Friday, April 23, 2010

Size Matters (It's the obvious pun--just read the post)

This Matthew Yglesias post from yesterday is one I strongly disagree with: in it, he argues that the amount of profits derived by financial institutions isn’t so bad in of itself.

Let’s think about the claim here. First, it’s important to note that the profits are as much symptom of an underlying problem as a problem in of themselves. You get profits in the financial industry by running bigger risks, naturally. The logical next step of the argument is that over the past decade or so, as the financial industry became more competitive and more profitable, that they ran far more risk. Sure enough, that’s what happened. So any regulation that decreases risk-taking might well take a bite out of profits. It’s also helpful to think of another source of Wall Street fees: namely, taking small cuts of various trades, market-making and advice. Insofar as the profit from fees can be reduced, then, it would flow back to companies performing productive services.

There’s the biggest nub: namely, what exactly is the productive service provided by banks? Well, it’s to allocate capital to invest it in companies or individuals who will use the money in socially beneficial ways. So we know that Wall Street is making tons of money—a large share of all the profits—and so, if it were doing its job, it would be providing money to people providing productive services. But nonfinancial company’s profits grew only marginally compared to Wall Street throughout Wall Street’s long boom, and we know that despite vigorous productivity growth, the American worker ended the decade making less on average than he or she began the decade with. This is not exactly conclusive evidence of massive social gains being made in the rest of the economy. So how is it, then, that the money Wall Street is providing is so useful to justify the outsized profits they’re making? The question is hard to answer, I think, which is why it would be desirable to reduce their profit. As it happens, a lot of the stuff we want to do in financial regulation reform—Consumer Financial Protection Agency, derivatives reform, etc. etc.—are good to do for other reasons besides reducing Wall Street profit, but they’ll do that too. We want Wall Street to make less money.

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