The Art of the Banking Controversy

By Charles Davì

Now that we are well into the depths of a recession, banker-bashing is all the rage. In addition to being fashionable, these “arguments” have an air of credibility about them, given the dire context in which they are made. As a result, the debate over regulating the financial sector is being recontextualized by portraying Wall Street as little more than a vacuous pig-pen. This view is informed by a grand equivocation, which lumps together all of finance under one roof, somewhere on Wall Street, where bankers convene and discuss how they can further redirect the world’s resources towards their pockets. And the shapeless anger that follows from this view has consumed not only the main stream media, but bloggers as well.

Brad Delong takes the view that both compensation and profits in the financial sector are wholly unjustified. Matthew Yglesias agrees. Another even more dubious theory, also espoused by Matthew Yglesias, is that those in finance are morally inept. (You can find Conor Clarke’s response to Yglesias here). Together, Delong and Yglesias employ straw men, false dichotomies, equivocation, conflate coincidence and causation, and in general treat a complex subject with glib answers that suggest the authors have no concern with getting it right, or have just finished reading Schopenhauer’s, “The Art of Controversy.”


Summary Judgment

In a sparsely worded opinion, Justice Delong condemns all of finance, finding the Economist’s piece on the likely pitfalls of blaming the wealthy for the current downturn an unconvincing defense to the charges. In structuring his opinion, Delong provides us with only two avenues through which we may prove our worth:

The rise in [financial sector] profits [as a share of domestic American corporate profits] from 20% to 40% would have been justified had finance produced (a) better corporate governance and thus better management, or (b) more successful diversification and thus a lowered risk-adjusted cost of and a higher risk-adjusted return to capital.

To say that profits can be justified only by satisfying exogenous factors strikes me as bizarre, especially coming from an economist. To say that there are only two such factors is simply ridiculous. There is no mandate which financial institutions must satisfy, other than the law, in order to prove their worth. The fact that Mr. Delong would like to see more emphasis on corporate governance and diversification does not create the presumption that profits earned at financial firms were somehow unjustified. Investors and clients are not in the business of making charitable contributions to financial institutions. If they paid financial institutions for services or products, they believed that they were getting good value in return at the time.

One sensible explanation for the rise in financial sector profits is that investor appetite was voracious during the relevant period. This was due at least in part to an influx of capital available for investment from the Middle East and elsewhere, which was itself due to record commodity prices, and a period of seemingly unbounded asset appreciation, each of which skewed the market’s appreciation for risk. Note that this explanation would not satisfy Delong’s demand for the justification of such profits. That is, Delong suggests that the mere existence of lawfully earned profits which the market elects to create through the demand for goods and services is insufficient. After all that happens, he, or some other economic Tsar, gets to determine which are justifiable and which are not.

Similarly, Yglesias writes:

Could it really be the case that so many people were naive enough to trust their monies to institutions that were only claiming to have brilliant investment models? Well, it seems to me that it could.

If we assume that financial institutions were merely feigning the existence of “brilliant investment models,” whatever that means, are we to simultaneously believe that these institutions were unaware of their inadequacy? After all, to accept Yglesias’ argument is to believe that Wall Street was not drinking its own Kool-Aid, but only selling it to others. This theory is quickly debunked by considering the glowing counterexample of Bear Stearns. Employees up and down the spine of corporate governance were married to Bear in the form equity. When Bear’s equity got wiped out, so did its employees, who held approximately one third of the company’s stock.

Despite Delong’s and Yglesias’ pronouncements to the contrary, the goings-on of Wall Street are not an elaborate ruse fashioned by the well-connected to deplete the world’s “precious bodily fluids.” That said, something has gone disastrously wrong. But indulging in argumentation that amounts to little more than hand waving will not help anyone to understand what happened, and more importantly, what policies should be implemented to prevent it from occurring again.

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4 Comments

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4 responses to “The Art of the Banking Controversy

  1. russell120

    “There is no mandate which financial institutions must satisfy, other than the law, in order to prove their worth”.

    You are ignoring the somewhat obvious counter argument that if their “legal” behavior annoys people, the laws will be changed. Which is pretty much what the discussion is about.

    The financial institutions’ managers used highly leveraged financial devices for short term gains that left them with the money and the institutions owners (shareholders) and the public (the tax payers) holding the bag.

    That they are also the purported “experts” within this field of course makes people greatly suspicious. Either the experts were not perfectly good in their area of expertise, or they were and are guilty of some form of fraud.

    Given the “experts” apparent lack of understanding of what happens to highly leveraged positions at margin call time, I suspect the former. That there are continued claims that this is all so unexpected, or your nebulous statement”something [not quite knowable] is wrong” somewhat prove the point.

  2. Internet user

    Good to see the whole world hasn’t gone completely mad. My faith in humanity has been restored. Great post and great blog.

  3. ari stotle

    perhaps the problem has more to do with economic illiteracy on the part of the general populace. a high school student graduates without basic knowledge of personal finance. a college grad, unless studying in a related field, graduates without the basic knowledge of personal finance, but unlike the high school grad, he or she gets an ear full of socialist dogma along with an unhealthy does of class-ism, racism, and every other -ism that is all the vogue in academe. the current president is a perfect example of someone who is well educated but understands little about how wealth is created or squandered.

    is it any wonder that populism abounds amongst those who are ignorant of the underpinnings of the market place? is it any wonder that socialism has an appeal? ignorance is a fertile ground, and bankers have become a convenient scapegoat.

    perhaps the fault lies not with the bankers, but with those who are supposed to educate. but the educators aren’t going to change anytime soon. the business and financial sector should remember that they are the torch bearers of capitalism. and if they won’t step up and do the job that educators will not do, then you can kiss capitalism good bye.

  4. zanon

    I think it’s become obvious to people that banking, in its current incarnation, net loses money. Paying yourself billions while losing trillions is a nice trick, but should not be supported on the taxpayer dime.

    It is also clear that banking is not a private business in any meaningful sense of the term. Most charitably, it can be called a public/private partnership, and as such, should have extensive public intervention, guidance, and constraints such that it furthers the public purpose of that partnership.

    This public purpose, fundamentally, is credit analysis and extension. Making loans that will get paid back. Anything that detracts, dilutes, or blunts this public purpose should be banned, for it has no point. Banks should keep 100% of their loans on their books and not be allowed to trade in secondary markets.

    It is also clear that the liability side of bank balance sheets is no place for market discipline. The Govt should make FDIC insurance infinite, stop charging a “premium” for it, and lend to member banks on an unsecured basis instead of this ridiculous and convoluted open market operation they have right now. Bye bye money market funds.

    Finally, banks should be subject to strict capital (or leverage) requirements, that they cannot get around using derivatives or off-balance sheet vehicles that, at crunch time, are anything but.

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