Saturday, February 2, 2013

Noah Smith and the Value of Finance


Parsing Noah's of 20 Jan: How much value does the finance industry create?

In his opening lines Noah links to a couple relevant files that sound most interesting. I'm not gonna go there. I'm gonna be lazy and trust Noah's judgment, and just review his post. For now. Noah writes:

In 1980, finance took home about 5% of all the income in America; in 2007, about 8%. This has led many people to question whether all this activity is worth what we pay for it; in other words, how much of the increase in finance-industry GDP is actually value added, and how much is "rent" extracted from the rest of the economy?

Well, sorry to disappoint you but it's all value added. By definition.

It's the wrong question. How much is value added and how much is rent is the wrong question. No matter. Noah likes John Cochrane's answer enough to quote it:

I don’t claim to estimate the socially-optimal “size of finance” at 8.267% of GDP, so there...After all, if a bunch of academics could sit around our offices and decide which industries were “too big,” which ones were “too small,” and close our papers with “policy recommendations” to remedy the matter, central planning would have worked.

Pissed me off. Irrelevant, ego-driven politics. But then (oops) I read his next sentence;

A little...modesty suggests we focus on documenting the distortions, not pronouncing on optimal industry sizes.

Kiss my ego remark goodbye. A little modesty has exposed itself. Here, let me cherry-pick another one, so I can say John Cochrane has it exactly right:

Third, we often discover a “government failure,” that the puzzling aspect of our world is an unintended consequence of law or regulation. The regulators got captured, the market innovated around a regulation, or legal restrictions stop supply and demand from working.

Yes, or... or maybe the government failure is a policy failure, or rather a failure of economists and policymakers to understand the "drug interactions" of their remedies.

Noah likes it:

In casual discussions of finance in the media and blogs, we've heard all of these ideas before. The idea that finance is excessively large due to collusion with the government (policy failure) is probably the most prominent - this is the idea that big banks have the government in their pocket, allowing them to dump their risk onto the taxpayer (through bailouts) while keeping their gains for themselves.

But, oh, that's tiresome. Remember "Japan, Incorporated" from back in maybe the 1980s? Know what that was? Wonderful, from the American media perspective. Know what else it was? Collusion. But things were good in Japan (Oh, it must have been the 1980s, or anyway before the start of Japan's lost decade)... Things were good in Japan, so people thought of Japan's business-government collusion as "cooperation" and they said good things about it.

Sorry for the history lesson. But it's not really a history lesson. It's a lesson about how to do things wrong. Here, let me show Noah's remark again, with just a trace of editing:

In casual discussions of finance in the media and blogs, we've heard all of these ideas before. The idea that finance is excessively large due to collusion with the government (policy failure) is probably the most prominent - this is the idea that big banks have the government in their pocket, allowing them to dump their risk onto the taxpayer (through bailouts) while keeping their gains for themselves.

I let the introductory sentence stand. I captured the concept. I scratched out the conclusion. See how much of that paragraph is conclusion?

Almost all of it.

Not Noah's fault. It's not his argument. He's just reporting it. Anyway, it turns out that the paragraph I quoted and scratched out was only half of Noah's paragraph. The rest wasn't even worth scratching out, I guess. But it ended with this line:

Maybe value is being created and we just don't understand it."

Maybe value is being created by what seems to be a bloated financial sector, and we just don't understand it. Noah picks up on that and runs with it. He says there's a lot economists don't know.

Noah says "economists urge caution" and provides an analogy:

As a doctor, you wouldn't say "I can't figure out how this organ is helping the body function, so let's just take it out." Similarly, it would be foolish to say "I don't see how this finance industry is adding value, so let's regulate the heck out of it." We start with the presumption that things are there for a reason - in biology, because evolution put them there, and in economics, because...evolution put them there.

Yeah.

No.

Yeah, evolution turned finance into a bloated monster. No, it wasn't a natural process. It was a process of misunderstanding -- an unintended consequence of economic policies that conflict with each other. Like Cochrane said, more or less.

Oh, no. That was me.

But of course value is being created. Value is in the eye of the beholder. The guys paying for those bloated financial services are the same guys who value them.

The rich guys?

Nope. Us. You know, the borrowers. The ones creating the demand for all those loans. We are the customers that keep the finance industry afloat. Bloated and afloat. We think there's value in it, or we wouldn't do it. Right?

Eh. Not really. The playing field isn't level. All of economic policy is tipped a certain way. And you can tell which way it's tipped by the results we get. For example, we keep accumulating more debt and more debt until we have a crisis. That's natural? Pfft! If it was natural we'd have had the crisis already by 1974. Maybe before that.

The crisis was delayed by policy. Policy did things, unnatural things to extend and preserve the expansion of finance. Policy made unworkable finance workable. But it was still unnatural, and it couldn't last.

And it didn't last. But poor Noah, I guess my explanation is too simple for him. Noah is poking around in the dark with analogy and a stick:

Of course, if the organ explodes and threatens the rest of the body, then you take it out... And if you can, you figure out why this organ, or this industry, tends to explode, and you figure out if there are ways you can prevent an explosion, or see it coming, without creating nasty side effects.

Oh, but then his next sentence is good!:

But the question of whether finance is unstable and tends to explode (and how to deal with that) is very different from the question of whether its compensation is equal to its value added.

Told you: The "value added" question is the wrong question.


Noah spends the balance of his post trying to justify the idea that bloated finance creates value. I lost interest. Dammit, Noah: Value is in the eye of the beholder!


So, what conclusions do I draw, to bring these remarks to an end?

5 comments:

Greg said...

UUUUGH! That was tough to read. I didnt get through the whole post. I have enjoyed some of Noahs stuff before but this is just a trash piece from a financial status quo apologist.

I hate it when guys appeal to evolution in situations where their is obvious "design". These relationships didnt just evolve or happen, they were selected by powerful people. These are choices humans made not some unbiased force like natural selection.

Not that there arent some useful ways to view our economic history using evolutionary models, there are. But they would be better applied I think if we look at how money systems over time have evolved away from pure gold backed currencies and pure private banking to modern nation state currencies with coordinated Central Banking and Treasuries.

Of course the reason we evolved to these types of money systems is because it benefitted many of the powerful people. It did help our society at large as well but the primary goal was not the little people. It was not pure evolution in the biological sense it was the next in the series of ideas to preserve power for those who were prone to losing some of theirs in times of financial upheaval.





Greg said...

And about the question "How much value does finance create?"

Its time, I think, for those of us so inclined, to use one of the "other sides" more effective critiques of public intervention on themselves. It is often said (correctly I might add) that govt creates nothing. They are a facilitator and they can only redistribute that which is already present. We can quibble a bit about the true nature of some of our public investments of the past but I do agree with most of the sentiment of that statement. But isnt it also true of finance or banks? Banks dont create anything, they facilitate as well. The only difference is cost and public/private support for the ventures. What is the cost of finance?........ Interest. What is the cost of govt?...... Taxes.

Both institutions provide ways for a polity to try something new or augment something current and grow its size. There are times when one or the other is better used. Here's a rub though. Interest from finance is always collected by and for the benefit of a very small minority whereas taxes, in a society like most western societies, are recycled and used for public benefit to a large extent.

The Arthurian said...

Greg, ya got me grinnin. You wrote: "But isnt it also true of finance or banks? Banks dont create anything, they facilitate as well."

Check out this image of my posts for today and tomorrow, from Blogger.

Post for tomorrow: The Factor of Facilitation.

You and I think much alike.

The Arthurian said...

Greg: "UUUUGH! That was tough to read."

I had the same reaction to Noah's post. My post here was a sort of knee-jerk reaction, as opposed to my usual lethargic writing. Kinda like "UUUUGH" but in more words.

Not sure about this. You say: "I hate it when guys appeal to evolution in situations where their is obvious "design". These relationships didnt just evolve or happen, they were selected by powerful people. These are choices humans made not some unbiased force like natural selection."

I think I take a step back from that view, and see "powerful people" as part of the evolutionary process. I think the whole of human existence -- since the rise of the first civilization, anyway -- is a Toynbee cycle of rising and falling concentration of wealth. Powerful people play a central role.

Agreed, about the evolution of money.

And you may be right about "pure evolution in the biological sense". But then, I need a word.

Greg said...

You are correct Art. Social evolution, that which we humans do after we become human and form groups, is certainly a natural aspect of our human-ness, but I think the fact that strong individuals always emerge must be understood as MORE THAN natural. People do acquire the ability to shape things and influence other people via their ideas and the stories they tell to communicate their ideas. Sure these all emerge from natural processes (I dont think ANYTHING is supernatural) but I think to simply call these things natural is to fall for Blankfeins "We are doing gods work" fallacy.

The truth is EVERYTHING on this planet; every created item, every human idea and human institution is natural but humans have developed ways to get more than their natural share, so to speak.

Lions and their prey have reached an equilibrium and both have adapted to changes of the other as life has moved on. Kenyan lions today are different in very subtle and some not so subtle ways from Kenyan lions of 1000 years ago but no lion ever figured out a way to get a gazelle without hunting for it, without having to do some running. If one did figure out a way to get gazelles without running, it would be natural per se but the game would now be fundamentally different than it was. The possibility would exist that that lion might be stupid enough to sit there and just kill gazzelles for fun. He might get real fat and lazy and eventually, as other lions died off from not getting enough gazelles, he might also die off. He might run out of gazelles and his trick might not work on cape buffalos or Impalas, and now he has forgotten how to run and hunt.

We have the ability to fundamentally change our world to where we cant survive in it. And we have people who are arrogant enough to believe that is not possible and many are our "leaders".

This is all over and above biologic evolution although our brains are a product of biologic evolution.

Ideas come from brains, brains come from biology but some ideas will wind up ending biology as we know it.

There are good ideas and bad ideas. There is healthy distribution and un healthy distribution.

I'm talking too much now aren't I?