The Value of Finance


You sometimes hear people question the value of the financial sector. Indeed, sometimes you’ll hear me doubt it. The doubting claim would be that it doesn’t appear to be the case that “financial innovation” has created the kind of economic benefits that you associate with, say, the technical innovations that have given us faster laptops, better cell phones, and more fuel efficient cars or the kind of business process innovations that have helped bring us lower retail prices for many kinds of everyday consumer goods.

To this one typical argumentative move in reply is to simply make the case that if there were no finance at all the world as a whole would be a much worse place. Household savings needs to be aggregated and channeled to people who have potentially profitable investments they would like to undertake. But I think that’s not really the issue. Rather, as Brad DeLong says, the issue is whether the sharp pre-crisis rise in the profitability of the financial sector had any relationship to the creation of real value:

I find the plea on the second charge unconvincing too. The rise in profits from 20% to 40% would have been justified had finance produced (a) better corporate governnance and thus better management, or (b) more successful diversification and thus a lowered risk-adjusted cost of and a higher risk-adjusted return to capital. There is no evidence that a sector that could not provide good corporate governance to itself was successful at providing good corporate governance to its clients. And the claim that modern financial markets provided successful diversification is to laugh: if it had we would not be here now, would we? Guilty as well.

I think the sources of finance’s outsized payrolls are to be found: (a) in the naivete of investors who are not able to calculate what they are paying people who are essentially gambling with their chips in the casino–investor who should be entrusting their money to Vanguard and PIMCO but cannot figure that out–(b) in the naivete of corporate CFOs who overpay for financial products so that they can tell their CEOs “yes, we are hedged”; and (c) in the naivete of the stockholders of financial services corporations who did not insist that the traders they hired keep all their money in the firm in order to give everybody an incentive not to take equity-destroying risks. And none of these three are reasons to believe that the payrolls ever corresponded to the effect of their actions on social welfare.

Could it really be the case that so many people were naive enough to trust their monies to institutions that were only claiming to have brilliant investment models? Well, it seems to me that it could. And that this would explain why it might make sense for a firm financial firm to pay Larry Summers $5 million a year for a one-day-a-week job. When your company’s underlying product isn’t necessarily sound, it’s important to invest a lot in marketing. Summers is like a celebrity endorsement. This is also a reason, I think, why having gone to a fancy college seems to have been very helpful for getting a job in finance. The firms’ business models very much depend on putting a certain image of themselves forward.