Finance rather than, say, Genetic Engineering. This is something I agree with. This seems to be a classic Austrian School Mal-investment in terms of human capital. Another example of when the government screws with the system, unintended consequences abound.

    Keep up your rants. They are interesting.

  4. Steve Howard Says:

    Yes. Yes. Yes. Free financial markets great, but only to the extent that price discovery can be suppressed by collusion. Democracy, fabulous, but only to the extent that the starting gate is set so narrow that only parrots can slip through.


  5. Blue Says:

    Just got around to reading this post. Of course I agree. The real question is what’s to be done about it.

  6. kilroz Says:

    The US pumps out more lawyers than any other country. Is this a misallocation of talent? I remember when I was an undergrad studying for a BA in math. I was an avg to slightly above avg student, but I remember being in class and getting help by these wunderkinds. The math just seemed to come naturally to them. I would ask what they wanted to do after college and many wanted to teach High school math and eventually go on to graduate studies. Should their talent be used toward a different field than a 50k a yr teaching job?

    It’s a global economy not just the US.

  7. isomorphismes Says:

    So the intuition is clear enough as to why sending bright young people into finance instead of biochemistry, but what’s the cold hard evidence that financialisation ruins an economy?

    Riffing a few counterarguments against “just throw them into biochemistry”:
    • bright young people don’t count; it’s about the organisation of large masses of bodies—like an army doesn’t need to have all the genius generals to win, in fact maybe it just needs vicious, goal-directed mediocrity
    • basic science doesn’t necessarily get connected to anything productive for anyone
    • The people doing biochemistry research both in industry and in academia have blunted incentives that don’t really serve the broad constituency of humanity. The academic rat-race and big pharma research rat-race don’t point toward the global optimum; evolution there favours the local winners of games within their own institutions.
    • Biotechnology has been supposed to make us immortal as long as we’ve been promised flying cars. Maybe biochem. has a great narrative but doesn’t work out in practice for some reason that’s obscure to the naïve among us.
    • Finance actually serves a purpose. Let’s say 1 financial person is required per 1,000 human population with at least $X wealth. (In the same way as 1 doctor is “required” by 1,000 human population with at least Z dishealth. More can still be better.) Then let’s say London is just soaking up demand for financiers from elsewhere—it’s analysing transactions or providing excellent advisory services (thought outsourcing—where the brillianti really should go!) for Egyptians, Chinese, and now Icelanders.
    • Finance actually serves a purpose. Give someone a rifle but they can’t aim it. How good are they with the rifle? Give someone a blowgun and they know exactly what to do with it. How good are they with the blowgun?

    And so on….rather than continue to manufacture counterarguments it would be cool to see some mechanism-independent stats on how bad financialisation really is for an economy.

  8. isomorphismes Says:

    (my comment that “Basic science doesn’t necessarily get connected to productive activity” is supposed to link to → “That’s Business’ job” → from there to “How does business decide what to work on?” → to some finance jocks doing whatever increases the bottom line as opposed to what a subject-area expert’s intuition of what’s “better” → CFO vs CEO / Mitt Romney liquidating jobs because they’re tying down capital / privatisation of British Rail leading to an “efficient” (read: higher) number of accidents / http://condoroptions.com/2010/01/07/retail-vampirism/#comment-17770 “efficient” destruction of winter coats nearby freezing-cold homeless → and collapse in a self-referential circle of pessimism.

  9. Jared Woodard Says:

    Ok, so 3 years later I also disagree with the author of this post. I don’t think financialization is bad; risk transfers / insurance in particular are really really good. And several commenters, esp gappy and iso, make decisive responses.

  10. isomorphismes Says:

    haha. Very nice. I came back to remark that this story reminds me of an options newbie who accidentally took delivery of potato futures or something and got 20 rail cars of (let’s say it was potatoes). You couldn’t give away that many potatoes if you went around and knocked on doors with bushels of them full time. His city was so small that even if people diligently spent their time stealing potatoes from him, most of the potatoes would have rotted uneaten. But, you know, capitalism and the market process and the specific transactions he went through had dumped those potatoes on his doorstep.

  11. isomorphismes Says:

    oh. So what made you change your mind on financialisation and risk transfers? I still don’t know the evidence either way.

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More


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