Miles Shang home about

This is a response to the following article which I found on reddit:

Out of Control: The Destructive Power of the Financial Markets (Der Spiegel)

I had always though that Der Spiegel was a daily newspaper, providing factual news. I had never actually read one of their articles; I simply got this impression because they were mentioned in the same breath as Le Monde, The Guardian, and The New York Times in their role in the diplomatic cable leaks of Wikileaks. After reading this article, I now understand that Der Spiegel is actually a weekly newsmagazine, providing news along with speculation and opinion like Time Magazine. This is not a criticism; there is certainly a role and a demand for these publications. It just wasn’t what I expected.

The article itself is well-written and raises good points, although the style is a bit aggressive. The main point of the article, in my view, is that the worldwide financial system is too big. It is so large that it is a threat to the economic health of the world. This is a point that has been brought up many times before, in documentaries such as Inside Job, and by both Republicans and Democrats in discussions on quantitative easing. I’m pretty much sold on this idea, however, I think that it’s interesting to examine a few of the phenomena that the article mentions.

Over the last few weeks, stock markets have been on a roller coaster ride. There have been several single-day swings of greater than four percent in the S&P 500. This is especially worrisome for the many individual small-time investors whose retirement portfolios depend on the stock market. A bad day could put Joe Average another five years away from retirement. Is this the fault of fat bankers in mega Wall Street banks? The article puts it this way:

There is little that the traders at investment banks and hedge funds fear more than a boring market, one in which the economy is humming along nicely and the prices show little movement.

Keep in mind that equity markets exist to provide volatility, in a sense. A stock that always grows slowly and steadily might as well be a bond. If the whole market grew slowly and steadily, eventually bond returns would have to catch up, as well as the risk-free rate. If everybody’s making money, nobody’s making money (excluding real growth). If you don’t like the volatility, don’t invest in the stock market.

It’s true that the role of banks has changed tremendously over the last few decades. Investment banks have evolved from small partnerships into full-service behemoths. Perhaps they control politics to their own ends. Much of the trading is now done by computers, not humans, using algorithms that even most Wall Street employees could never hope to understand. I agree that on this front, more regulation is needed, the main form being the breaking up of banks that are “too big to fail”. However, there is some question in my mind regarding the size of the financial industry in the USA as a whole:

According to Woolley, there is no justification for the fact that this industry brings in more than 40 percent of all US corporate profits and pays the highest salaries in good years, while in bad years it is bailed out by taxpayers.

I agree on the second point; bail-outs are a very dangerous tool because of the whole moral hazard issue. They should come with huge caveats which have not been included recently, such as the break-up of big banks. With regards to the first point, I’m not convinced that the financial industry in America is too big. Some lament the fact that America doesn’t make things anymore. However, we should keep in mind that this has been very much a conscious decision. America has been proud of the fact that its economy has moved from a manufacturing economy to a service economy. This has not been a passive process. Government has pushed to create jobs in the service sector because a service economy is the sign of a mature economy. Maybe this is a good thing. Maybe the fact that the financial industry represents 40 percent of US corporate profit is actually a sign of America’s economic might, not stagnation.

We should also keep in mind that the monster that we so love to rag on, “Wall Street”, is fed by somebody. That somebody can eventually be traced back to you and me, through pension funds, mutual funds, individual companies, etc. We as individual investors also bear responsibility for the problems of the financial industry that threaten the economy. The article doesn’t go so far as to point fingers, but it does point out the herd-like behaviour of investors. The successful money managers are the ones that give in to the herd.

So, how do we fix all this?

An effective financial market reform would have to treat shadow banks the same way all other banks are treated. This would mean completely banning so-called short selling, which is essentially betting on falling prices.

I have never understood the hatred towards short selling. If buying a stock is like betting on black at a roulette table, selling a stock short is just placing the opposite bet, i.e. betting on red. The only difference is the direction. True, sometimes short sellers can trigger a panicked sell-off, wiping perhaps billions of dollars of value off the books from over-inflated fear. I don’t see how this is any different from long investors who buy into a bubble, thereby propagating the very same bubble. There is some hypocrisy here.

By the way, I also don’t understand the hatred towards George Soros with respect to the Bank of England incident:

The 81-year-old is one of the founders of the hedge fund industry. In the early 1990s, he suddenly became the quintessential unscrupulous speculator, one who takes advantage of even the tiniest weakness in the system without regard to the consequences.

A pegged exchange rate is nothing more than price fixing. If the price is reasonable, nothing will happen. If not, somebody like Soros will come along and call you out on your bullshit and your regime will collapse. He didn’t create a crisis out of thin air.

I have no problem with the suggested reforms:

Banks would have to concentrate once again on the role they played prior to the great deregulation of the financial market, namely to organize payment transactions, manage the investments of private customers and companies and finance their business deals with loans.

However, my takeaway from this article is that it’s easy to blame Wall Street bankers and politicians, but we should also look in the mirror. We are the ones who create the demand for splendidly-paid money managers. We are also the ones who took out sub-prime loans. Everything that went on behind the scenes was surely very shady, even criminal, but we are not entirely devoid of responsibility.