Why Investment Banks Like Having Booms and Busts
"In an unstable economy, speculation dominates enterprise." -- Hyman Minsky, Stabilizing an Unstable Economy, p. 17
... the veracity of which was questioned by commenter Prateek by pointing to a break-down of operating profits at Goldman-Sachs --
Investment banks largely earn their revenues from underwriting IPOs, helping stabilize IPO prices with a stabilizing mechanism, and arbitrating negotiations between merging companies. These are activities that directly channel funds to the real economy, rather than just shift funds between financial assets. So they are very vulnerable to the state of the real economy.
The last time I checked Goldman Sach's financial statements, I saw that their revenue breakdown was 40% deal-making, 40% wealth management advisory, and only 20% trading in the markets.
Gene stood by his assertion, but declined to elaborate -- I suspect mostly because he didn't feel like it at the moment, not because he actually couldn't.
I think Prateek raises an interesting objection, though. If trading only accounts for 20% of revenue, then how much can Goldman-Sachs really be profiting from unstable markets -- which would presumably put a big dent in the sectors of their business that actually make most of their money? Since Gene declined to take on this objection directly, I thought I'd take a stab at answering it myself.
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In general, when someone persuaded of the Austrian take of things says something like "banks are parasitizing the economy," he will be talking about inflation, and how extending credit through expansion of the money supply allows the bank access to what is effectively 'free income.' They get to collect interest on money which they printed themselves -- nice gig if you can get it. I won't go into the details here, as you can find them a million other places.
But a bank like Goldman is not really a money-issuing bank. It is an investment bank, not a commercial bank (though, as I recall, it temporarily re-designated itself a commercial bank in order to qualify for bailout money back in '08...), so it does not really profit through this mechanism. I contend that it does profit, however, from many indirect effects of this process -- for one, market instability -- and that this is mostly a matter of reaping a rent-seeking profit.
Maybe the best way to see how this works is to think in terms of a similar market that is intrinsically unstable and therefore has come to incorporate a great deal of financial risk-mitigation -- agricultural commodities. Farmers generally use two main financial arrangements to mitigate risk: insurance and futures contracts. Crop insurance allows the farmer to protect himself from the vagaries of weather and other matters of chance that might have the effect of destroying large portions of his crop. By purchasing an insurance policy, he ensures that he will at least receive some income, come what may.
Futures contracts allow the farmer to sell his crop far in advance -- before the crop is even produced, and before the price of his crop at harvest time is known. Many crops are highly perishable, and nobody knows for sure just how much will be produced until the time to harvest comes. At this point, if the market is glutted with his particular crop, he will not get a good price and will probably be faced with tremendous losses. By selling his crop in advance with a futures contract, he will know ahead of time exactly how much he will make -- again, come what may.
I go through all of this to show how the arrangement has a real effect of contributing actual utility to markets. People employed in insurance and futures market speculation perform a valuable service by inquiring into and researching possible future conditions, providing valuable information to markets. This allows farmers and other agricultural workers to plan their production strategies to better optimize their efforts and use of resources and avoid waste -- such as by producing way too much of one crop and not enough of another.
Contrast this with, say, your own experience buying groceries at the grocery store. When you go to the store, you probably do not spend too much time worrying about how much prices will change from one moment to the next, or from one location to another. You pretty well know that prices are generally uniform from one place to the next, and generally stable over time. You probably do not employ people to track the prices of things to try to get a better deal, because this would be a waste of your money and the employed person's time.
But suppose that prices were somehow artificially made quite volatile, from place to place and time to time, and in a manner that was rather complex and not easy to predict. It might actually make sense for people to get together to employ someone to spend all of his time studying the 'grocery market' to get the best deals while his clients were away at work or spending time with their families. When things are straightforward and simple, people are mostly able to take care of themselves without too much additional effort. But when things get hairy, they must resort to the division of labor, employing labor and resources to deal with the instability.
Enter Goldman-Sachs. To the extent that its activities profit its clients by mitigating real risks inherent to a market economy, it is generating income for itself by performing a valuable service that contributes utility to the marketplace. But to the extent that the 'risks' they are mitigating are merely a creation of a dysfunctional financial system -- which is to say, they are artificial and not intrinsic to the market itself -- their efforts are actually a waste, but necessary to their clients who must deal with the system as it is. It would be more efficient overall to have a functional financial system and less labor and resources spent trying to cope with all the chaos.
To the extent that this is the case, Goldman-Sachs is like a tire repair shop located right outside the nail-and-screw factory. There may be some necessary repairs in any event, but it is not helpful that the drivers for the factory deliberately strew some of their cargo about the road. 90% of the repairs -- and the income derived from them -- are actually just 'make work' and wasted resources.
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The other money-making activities could be subjected to a similar analysis, with similar results. Certainly, there is utility to be derived from public issue of stock, mergers and acquisitions, and the like, but only under a limited range of conditions. To the extent that these conditions emerge naturally, intrinsic to the market dynamics in play, the services of an entity like Goldman-Sachs are providing real utility in return for real income.
But to the extent that such conditions are produced artificially -- such as through the centralizing effects of inflation -- these incomes do not represent contributions to the economy, but mere rent-seeking in response to conditions which are the product of dysfunction. And again, such volatility is going to be centralizing for the reasons described above -- it encourages an elaboration of the division of labor, much as convoluted regulatory structures encourage larger company sizes so that compliance costs can constitute a smaller share of revenues.
So, even though very little of Goldman-Sach's revenue derives from actual trading, I would suspect that market volatility contributes very heavily to their ability to 'earn' income.
2 comments:
Scott, you understand this stuff much better than I do. But aren't the points you make about arbitrage and Goldman Sachs and the gaming of derivative, etc., very similar to why Hamilton and others argued AGAINST a Central Bank?
People argue that a "central bank" can modulate inflation and ease the ups and downs of the business cycle. But when Bernanke says that 2% inflation is "stability," and a goal, isn't he just a statist son of bitch, hiding profits and leverage of bankers behind government-protected ponzi schemes?
Wasn't the initial mandate of the central bank to STOP INFLATION? That is, despite business cycles, wasn't the bank supposed to guarantee the value of money? When/how did 2% devaluation of our dollar become the norm? (That's a rhetorical question. It became the norm as soon as we created a government entity to "protect" it.)
I am no expert in early American history, but it was my understanding that (Alexander) Hamilton was very much pro-central banking -- and much other pomp and trappings that go with a strong, centralized state. He thought America should model itself more after Britain of the time. Most of the other FF's were very much against him.
But yes, that's about right. I don't think the mandate of the central bank was ever to 'stop' inflation, though. It has basically been to 'manage' the money supply to 'achieve' 1) maximum employment, and 2) 'stable prices.' Stable prices has generally been interpreted to mean 'consumer prices,' which means that they can pump stock markets and housing prices up to kingdom-come (very popular) and everybody waves it off -- even as it ruins the economy.
As to the 2% policy question -- actually, it is my understanding that it began with Bernanke. Bernanke believes more in 'inflation targeting,' which is in general the accepted European policy. Previous FED chairmen had no stated target. Greenspan liked to confound observers because he thought it critical that FED activities be unpredictable, so that markets would work things out in an unbiased manner, supposedly independent of the FED's activities. Others (like Bernanke) think that policy should be predictable, so that people know what to expect, and won't bias their activities in anticipation of changes in FED policy.
Or something like that. Which should tell you that it's all witchcraft and voodoo.
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