Why do bankers make $squillions (and you don’t)?

Road pricing in London in the 18th century

There’s an interesting discussion going on in the blogosphere right now about how Wall St made and lost so much money in the noughties.

It started yesterday our time when George Mason University economist and ‘the world’s most read economics blogger’, Tyler Cowen, announced that he’d written an essay on inequality in The American Interest.

He makes some interesting points – for example, Americans are more likely to be envious of their better paid colleague or their slightly wealthier brother in law than they are of billionaires and financial high rollers. Nevertheless, he focuses on “the pernicious role that big finance plays in modern political economy”.

As I interpret it, his thesis is that the finance sector takes big but self-enriching risks in the good times because it relies on government bailing it out on the odd occasion when real disaster strikes. As Ross Douthat from the New York Times puts it:

The “bust” part of the cycle tends to make taxpayers suffer more than the Wall Street investors themselves, thus incentivizing further recklessness and still worse crack-ups down the road

By this morning (Thursday), the debate has been joined by an army of influential pundits, including Ross Douthat, Ryan Avent from The Economist, Kevin Drum from Mother Jones and political blogger Matthew Yglesias. By the time you read this it is likely there will be many more.

This is the kind of event that’s never going to happen in the conventional media. Only the internet could draw these thinkers together so quickly and spontaneously, together with hundreds of comments by smart and informed readers from all over the world.

It is relatively common for these sorts of intellectual wildfires to flare up, burn and smoulder awhile and die out. For example, Steven Leavitt and Stephen Dubner were roundly attacked by various bloggers last year when a chapter on climate change in their (then) forthcoming book, Superfreakonomics, was posted on the net. It started a veritable shitstorm for a week or two, virtually all of it confined to the web.

It’s not just speed that defeats the mainstream media either. Even if they picked up immediately on Cowen’s essay, simply assembling large numbers of the right talking heads or columnists in one place would be a logistically difficult and expensive undertaking. And it would have to compete for air time or column inches with news and opinion on more popular topics.

But why are bankers in the US making billions? I’m not going to put my bush accountant’s hat on and wade into this debate, so I’ll settle for Kevin Drum’s take in Why are bankers so rich?:

This has always been one of the central mysteries of modern finance: Why is it so damn profitable? We’re talking about an industry that’s global, largely commoditized, and highly competitive. Profits should have been under extreme pressure for the past few decades. And yet, somehow, just the opposite was true. Against all theory, banks were able to consistently charge excessive prices; consistently take the better side of financial bets; and consistently persuade every other actor in the business that mispriced risk was, in fact, correctly priced. The result has been wild profitability and huge bonuses.

And where did this insane gusher of money come from? There are three possibilities: (1) banks created it, (2) their activities caused the economy to grow faster than it otherwise would have, and they reaped the benefit of that extra growth, or (3) it was somehow skimmed away from the rest of society. Possibility #1 is unlikely: banks certainly created mountains of debt, but mountains of money would show in skyrocketing monetary aggregates and high inflation, neither of which happened. Possibility #2 also seems unlikely. There’s simply no evidence, either in comparisons over time or comparisons between countries, that economic growth over the past two or three decades has benefited from financial rocket science. So that leaves possibility #3: somehow, all this financial engineering was based on skimming money away from everyone else.

So, in the end, Tyler’s piece really is about income inequality. The incomes of the vast middle class have lagged productivity growth by a small amount each year, and that small amount has accumulated into a gigantic pool of cash that gets funnelled to a tiny number of the super rich, many of them in the finance industry.

But what is the mechanism that funnels the money? That’s a mystery, he says, that no one has ever been able to explain.

P.S. This morning (Friday), Tyler Cowen has posted a response to Kevin Drum. And again on Saturday.

Map from David Rumsey Map Collection.

5 Comments on “Why do bankers make $squillions (and you don’t)?”

  1. Mahyar says:

    You betcha that if governments (read: taxpayers) didn’t bail them out regularly, they’d take fewer risks and their profits would drop. Same goes for the insurance industry. But then their failure would change society too dramatically for our leaders and their paymasters to bear.

    I wonder, if we had democratic participation in matters that affected us, not ‘representatives’ deciding for us, whether people would vote to bail out such entities and individuals. I’d suggest not. So much for a free market: privatise profits, socialise debt. And so much for democracy.

    By the way, that was not much of a break, Melbourne Urbanist.

  2. Michael says:

    I have been thinking about this issue since I heard Dr Paul Woolley’s talk “Global finance: big, bloated and dangerous?” broadcast on the ABC. He basically asked the question if markets are efficient how can a service sector like finance generate super-profits and account for 40% of corporate profits?

    John Kay also asked an interesting question in 2008 in his FT column. “How could banks have persuaded themselves, their shareholders and the public that they were making so much money when in reality they were losing it?”

    Maybe markets are efficient and self-correcting, but not in a timeframe that is safe for civilisation.

  3. […] account of how finance fuels inequality in America is generating a lot of interest. Alan Davies at The Melbourne Urbanist has links to commentary by Ross Douthat, Ryan Avent from The Economist, Kevin Drum from Mother […]

  4. Moss says:

    Sorry I missed this original entry.
    May I recommend to everyone a couple of extremely lucid writers on this whole financial engineering fiasco? These guys know exactly where the money has come from: Eric Janszen over at iTulip.com, and Doug Noland at PrudentBear.com.
    These guys are so far ahead of the rest of the punditry it’s not funny. Happy reading!

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