Monday, December 21, 2009

So Damn Much Money

The CEOs of the world's largest banks finally "get it." In the course of doing God's work, they acknowledge that they may have had something to do with last year's implosion of the financial system and the hemorrhaging of jobs and retirement funds it has wreaked. (Though they would never put it in such grave terms.) Perhaps they're also ready to mend their ways, to acknowledge that their swelling profits are less the fruit of their own whiz-kid abilities and more the inevitable side-effect of a massive dosage of Treasury/FDIC/Fed medicine. Who wouldn't show numbers in the black if the government was spoon-feeding them newly minted greenbacks in exchange for credit risk, assets no one wants, and a nominal fee? Perhaps, in their newfound awareness of fallibility, the banks will plow that cash into the capital reserves that the crisis found to be so wanting. And maybe the Squid itself will lead the way for all of the other converts.


Sonuvabitch. I guess they don't "get it."

Why is it that executives and senior employees in financial services rake it in every year? As Felix Salmon notes by way of Ryan Avent, such consistent payouts to traders are less an indication of excessive added value than they are a signal of an inefficient, failing market. The "innovations" of finance should be making the cost of credit intermediation lower, and astute outsiders should be flooding into the market to skim off some of that fat themselves. At least in a competitive market. Instead, we've seen hordes of astute outsiders (some of the best and the brightest of the past two generations, probably) move into financial services and yet everyone continues to pull down hefty rents. What gives?

For one thing, volume matters. Trillions of dollars slosh between the bank accounts of broker-dealers, investors, corporations, municipalities, and others every day. Taking only a few dollars -- even pennies -- here and there for these transactions is enough to add up to tens of billions of dollars per year, or more. This is the "flow" that earns a bank (and here I'm talking about the largest wholesale banks, not your local community bank) a consistent profit. These are precisely the kinds of trades that should benefit from innovation in other fields, namely information technology. Here's Felix:

Wouldn’t you expect...that financial companies would have become more efficient at intermediating between companies and investors? Shouldn’t it have been much easier and much cheaper to issue a billion-dollar bond in 1998 than it was in 1968?
Surely enough players can jump into the broker-dealer market to drive the costs of clearing and settling trades down to miniscule amounts. But the financiers themselves would argue that it's not the technology that costs them, but rather the salaries and bonuses for the traders who sit on bond desks pricing bid-ask spreads and engaging in prop trading (not always a clear-cut distinction). Market-making requires skill, yes, but how much more than real rocket science? Every time the payment of exorbitant bonuses comes up, bank executives immediately seize upon the notion that their top talent will walk away at the first financial sleight, i.e. the first time they are paid for what value they add, rather than for "what they kill." Subtract out the massive government guarantee floating silently in the background, or the extensive network of systemic risk built up with all the OTC derivatives hedges, and "what they kill" begins to look a lot less impressive.

So what stops new firms from competing on the basis of price? The products banks trade may be heterogeneous, but the underlying skills and back-office technogy aren't. Why wouldn't investors and issuers go for a new institution or boutique that draws business away from competitors by offering lower trading costs and underwriting fees? Because no one would want to work there! Not if these same skills could be more highly rewarded elsewhere. They'd rather stick with the investment bank that pays them six figures or the private equity/hedge fund that pays them seven or eight. (Hell, the tax code even institutionalizes these relative pay differentials by treating some fund managers' earnings as capital gains rather than earned income.) And even if this "boutique" could lure away some traders willing to work for less, their brethren at the market-entrenched, too-big-to-fail dealers would still look like the better trading partners and counterparties to potential customers. After all, it's the big existing banks that dominate the market with their trading presence, existing base of asset management clients looking to put money to work, and 0% probability of being allowed to disappear any time soon.

All of this is to say that the bonus babies at some of our largest financial institutions should see their compensation "haircutted" down to levels that reflect their value-added; a level that is closer to engineers, doctors, and attorneys, if not less. Trading or underwriting $200 million of securities does not take twice as much intellectual skill as doing the same for $100 million of securities, so why is it compensated that way? Because market entrants would have to contend with the existing players that can't fail. Because this compensation is partly the monetization of government guarantees. And because there are always other institutional players -- some tax-advantaged -- that can afford to pay more the instant banks treat $200 million more like $100 million.

As I see it, the problem boils down to the nature of banking and finance itself. In particular, high levels of liquidity and low capital requirements allow credit to flow too easily relative to counterparty and systemic risk. A large amount of this credit goes toward making risky bets, paying off the gamblers, and making a given institution larger, more complex, and significantly too-big-to-fail. (Which is to say that strict limits on leverage and bank size can go a long way toward reforming the system). When all the cards tumble down, taxpayers step in to take the hit. Financiers can and will pay themselves ridiculous amounts until regulators, customers, and bank equity investors do something to stop it. But we've heard enough of their meritocratic horseshit. Their pay doesn't represent superior value, just their cut of the loot from a deregulated, inefficient marketplace.

Thursday, December 17, 2009

The Greater Good

I recently took the time to re-read Michael Tomasky's 2008 piece in The American Prospect, "Party in Search of a Notion." In it, Tomasky (now editor of the excellent Democracy Journal) urges Democrats to revive the party ethos of an earlier era, one in which the values of so-called civic republicanism prompted American citizens to support major domestic and international initiatives that benefited the common good and the larger American project of an ennobling liberal democracy. The New Deal at home, as well as the Marshall Plan abroad, are two examples of such efforts; ones that had the effect of improving the immediate and future socioeconomic well-being of millions, but which did not invoke an appeal to self-interest for every citizen individually. Contrast that with today's political scene, where every legislative proposal draws out a visceral individual defensiveness -- health-care: I like my (horribly inefficient) employer-sponsored health care! -- or corporate appeals masked as consumer protection -- credit card reform: You'll shrink the availability of credit to the economy (subsidized by the poor, unlucky, and imprudent)!

Tomasky says that the Democratic Party lost its common good civic republicanism in the 1960s, a time when individual rights -- another liberal tradition -- came to the forefront:
Against this small-r republican tradition that posits sacrifice for larger, universalist purposes is another tradition that has propelled American liberalism, that indeed is what the philosophers call liberalism proper: from Locke and Mill up to John Rawls in our time, a greater emphasis on the individual (and, later, the group), on tolerance, on rights, and on social justice. In theory, it is not inevitable that these two traditions must clash. But in the 1960s, it was inevitable that they did. And it is clear which side has won the argument within the Democratic Party.
I agree that "in theory" these two traditions don't appear mutually exclusive. After all, for the last fifty years most appeals to tolerance, rights, and social justice have been made not for the broad public (with the recent health-care debate being an exception), but on behalf of some marginalized segment of society. Implicitly, these movements are appeals to the greater good, to the ideals of fairness and opportunity that political leaders evoked much more explicitly during and prior to the 1960s.

But the sentiment has been lost. The Democrats and President Obama repeatedly fail to maintain a convincing "common good" narrative in what should be slam-dunk arguments. In health-care reform, evidence-based medicine may crowd out procedures that patients now expect or demand, but that are wasteful or ineffective on net. Limiting such practices would lower everyone's insurance premiums. "Cadillac" plans would be taxed at higher rates, but this would partially offset the subsidy they receive from employer-sponsored health insurance. In other words, serious health-care reform is going to require self-sacrifice. Not everyone can expect to be made immediately better off should a health-care bill pass, but their support for reform will mean both new coverage for those that may have suffered or died without it, and a stronger safety net and economic infrastructure for everyone.

Health-care reform is just one example of a relevant contemporary issue warranting a solid "greater good" narrative. The gay rights issue -- even though it would seem to fall on the Locke-ian side of the liberal tradition -- desperately needs to be seriously framed, in LBJ fashion, as a vital test of our collective American character. Indeed, every single problem that threatens the endurance of our nation (structural deficit) or our species (climate change) necessitates the return of civic republicanism and the ascendancy of those leaders ready to embrace it.

I don't pretend that the Democrats have anywhere near the political credibility to convincingly argue for large-scale economic sacrifice, particularly after the Wall Street bailout and obvious institutional corruption of Congress itself. But if their Republican counterparts are going to avoid issues of governance and recede into Nixonian ressentiment, the Democrats would be wise to regain some measure of magnanimity by relentlessly redefining themselves as the party of the common good.

Monday, December 14, 2009

Declaration of Principles

Welcome to kentropy's opening salvo, if it can be called that. With his blog, I hope to join the ongoing discussions occurring across the web on innumerable subjects. With a lot of self-restraint, I may be able to limit my posts to the areas that interest me most, namely: finance and the economy, media and journalism, politics (in doses I and my readers can stomach), and culture more generally. To be honest, "culture" is my not-so-secret trapdoor for talking about anything I damn well please. But I'll post with you, my dear reader, in mind. In fact, I'll codify that.

Declaration of Principles

1. kentropy will enter the sphere of public discussion with readers and virtual compatriots in mind. Dialogue -- not ego or self-aggrandizement -- is the goal.

2. We look to raise both questions and eyebrows. Ideas will be taken seriously and subjected to the purifying waters of skepticism and irreverence.

3. Righteous indignation will not only be tolerated, but welcomed. Vitriol has its uses.

4. We reserve the right -- nay, have the obligation -- to reconsider our thinking and admit mistakes.

Let's see where this takes us.