Not long ago, Mike at Rortybomb had an interesting series of posts considering the appropriate size and scope for the financial industry. He made an interesting point — that in a perfectly frictionless market, there shouldn’t be a financial industry. Willing lenders should lend directly to borrowers. In a sense, the farther we get from that ideal, the more inefficiency we’re dealing with.
In practice, we’ll never be able to eliminate the need for finance. There are many practical difficulties connecting lenders with borrowers, and financial institutions have arisen to help address them. They’re there to reduce transaction costs, to provide information, and to help lenders and borrowers manage risk and uncertainty. And they’re clearly doing a bang-up job. When we think about the value of recent financial innovations, it’s worth considering how they contributed to the ways in which financial firms handled the above tasks. Have transaction costs been reduced? In some cases, the answer is clearly no, while in others they answer is yes, but at the expense of the latter two functions. Have firms become better at obtaining, understanding, and providing information? To the contrary, firms seem to have primarily tried (and failed) to create products that made information gathering unnecessary. And for the most part, firms seem to have magnificently misunderstood the effect of their decisions, individual and in aggregate, on the stability of the financial system.
Frankly, I have no idea what most of the recent growth in finance was for. There seems to have been a simply remarkable amount of waste. Consider this, from a recent Felix post on a potential Ponzi scheme:
The one thing which is abundantly clear is that Jeffry Schneider (always mistrust people who canâ€™t spell their own name) is a very shady character indeed, who was fired from various financial-sector jobs before ending up selling fraudulent hedge funds and seemingly working out of the Bidensâ€™ hedge-fund hotel. Schneider was a â€œmarketerâ€ for hedge funds, including Ponta Negra â€” which means he sold them to rich individuals, and took a commission for so doing. How did he find the rich individuals? Lots of ways, but one was that he paid upwards of $10,000 a month for access to lists of people who were rich enough to qualify as hedge-fund investors.
Now this case obviously involves some lawbreaking, but still. You have some people engaged in assembling lists of rich people, which they then sell. You have others buying these lists and using them to try and get people to invest in various funds. And then you have the funds themselves, and as we learned from the Madoff case, a lot of people out there were paying managers two and twenty only to have those managers turn around and dump the money in some other fund. How many middlemen are involved here?
To get back to Mike’s original point, when you have a few people taking home billions, that’s a sign of either very good luck or some brilliant new strategy. When you have a lot of people in finance taking home billions, then something has gone badly wrong. Either something unsustainable is building, or there are some serious inefficiencies in the market.