Public animosity against Wall Street is high. Notably free market economists are taking the position that recent profits in finance are just about playing "heads I win, tails you lose."
I am skeptical.
I am skeptical because this presumes that the financial industry is amassing profits simply by transferring money from some group of losers to itself. The immediate question is, why would the losers agree to this?
A possible retort is that the losers haven't agreed to it. The losers may be the taxpayer who is by law forced to pay taxes. This is the bailout explanation.
However, as I have pointed out before, if this were true it would be really nice to see evidence of the taxpayer losing through bailouts. Right now the most direct evidence seems to be that the taxpayer has gained through bailouts.
Another retort might be that the loser is being consistently tricked. This is possible but we have to ask a few questions. One, why doesn't the loser wake up to the fact that he or she is being tricked? Two, why doesn't this pool of unrelenting suckers attract so many sharks that they drive each other's profits down?
This is part of why I was skeptical about the notion of Consumer Financial Protection as doing anything major. Maybe consumers have no idea what they are doing and are constantly getting tricked. Yet, then why isn't there a market for trust. Indeed, we have financial institutions like Credit Unions which would seem to offer more of the simple trustworthy products consumers advocates would like to see. However, people aren't choosing them. Why?
Somehow people not only have to be fooled once, but they have to be willing to keep going back to the place that burned them. This implies some sort of fundamental decision making problem with the loser.
A potential answer to all of this is that there are deep biases shared by lots and lots of people. Overcoming that bias is a lot of work for some, but really easy for others. Thus those who easily overcome their biases reap are able to consistently get the better of those who can't.
This post from Jeff Sommer seems to support that view. Sommer says
With bond yields rising and plenty of headlines about the fiscal pressures on embattled state and local governments, mom-and-pop investors have been selling tax-exempt mutual bond funds in droves lately. In the meantime, professionals have been making rich profits on bonds that have been swept up in the turmoil, including some from deep-pocketed institutions like Cornell and Harvard. There have been some good deals recently on California state bonds as well.
Though University Endowments usually don't draw the same ire as private hedge funds they have been routinely successful in beating out the average investor. The news stories were about the big losses in the Great Recession, but the real story was the enormous returns made in the years leading up.
More importantly here is a potential source for the bias. Mom and pop investors have a hard time not responding to news stories. This need not be naiveté.
There could be a simple structural explanation. News stories about strained state budgets make it hard for Mom and Pop sleep at night with their retirement in munis. Not being able to sleep at night is a real cost. Mom and Pop sell their assets at a loss to improve their quality of life.
On the other hand, the Money Manager at Cornell is unaffected by news stories. He or she suffers no pain or discomfort from holding munis and so buys them at a gain.
The structural nature of this explanation explains why the market forces can't make this problem go away. Mom and Pop aren't consistent suckers. They are people responding to the real costs they face. This discomfort associated with fear of loosing your retirement is a real thing, it can't simply be waived away.
Moreover, the number of people immune to this fear may also be limited, implying that the number of sharks is fundamentally limited.
In this case there is no natural mechanism that will stop Mom and Pop's returns from going down and the professional managers returns from going up.
However, to the extent this is true the amassing of wealth in the hands of professional managers increases efficiency in the economy. It turns investment decisions over to people who can produce them at lower cost.
That is to say in this model of the world choosing investments is not simply a matter of information, it is a matter of being able to bear the emotional costs of making certain types of decisions. Sourcing those decisions to people with lower emotional costs really does increase efficiency.
Now to be clear I am not pushing this model as the truth. I am just kicking around ways to reconcile the fact that Wall Street is making outsized returns with what we know about markets and human behavior.
Comments feed for this article
Sunday ~ March 6th, 2011 at 3:38 pm
Here’s one thing the CFPB can do, fix the acts of violence here: http://wapo.st/gbnLmt
And that’s a sophisticated couple, with power, voice and money to fight.
Sunday ~ March 6th, 2011 at 3:54 pm
In the presence of limited liability, I don’t think its at all clear that professionalizing risk-taking is necessarily efficiency enhancing. It seems to me that too much risk-taking is to be expected.
I will agree that when “the public” becomes more risk-averse that the room for professional risk-takers to make profits ought to increase. To say that this is efficient, though, is just to say that the flight to safety is an inefficient outcome.
Sunday ~ March 6th, 2011 at 4:31 pm
I would argue that this same psychology goes in the other direction as well.
You asked the question: “…why doesn't this pool of unrelenting suckers attract so many sharks that they drive each other's profits down?”
You might ask a similar question, why don’t these massive payrolls attract so many great quarterbacks that the NFL lowers salaries? Why doesn’t the amount of money in the fashion industry attract so many elite models that salaries go down?
The good salesmen are there because they are the NFL quarterbacks of selling investments. There are plenty of sharks, but some sharks are much, much more effective than others. And the Internet has given them access to every fish in the sea.
Just like star athletes or the physically beautiful, good salesmen have a genuine ability that is the result of both natural talent and intense training. Their talent is the ability to observe, understand and manipulate human emotions that go into the decision-making process.
Sunday ~ March 6th, 2011 at 5:17 pm
Good post. The one thing I’d expound on is the “emotional cost” part. The reason they are able to bear that cost is because they can bear those OTHER (financial) costs. Someone with 10k is going to feel a whole lot more pain losing 10% of their money than someone with 1 million. This isn’t just about diminishing marginal utility, it’s about /survival/. The person with the million is likely not one job loss or bad investment away from homelessness; the one with 10k may very well be.
Sunday ~ March 6th, 2011 at 11:52 pm
“the real story was the enormous returns made in the years leading up.”
Many of those returns were enormous because of leverage. The losses would have been enormous if the Fed and Congress did not help them out.
“amassing of wealth in the hands of professional managers increases efficiency in the economy.”
In the boom this was loaning people money to buy houses they could not afford. I don’t see how this makes the economy more efficient.
Monday ~ March 7th, 2011 at 1:10 am
I like your story, but it didn’t really explain why people don’t use Credit Unions instead. Or maybe I don’t know enough about C.Us to understand why you implicitly explained so above. I suppose a theory that explained that would also explain why people don’t just accept the EMH and put their money in passive indexed funds (in my case, I’m just not proactive enough to make my “portfolio”, or lack thereof, match my beliefs).
Monday ~ March 7th, 2011 at 10:30 am
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