Fear of Finance
For Project Syndicate:
We are at that turn of the intellectual cycle where the world's great and good become fearful of finance: distrustful of the rich and high-paid people who live very well indeed and work behind computer screens in the cores of the world's major cities doing... well, doing something that doesn't look like work, or productive, or useful. Each turn the fears are similar: paper-shufflers are doing better than makers, speculators are doing better than managers, traders are doing better than entrepreneurs, rootless global cosmopolites are doing better than those with their toes and ancestors in the soil, arbitrageurs are doing better than accumulators, the clever are doing better than the solid, the (financial) market is more powerful than the (regulatory, bureaucratic) state. This, the current of opinion goes, is an inversion of the normal and the natural and the just. We must cast down, as Franklin Delano Roosevelt put it, the "money changers" from their "high seats in the temple of our civilization." We must "restore the ancient truths" that growing, making, managing, and inventing things should have higher status, more honor, and greater rewards than whatever it is that financiers do.
Truth to be told, there is a lot to fear in finance. The rewards to the successful are staggeringly outsized. The punishments to the unwary are brutal. The average investor in individual stocks achieves risk-adjusted returns of the overall global stock market return--call it 6% per year in inflation-adjusted terms--minus 3%. The average investor in a managed mutual fund receives the overall return minus 2%. The average investor in an index fund receives the overall return minus 0.5%. Since the average return must be average, the informed financiers pocket the vast gaps that the poor trading strategies of the uninformed and the rash open up between their returns and the average. And it is true that nothing visible is created.
Truth be told, the scale of modern global finance is staggering: more than 4 trillion dollars of mergers and acquisitions this year, with tradeable and (theoretically) liquid financial assets reaching perhaps 160 trillion dollars by the end of this year, all in a world where annual global GDP is perhaps 50 trillion dollars. Martin Wolf of the Financial Times quotes the McKinsey Global Institute as estimating that world financial assets, which today are more than three times world GDP, were only equal to world GDP in 1980 (and to only two-thirds of world GDP in the aftermath of World War II). And then there are the numbers that sound very large and are hard to interpret: 300 trillion dollars in value of "derivative" securities; 3 trillion dollars of wealth managed by 12,000 global "hedge funds"; 1.2 trillion dollars a year committed behind the screen of "private equity."
But things are created in our modern financial system: important things, and valuable things--both positive and negative.
Consider the 4 trillion dollars of mergers and acquisitions this year, as companies acquire and spinoff branches and divisions in the hopes of gaining synergies or market power or better management. Those owners who sell these assets will gain roughly 800 billion dollars relative to what the pre-merger speculation value of their assets had been. The owners of the companies that buy--the shareholders of the acquirers--will lose roughly 300 billion dollars in market value, as markets take the acquisition as a signal that managers are exuberant and uncontrolled empire-builders rather than flinty-eyed trustees maximizing payouts to shareholders. This 300 billion dollars is a tax that shareholders of growing companies think is worth paying (or perhaps cannot find a way to avoid paying) for energy in their corporate executives.
There is left a net gain of roughly 500 billion dollars in global market value. Where does this come from? We don't know. Some of it is a destructive transfer from consumers to shareholders as corporations gain more monopoly power, some of it is an improvement in efficiency coming from better management and more appropriate scales of operations, and some of it is an overpayment by those who become irrationally exuberant when companies get their names in the news that will be taken back over time as irrational exuberance dissipates. The proportions? We don't know.
Let us, however, guess that the proportions are 1/3, 1/3, 1/3. Then several conclusions follow:
The first is that, once we look outside transfers within the financial sector, the total global effects of this chunk of finance is a gain of perhaps 340B in increased real shareholder value from higher expected future profits counterbalanced by a loss of 170B in future real wages, for households will find themselves paying higher margins to companies with more market power.
Subtract one number from the other and get a net gain of 170B of added social value in 2007: it's 0.3% of world GDP, equal to the average product of 7M of the world's workers. In one sense we should as a globe be glad that we have our M&A technicians, well-paid as they are, hard at work: it is very important that businesses with lousy managements or that are operating at inefficient scale be under pressure from those who think they could do better, and can raise the money to attempt to do do so. We certainly cannot rely on shareholder democracy as our only system of corporate control.
The second conclusion is that the gross gains--fees, trading profits, and capital gains to the winners--of perhaps 800B from this year's M&A--are greatly in excess of the perhaps 170B of net gains. Governments have a very important educational, admonitory, and regulatory role to play in this business: people should know the risks and probabilities, for they may wind up among the 630B worth of losers. So far there is little sign that they do.
Third, finance has long had--since before the days of J.P. Morgan it has had--an interest in stable monopolies and oligopolies with high profit margins, while the public has an interest in competitive markets with low margins. The more skeptical you are of the ability of government-run antitrust policy to offset the monopoly power-increasing effects of M&A, the more you should seek for other sources of countervailing power--which means progressive income taxation--to offset any upward leap in income inequality.
The eighteenth-century Physiocrats thought that only the farmer was productive--that the rest were somehow cheating the farmers out of their fair share. The twentieth-century Marxists thought that only the factor worker was productive--that the traders and the organizers were somehow cheating the factory workers out of their fair share. Let us educate and regulate our financial markets so that outsiders who invest are not sheared. But let us not make the mistake of fearing finance too much.
