Let the Financial Scapegoat Go

How did the current financial crisis, basically due to falling home prices and a type of dangerous mortgage derivative, create the widespread notion that the entire financial system is broken, too large, has overpaid employees, etc.?

Somehow this notion has become taken for granted, and all of finance is now being attacked as if every piece of the industry is the same, is culpable, and the entire system is flawed. Anyone adopting such a stance significantly misunderstands what happened.

I'll throw out some perpetrator examples. The Baseline Scenario.

Ordinarily, if an industry innovates, a few people make a lot of money, and then most of the benefits flow to that industry’s customers. Let’s take one of the greatest examples of recent history: Microsoft (MSFT) and Intel (INTC) together probably created a handful of billionaires and a few thousand multi-millionaires out of their employees;

That’s the way innovation is supposed to work. You invent something great, you make a lot of money, then your competitors copy you, prices go down, and the long-term benefits go to the customers. And you and your competitors all get more efficient, meaning that you can do the same amount of stuff at a lower cost than before. If you want to make another killing, you have to invent something new, or at least invent a better way of doing something you already do.

Felix Salmon at Reuters:

Even so, one would hope and expect that between sell-side productivity gains and a rise in the sophistication of the buy side, any increase in America’s financing needs would be met without any rise in the percentage of the economy taken up by the financial sector. That it wasn’t is an indication, on its face, that the financial sector in aggregate signally failed to improve at doing its job over the post-war decades — a failure which was then underlined by the excesses of the current decade and the subsequent global economic meltdown.

On this view, the seven-, eight-, and nine-figure salaries pulled down by Wall Street folks aren’t a sign of how efficient they are at doing their jobs, but are rather a sign of how inefficient their companies are.

The financial sector failed at doing its job over the post-war decades? That's a pretty broad statement. The Baseline Scenario article above argues that financial innovations do not create benefits for their customers in the same way that other innovations do. It's another absurdly broad statement. There are tons of financial innovations that are great ideas. And some that are bad. Clearly the system in place for originating mortgages and then packaging them into derivatives with mislabeled risk was one of the bad. But to attack all of finance, and all of financial innovation, just because we had a crisis (a free economy is expected to have crises now and then by the way), is to completely ignore the vast breadth and depth of the financial industry.

Finance hasn't improved at its job? Its innovations aren't useful to its customers?

Remember that thought next time you travel abroad and withdraw foreign currency from a foreign bank you never heard of, while using your hometown bank ATM card. Then think about how companies today use derivatives so that they can focus on doing their core business rather than being a commodity trader at the same time. Or think about how both companies and people can reduce or remove risk from portions of their lives through insurance. Or how with investment banking and many methods of funding, a good company or even a good start-up idea has easier access to capital than in the past.

Broad-based assaults on finance are not productive, they take focus away from analyzing what actually happened. For example, high salaries for investment banking wasn't the problem. Most of the i-bankers had absolutely nothing to do with the problems.

Actually, anyone whom you ever heard at a dinner table say that housing "never went down" is far more related to the problems that led to the current crisis. People globally taking part in a frenzied real estate boom were far more related to the problem. And of course a group of people in finance. But not the entire industry, not the entire system.

To broadly attack the financial system is to completely misunderstand what happened, and counterproductive in terms of preventing a future crisis as well. Let's instead spend more time digging into things such as government policies to promote home ownershig... let's cut the financial scape goat loose.

Comments

[AndrewBaker:]

When someone does something that makes them very prosperous at the expense of many other someones who suffer financially, those other someones are entitled to take the very prosperous someones to task for what they did. Just because their institutions do other things that are useful does not exonerate them from blame for their greed and lack of caring and/or foresight as to what may occur if things went wrong.

Mathematically clever people make the rocket-science calculations that lead to the wrongly described packages of debt, and when it was done, some of those clever people knew that in certain circumstances it would all go bad; yet they were ignored: because less clever and infinitely more greedy people jumped on and ran with the idea to the ultimate level of constructing these securitized debt products and selling them badly described and inherently toxic in the extreme given that very probable events would cause financial catastrophe for many. And those events came to pass. Place blame where it belongs and root out those in banking and finance who were responsible. Let them share some of the misery they brought down on others.

Jun 01 12:34 PM

[Gregman2:]

See: www.debtdeflation.com/.../

Jun 01 12:52 PM

[farmer448:]

Hmm overspeculation in the real estate market. I guess it also did not happen in the S&L crisis in the US or in Japan before the lost decade.
And of my we cannot fault Standard And Poors or Moodys for sticking their head in the grouns.
And not hedge fund ever went bust except when they bet on Russian Bonds??? Long Term Capital had to be bailed out and not left to rot in bankruptcy,
Derivatives, we don't need no stinkin regulation...Opps Lehman and AIG. And 500+ trillion dollars of derivative contracts on a 600 trillion dollar economy. Homey thinks something is rotton in der state of Denmark.
Oh, manufacturing is great here in the US. Opps GMAC, GE's Financial, Chryler Financial took down these well financially managed manufacturing companies.
And please explain 140 plus oil without all the speculation the hedge funds were doing in the futures market.
And who would ever think leveraging equity at 30 to 1 is the smart thing for high risk investment banks when commercial is 10-12 to 1.
And finally, who put all the cheap money out there in the first place? Japan with zero rates and the Federal Reserve?
So it would appear you are taking the same kind of mind altering drugs the smart guys on wall street were dispensing.

Jun 01 01:58 PM

[henarl:]

It wasn't the underlying businesses of Enron, AIG, Lehman, Morgan Stanley, Citi, B of A, etc. that were faulty, rather it was the grossly overpaid mathematical wunderkind with their esoteric computer programs that even they obviously did not understand, and their insane derivitives of derivatives and naked CDSs, who brought these companies down. We need a reasonably conservative financial system that doesn't take enormous risks with the whole damn world's economy and isn't being run by a bunch of untested child prodigies.

Jun 01 02:31 PM

[Leftfield:]

Someone had to try to defend Wall St., I guess. But, singling out excesses in the economy doesn't explain the complete leveraged meltdown we are now supposed to pay for.
The collateral damage is beyond comprehension, yet financial industry pay is supposed to continue at hyper levels on our dime, X $trillions.
Our politicians are to blame as much as anyone, too. Doesn't excuse Wall St.; they are symbiotic.
It has been pointed out that Wall St. profits mainly from transaction costs as middleman in these costly, opaque products and doesn't care about national prosperity. I would go so far as to opine that Wall St. and Washington would prefer a prostrate citizenry so that they may continue their plundering.

Jun 01 04:06 PM

[Blackeyebart:]

There is a valid point in all this. There is enough blame to go around. As always investors must protect themselves from emotional enthusiasm. Not always easy when many people are making money by backing horses that have an odd number of legs.

Still we have all learned our lessons haven't we? It's all logic and common-sense now - right?

PS Commodities just had a record month!

Jun 01 04:54 PM

[Vincent Fer...:]

It seems many commenters didn't read what I wrote. Finance isn't one big group of people who all do the same thing. Most people in finance have nothing to do with the core problems in the current crisis. They are not to blame, they do not deserve the blame. Most of the things we do in finance work just fine and actually help the world a lot.

Thus the point of the article is that a lot of people, including many of the commenters above it seems, seem to treat everyone in finance as if they are all guilty, as if they all are doing the same kind of work; work that caused the crisis. So many people are thus now just broadly blaming the entire financial system and pointing fingers at parts of the system which had nothing to do with the crisis. Investment banker pay is a great example. It has nothing to do with what happened.

Blaming the wrong people and wrong parts of the system is counterproductive.

Jun 01 06:02 PM