Profit – 2parse

Wall Street’s enormous profits are evidence of a poorly functioning market.

[digg-reddit-me]Matt Yglesias and Ezra Klein had 2 complementary points in posts yesterday. (Damn you, JournoList!) Yglesias:

…[L]ooking at this chart I think it’s hard to avoid the conclusion that Wal-Mart is the last thing we should be worried about. The worrying trend is the domination of the corporate landscape by super-profitable firms in the heavily regulated energy, banking, and telecom sectors.

Yglesias is making a point most commonly associated with libertarians that large firms often use the government — through favorable regulation, tax breaks and incentives, etc. — to increase their profits. For example, increasing the barriers for new firms in the industry and restraining their indirect competitors from direct competition. This follows the well-known principle that any government policy whose costs are diffused and whose benefits are concentrated will be adopted more often than not. Thus highly regulated industries tend to be dominated by a small number of large firms that make very large profits — because thanks to government regulation, there isn’t much competition. However, Ezra Klein observed:

In a competitive market, there’s really no place to make 27 cents on the dollar. Some other firm will come in and offer the same services for 24 cents, and then someone will undercut them at 19 cents, and so it will go until the profit margin narrows. Wal-Mart, for instance, has a profit margin of around 3.5 percent. Ah, capitalism.

Not so in the financial sector, though, which ever since deregulation has been posting higher and higher profit margins.

So, the exception to this trend is Wall Street — where deregulation has lead to higher profits. All of this seems quite intuitively true — both from a libertarian and from a liberal perspective — and even from a liberaltarian one.

The enormous profits taken out of every dollar (as seen in much of the the financial industry) is a demonstration of a lack of competition and thus a poorly functioning market. Of course, Goldman Sachs didn’t manage to make it on the list above — but it had more than double the amount of profit out of every dollar it took in as compared to each of the companies here. Goldman managed to take $0.26 of every dollar they made as profit to their shareholders. (And that includes the massive bonuses given to employees as expenses.) I think I need to see more data though to draw the conclusion that Klein is hinting at — that the deregulation of Wall Street increased it’s profits as a percentage of revenues — while deregulation generally has the opposite effect (as in the case of Wal-Mart).

Annie Lowery drives the point home in analyzing the 1Q results from Wall Street:

This is not quite a picture of a healthy industry. In a competitive marketplace, prices and fees at Wall Street firms should fall and margins should become thinner. On the one hand, Wall Street firms like J.P. Morgan and Goldman Sachs have seen a number of their competitors die in the past two years, and have absorbed business from the failed Lehmans and Bear Sterns of the world. But on the other hand, Wall Street profit margins have remained sky high except for a short blip during the worst of the credit crunch. And, an economist would tell you, such sustained levels of high profitability point to anti-competitive behavior…

[T]he profits point to a lack of competition. That is one thing the Dodd bill — via derivatives regulation — attempts to fix. Right now, Wall Street firms do not bid for big derivatives contracts — they simply quote a price and work over-the-counter. For that reason, derivatives are wildly profitable for the companies. The Dodd bill will force derivatives pricing to become public to the market, driving down margins as companies compete.

There’s a whole lot to unpack within these points about the nature of American capitalism and the government’s role in it.

But one key takeaway seems to be a repudiation of the most ideological take of either the left or right — and an acknowledgment that free markets are not merely what happens when the government is out of the way — but are created and maintained by a complex balancing act in which government regulates and participates. What you end up with is something less than socialism or libertarianism and more like liberalism:

Contemporary liberals reject the doctrinaire distinction between the “market” and the government that animated so much of the conflict in the 20th century. The free market should not be treated as some theoretical utopian ideal or as a perpetually lost state of innocence. And the government is not some evil force which must be reduced until it is of a size that it “could be drowned in a bathtub.” Rather the government and the free market exist together – and in a capitalist republic such as ours, each is dependent on the other. The free market does not exist in a state of nature but must be created by and maintained by the society and the state which provide the values and the rules and other conditions without which a market cannot be free. In other words, a free market is a product of a just government.

Follow-up post here.

[Image by f-l-e-x licensed under Creative Commons.]

Theories of the Financial Crisis: Greed

[digg-reddit-me]

George Will may seek to defend greed (Or maybe not – it’s actually kind of hard to tell.) – along with Ayn Rand and other market fundamentalists.

But just about everyone else lists it as a fundamental cause of the financial crisis. Will tries to make the case that free markets punish greed. But what Will presumes is that an unregulated market is a free market – and on this fundamental point he is wrong. The market Will describes is not one heavily regulated by the government – but it is regulated by ebay which in this instance takes on the role of the government for this small market. The financial markets on Wall Street though were largely unregulated – especially the shadow banking system (which was created in such a way as to be unregulated) – and they were in this sense free from government interference. But they were controlled by a small number of individuals – and in this sense were part of a world where freedom was available only to a princely few. Will makes the point that greed is an immutable human characteristic – and thus does not account for the booms and busts of our business cycle (and of financial crises such as this.) But what does is the combination of perverse incentives for short-term profit (indeed a form of legal fraud), a relaxation of the regulations designed to keep the markets stable that tends to occur when Republicans have power, and greed.

There has always been an historical wariness in America about the combination of greed and concentrations of wealth – focusing on a national bank, on various financiers, on “the malefactors of great wealth” and indeed, on Wall Street. The people, in their wisdom, could see that this concentration of financial power undermined the democratic distribution of political power. But by the 1980s, there was an additional reason to be wary – as Ronald Reagan unleashed a money revolution. This money revolution – like all revolutions – was the commingling of many forces – globalization, the ad-hoc Bretton Woods II agreement, and the relaxation of regulations and reduction of taxes. This revolution helped to concentrate an increasing percentage of the world’s wealth in the hands of a small number of Wall Street (and also London) bankers. The function of these bankers – their expertise – was to balance risk and profit to their customers’ satisfaction – to maximize profit for themselves and their customers while minimizing (or controlling for) risks. As a small percentage of individuals accumulated more and more wealth around the world, these individuals entrusted more and more of this wealth to Wall Street bankers – and the more money the bankers controlled, the bigger their cut. As Michael Osinski explained in a piece for New York magazine:

When you’re close to the money, you get the first cut. Oyster farmers eat lots of oysters, don’t they?

This closeness to the money created an easy money culture – in which enormous sums money were distributed whether they was deserved or not and the culture began to prize attempts to satisfy the bottomless desire that is greed. Wall Street bankers took on the culture of gamblers – except with the market going up, everyone made money. The long boom began to create perverse incentives – as risks began to seem safer, as luck and a rising tide and short term profits made everyone seem like geniuses, they all became accustomed to a certain lifestyle. Financial innovations sought to overturn many of “the fundamental rules of banking” including “that default risk is an inevitable liability of the business.” The combination of innovation and the culture of greed and gambling led to greater and greater risks being taken.

As steady foundations of banking – both as a business and as a culture deteriorated – and as the cautionary tales of Oliver Stone’s Wall Street and Liar’s Poker morphed into guides – a new culture of excess developed – excessive greed, excessive pay, excessive drinking, excessive spending, excessive personal risks, and eventually excessive professional risks. Wall Street bankers began to betray all the symptoms of the easy money culture – like gamblers whose knew their earnings were ephemeral and that every up would be followed by a down to be followed by an up – as long as they could stay at the table. But as Matt Taibbi wrote, “this was a casino unique among all casinos, one where middle-class taxpayers cover the bets of billionaires…”

Osinski tells a story of how this easy money culture affected the individuals:

Now that I was spending more time on the floor, I wondered why the men’s room always stank. Then one afternoon at three, when I was in there taking a leak, I discovered the hideous truth. Traders had a contest. Coming in at eight, they never left their desks all day, eating and drinking while working. Then, at three o’clock, they marched into the men’s room and stood at the wall opposite the urinals. Dropping their pants, they bet $100 on who could train his stream the longest on the urinals across the lavatory. As their hydraulic pressure waned, the three traders waddled, pants at their ankles, across the floor, desperately trying to keep their pee on target. This is what $2 million of bonus can do to grown men.

This easy money culture warped the incentives at Wall Street firms as well – as they were structured in such a way as to generously reward short-term success (without controlling sufficiently for long-term failure.) Rather than being paid large salaries, most of a banker’s income was handed out in enormous bonuses based on yearly performance. As long as fees were generated, as long as this quarter’s profits were growing – bankers would be rewarded with enough profits to last a lifetime. This alone is enough of an incentive to cause massive fraud. But at the same time, the culture of Wall Street ensured that money would be spent ridiculously, ostentatiously, and quickly.

Perhaps no one has been more articulate in his visceral disgust for the excesses of Wall Street than Matt Taibbi of Rolling Stone.

[I]t’s time to admit it: We’re fools, protagonists in a kind of gruesome comedy about the marriage of greed and stupidity. And the worst part about it is that we’re still in denial – we still think this is some kind of unfortunate accident, not something that was created by the group of psychopaths on Wall Street whom we allowed to gang-rape the American Dream.

The story of AIG – in its way – symbolizes better than anything else what this culture did to Wall Street. Back to Taibbi:

AIG is what happens when short, bald managers of otherwise boring financial bureaucracies start seeing Brad Pitt in the mirror. This is a company that built a giant fortune across more than a century by betting on safety-conscious policyholders – people who wear seat belts and build houses on high ground – and then blew it all in a year or two by turning their entire balance sheet over to a guy who acted like making huge bets with other people’s money would make his dick bigger.

A culture of greed and excess – a lack of respect for tradition – a market free only to a princely few – negligence bordering on fraud with regards to the evaluation or risk – and an increasing percentage of the world’s wealth concentrated in the hands of a few. Together, these were the recipe for this financial disaster.

The problem with greed is that it is unsustainable. It exists in a cycle, like all unsustainable desires. Government regulation, like morality, seeks to control and channel greed in less destructive ways – to mitigate the effects of this cycle. The true cause of this financial crisis was not greed – but the ideology that held that finally the immutable human vice of greed had been overcome with clever financial innovation and the magic of the market.