First, it is an ethical problem. The idea of producing things is not taught in elite colleges, nor is the idea that it is possible to make a positive contribution to society (e.g. rms) without becoming superrich (no offense to those for whom this is their primary motivation).
Second, a lot of the products of which the GDP percentage is based upon simply involve repackaging and selling debt. (e.g. http://ow.ly/1sf8Rp ). In other words, a lot of the economy is based upon accounting tricks.
Not all ideas can or should be taught in (elite) colleges. The framework to analyze any idea should be and generally is taught at colleges.
Repackaging and selling things is foundational to creating value. The insurance industry is perhaps the quintessential example. They create no direct expected value, and yet they create societal benefit by creating risk-adjusted expected value.
Insurance creates value, and so do banks. The problem really begins when the banks try to get more revenue than the value they can possibly generate. That's when it goes into bubbles and finally breaks. Insurance has its risks also, but the insurance system doesn't crash every couple years from itself (major natural events, terrorist attacks etc not taken into account).
Fair enough, but culture matters. When you're surrounded by a culture of people who glorify rent-seeking jobs like finance and lawyering, "building stuff" tends to be regarded as lower-status and as such gets less of the top talent, even though it's the most important thing.
Repackaging debt is not an "accounting trick," it's creating liquidity. Which in turn allows more more "real" transactions to take place, more trade, more production, more manufacturing, more jobs, etc.
It's an accounting trick that artificially stimulates the economy by tricking people into thinking their imaginary dollars are worth more real goods than they actually are.
This advice may be two years too late, but may help someone just getting in now. The decision to leave a high-paying Wall Street firm is foolhardy and one that you will more than likely live to regret later. It would be much more prudent for you to stick around at a firm for 5-6 years, put away $500K-700K in cash, get some experience, make connections and then make your move. Otherwise, you'll probably end up stuck at a startup that is not really going anywhere anytime soon (maybe it will, but maybe it won't), and it will be too late to go back to Tier-1 firms to make some cash.
So the lesson for you young guys out there: Don't pull the trigger too soon IF YOU ARE ALREADY IN A MONEY EARNING JOB.
Wait it out for several years, build a small safety net, and stash away some capital for your entreupreneural endeavors a couple of years later.
"Life is what happens to when you are busy making other plans"
No better way to ensure you'll never follow your dreams than set yourself up to be dependent upon a large salary and plan on pursuing them "a couple of years later."
pay bulk of your salary into a savings account. get used to living on say, 20% of it. you'll see pretty soon if you're 'following you dream' or getting hooked on cash
Perhaps it's not a problem with finance but a problem with other industries that don't pay their people well. Who is to say that a CDO isn't a valuable economic activity?
If creating a CDO creates more value to the economy than designing an automobile why shouldn't engineers focus on building those?
People forget that prices and money are essentially information about the supply and demand of a good. As we progress in the information age deriving information from price will consume and produce ever more of our GDP. Spending money efficiently and directing it to the right purposes is a VERY valuable thing for a nation to do. Perhaps, dare I say it, more valuable than engineering widgets.
If YC had engineers figuring out algorithms to determine the best startups and they found one that worked it would be a very valuable piece of information. Or more relevantly, what if you had a site that required a lot of bandwidth and you could buy a bandwidth future? If you could buy that sort of thing you could offer 4 year contracts to your customers with out taking on any risk.
How about this instrument, a YC Summer 2014 startup future, it estimates the expected return from S14 and pays you if the return is less than expected. YC could sell them today and gain the advantage of knowing how many startups they could fund in S14. It would allow all sorts of people to pool their knowledge about what the Summer 2014 startup scene is going to be like. You might want to buy one right before the S14 season because you know that some great startup is applying, etc. If you held office space in SOMA you could use this as a hedge against losses incurred due to a poor S14 startup season.
Most complicated financial instruments are actually risk mitigation and/or information pools. The fact that that kind of thing is pricable due to these engineers spreads all sorts of great information to our economy that you can use to make informed decisions about how to conduct your affairs and you don't even need to participate in the market to use it.
Want to know what the best guess as to the price of oil in 6 months? Check the oil futures market. This one number contains the all the information known to man, vetted by experts as to what the supply and demand of oil is going to be in a few months. It also allows anyone with new knowledge to monetize that information and communicate it to all participants almost instantly. Southwest can offer cheaper flights because they use oil and jet fuel futures to buy jet fuel, the brilliant thing is that Exxon also gains knowledge of what Southwest and every other airline expects their passenger load to be in a few months and can make decisions accordingly.
It all comes down to allocation of capital, though. It's all economic overhead. How much are we spending to efficiently allocate capital? About nine percent of the whole economy, apparently.
That's assuming that all that work does end up effectively and appropriately distributing capital at the end of the day. If you read up on the recent financial bust, you'll quickly realize that all is not well in the world of finance. Many complicated instruments such as CDOs have sometimes not been designed to benefit the buyer. Papers have been written establishing that it is impossible to know if a CDO has been designed to fail. Check out propublica's reporting on magnetar for an example of how CDO trading flew off the rails.
I could go on. Suffice to say that there are regulatory issues (no regulation, basically) there are issues with defining, standardizing, and regulating these complicated derivatives, there are issues with high frequency trading, issues with predatory consumer financial services, and finally there is the giant issue of a clear moral hazard now that the government has saved everyone's tail.
> How much are we spending to efficiently allocate capital? About nine percent of the whole economy, apparently.
What is the optimal amount we should spend to efficiently allocate capital? I don't have a principled reason to be able to pick a number; all I have is a gut feeling, which isn't worth anything.
The problem isn't the ability to create financial instruments. It's the fact that the people that created and purchased these ill-advised investments were given the resources of those that didn't make bad decisions (through inflation and taxes).
It's easy afford outrageous salaries when your revenue comes from government assisted theft.
I definitely agree with you that the bailouts are a huge problem, however, it's not like the alternatives presented for engineers in the article also don't get a sizable portion of their funding from the gov't.
Given that schooling is heavily funded by the gov't it would only seem natural to follow the funding train. They're practically begging people to go to engineering school and become a financier the way they fund things.
Your argument falls apart at the predicate. CDOs (and other exotic financial instruments) do not provide real value, not in the long term, anyway. This argument is exactly how Wall Street bankers & traders justify their crappy activities.
"CDOs provide value! We're making people rich!"
> People forget that prices and money are ... information
No, prices and money are imaginary measurements of imaginary things that do not exist except in our collective consciousness[1]. Cars, computers, buildings, aircraft... these things are not imaginary and provide real value.
To understand what I mean by "imaginary" you have to understand (and accept) that a dollar, or a pound, or a real, or whatever, represents our agreement that we'll all play the same game. It doesn't represent a real thing. Google and Facebook provide information about actual things, like people, places and events.
Money provides information about itself. Which, hey, I like having an agreed-upon exchange rate so I can trade my labor for stuff (RIP Carlin). The problem is that exotic derivatives create an insane level of abstraction to the terms of our social agreement. Once you take away the ability of people to understand what money is for (I mean, seriously, buying insurance against the failure of a company you don't own? slices of a house's future value?) that agreement starts to corrode.
And yeah the short-term profits of these abstractions does create PROFIT, but it's an unsustainable cash flow. It didn't arise from producing a better quality product.
To say that Google's search service and CDOs are essentially the same thing shows a pretty poor understanding of both concepts.
I find your arguments plausible, but many finance companies were bailed out in a big way by the government recently. I think it's possible that some of these companies were playing games that gave them a high probability of a decent gain and a small probability of a catastrophic loss. It seems unlikely that playing this sort of game contributes to more accurate pricing.
Well actually some of the guys who did VERY well did so by buying CDSs (credit default swaps) against CDOs (collateralized debt obligations) it's very likely that the bubble was curtailed before it got even further out of control as some very smart individuals were able to short the housing market via a CDS against a CDO. This pricing differential was essential to Goldman getting out of CDOs and into CDSs against CDOs after they figured out what John Paulson and others were up to.
The price increase in CDSs against CDOs in retail mortgages alerted Goldman to the fact that people were very interested in a CDS against what they thought was a very solid asset (CDO consisting of residential mortgages).
This is also why AIG got bailed out, GS had enough CDSs with AIG that if AIG went so would GS. I definitely agree with you that in the long run bailouts create an atmosphere of moral hazard and irrational exuberance.
The problem also largely stems from political economics, as a representative you want to remain elected, therefore if you can kick the economic collapse can down the road a few years or spread its impact over many years you can stay in office. Therefore the rational economic choice for politicians is to favor bailouts. Very few people will not vote for you because 5 years later their taxes are 10% higher, but most will not vote for you if they lose their job. By the same token most people would rather take a 10% pay cut for 10 years than have no income for 1.
So give the YC futures market idea a couple years. What would the result be? My guess:
The biggest beneficiary would be banks. They would be trading it with a focus less on spotting good companies and rather on extracting profits from the activity of trading. Computers would be doing most of the trading. They'd have algos less focused on the quality of the applicants and their ideas, and more focused on how [black box X] can take money out of the system overall. The startup community would stop applying to YC because it's much more excellent to work at a bank, finding ways to manipulate the YC stock for fun and profit.
Complex financial derivatives may not be as tangible as other engineering endeavors, however they do have tremendous value to businesses looking to hedge their risk and offer flexibility to their business models. The economic collapse caused by these complex financial instruments was not due to the Phd's that created these derivatives, but by the traders that didn't full understand the limitation of the risk models, as well as the moral hazard in packaging toxic assets into CDO's knowing they would easily be able to pass it along. Having said that, I'm glad I didn't sell my soul and become a banker ;)
"They note that the finance sector today produces a greater percentage of GDP than at any time in history."
This is not an effective argument. The computer software industry is also producing a larger than ever percentage of GDP. In other news, the building wooden ships sector is not responsible for much of the GDP in recent years. Is that a problem?
It's a problem because unlike other activities finance produces benefits to society only when it well, finances people doing things other than finance. Other activities are valuable in themselves.
I still find it hard to parse that as a problem. I mean, power generation only provides a benefit to society when someone uses the electricity to do something.
So what? Infrastructure isn't inherently parasitic. Lots and lots of infrastructure isn't even necessarily bad.
I view finance as infrastructure. The machinery that hooks investors up with investees is fundamentally useful. The machinery that lets people and businesses manage risk, that lets them define very specifically what gains and losses apply to them in what events . . . that's really darn useful stuff. If it's complex sometimes--even incomprehensible--in order to achieve something, so what? So is software. So is engineering in general.
Some people practice finance badly, I don't doubt; some engineers are snake oil salesmen, too, hiding behind the inherent complexity of problem and solution. The government bailed out finance and that's bad, but it bailed out auto, too. That doesn't make car manufacture generally parasitic.
Those are historical specifics, justified complaints against individuals and events. But I don't see anything here justifies the demonization of the industry in general.
If you see finance as infrastructure to help other businesses grow (as I do), then it's growth should result in the growth of other industries. Instead what we see is finance growing and other industries declining. To me that suggests a general dysfunction in the role of finance. It simply isn't doing the good it's supposed to.
There may be many or even most individuals who are acting in good faith, but the sector as a whole appears to be broken.
This isn't about demonization. It's about pointing out a serious threat to society's continued prosperity.
And as for the auto industry - they shouldn't have been bailed out either - that doesn't somehow make it better that the financial industry was. Also the auto bailout was a rounding error compared to the financial bailout.
What industries are declining? As far as I know, virtually every sector of the economy has grown. Manufacturing, medicine, education and technology certainly have.
What industries are declining, and why do you believe that finance has failed them?
The private goods-producing sector value added fell 6.4 percent in 2009, after a 4.2 percent decline in 2008. The private services-producing sector declined by 2.1 percent, after a 0.4 percent increase in 2008. The finance and insurance industry grew 6.1 percent in 2009, partially offsetting the widespread economic decline. The increase was primarily driven by the strong recovery of the insurance carriers industry.
That's a quote from a December 2010 report from the government's bureau of economic analysis.
Sorry, I didn't realize your comment was limited to a single year of our current recession. You are correct - for a short period, finance has grown while other sectors have shrank.
That's not the general trend, however, that's just a blip caused by the recently ended recession.
[edit: can't respond to your post, but June 2009 is also the time period when industrial production and retail sales started growing, and when the stock market recovered.
Funny - according to the very report I just quoted that positive GDP growth in 2009 is due only to growth in the financial industry which makes up for the declines other sectors are still seeing.
Finance was being discussed as a percentage of GDP. Every sector can't increase as a percentage of GDP. That should correct to a fair amount for the general growth in all industries.
If you see finance as infrastructure to help other businesses grow (as I do), then it's growth should result in the growth of other industries. Instead what we see is finance growing and other industries declining. To me that suggests a general dysfunction in the role of finance. It simply isn't doing the good it's supposed to.
Well, I don't know that I find that very persuasive. Industries rise and fall all the time, for many reasons; the world is a complex place. Perhaps a useful financial instrument now is keeping things from getting worse somewhere else. Or perhaps it will bear fruit in a decade, as one would generally expect with an investment. Such an argument seems hasty without a good understanding of what the relative growth rates of different industries under different conditions should be -- a rather tall order.
I do certainly see the moral distinction between George Soros' currency manipulation and Warren Buffett's shrewd investment, despite the fact that both men made their money with money. But I don't think it would make sense to reckon their true productivity by comparing their fortunes. Likewise, if one is going to suggest general dysfunction in the financial industry, I'm much more interested in what you think it's doing wrong specifically -- where the growth that you think is unhealthy is coming from -- than how big it is.
To talk in concrete terms, I think I read elsewhere that a lot of the recent growth in finance has been in insurance. It seems sensible to me that if a lot of people have lost money, insurance, and its role in mitigating financial risk, would be more important. Without it, we might see people completely unwilling to take on financial risk at all until they had more money, which would be devastating. At a first glance, I don't see anything unhealthy about such an industry's growth being decoupled from the rest of the economy--or even inversely correlated.
And as for the auto industry - they shouldn't have been bailed out either - that doesn't somehow make it better that the financial industry was.
Oh, indeed, I am not arguing that. Both were terribly bad. I was arguing only that a bad, but specific, historical event doesn't make the industry as a whole fundamentally bad. No one would say, "The government bailed out the auto industry -- making automobiles is fundamentally parasitic on society!" I mean, making those particular automobiles, sure. But all automobiles ever? That's overblown. But people do seem to take the financial bailouts as evidence that the industry as a whole is amoral.
What would have happened if the US government did not bail out GM? Would other auto manufacturers fill the void? How many american workers would be out of jobs (both from GM and from their suppliers, and their supplier's suppliers, etc.)? We would still have Ford, either way and most imports.
Contrast this with the finance sector. What would happen if Goldman was not bailed out. What investment banking firm would still be standing and what would it look like?
Of course there are benefits to the finance industry as a whole, but that doesn't mean the world couldn't do with letting the air out of its tyres a bit.
This is an industry that has an increasing percentage of our smartest minds. Add to that its extreme proximity to all money anywhere. The result? It's obvious that this industry is going to drift towards increasingly smart ways of capturing as much of our money flow as possible.
The finance world seems to become increasingly centralized, where very few companies become better at leveraging their size to increase their share of smart minds, money and power. That is the opposite of what competition is meant to do. With all these advantages, it seems insane that the industry needed a bailout.
It's not a few companies being bad. It's a market structure that can only result in bigger banks needing to pay their staff bigger bonuses to compete with each other, getting more power, extracting more money from everybody else. How could it be otherwise?
The issue with finance is that people are using huge amounts of leverage to place bets. If they werent allowed the level of leverage that they are using (i.e. 1:30) there would be a whole lot less "money" in the system. The financial system is allowing people to assign value to intangible assets 3-4 times removed from an actual physical asset. The main issue with that is that it has the capability to take us all down.
You do realize companies that provide those valuable goods can grow faster, hire more people, and grow our economy's GDP much quicker, with more capital, correct?
No. Not correct at all. There is no evidence whatever showing that the current size of the financial industry caused faster growth, more hiring or GDP growth other than the financial industry itself.
And since we're on the subject of evidence - what do you think of this:
The private goods-producing sector value added fell 6.4 percent in 2009, after a 4.2 percent decline in 2008.
The private services-producing sector declined by 2.1 percent, after a 0.4 percent increase in 2008.
The finance and insurance industry grew 6.1 percent in 2009, partially offsetting the widespread economic decline. The increase was primarily driven by the strong recovery of the insurance carriers industry.
From a December 2010 report from the government's bureau of economic analysis.
They follow up with why it's noteworthy in the very next paragraph: "Historians will tell you that empires collapse when they become too dependent on finance, but I’m not so pessimistic."
Wait, what? Maybe the Austrian School goes by theory if that, but every other school of economics goes by facts -- including the Chicago School, Monetarists, Keynesians, New Classical, etc.
Economists' whole basis for their arguments is through empirical data and mathematical facts. Saying economists just relies on dreams is absolutely absurd and shows complete ignorance of the field.
The report was produced by the Kauffman foundation, a foundation dedicate to improve entrepreneurship. It's not exactly an unbiased piece of research.
Attacking finance is the popular theme of the days, but finance has done a huge amount in supporting global economic growth. From providing debt and capital financing to reducing foreign exchange costs.
US GDP today is seven times higher today than it was 60 years ago.
At the worst point in the recession US GDP dropped to the same level it was in 2005. Yes, the US GDP grew as much between 2005-2009 as it shrunk during the recession.
I'm relatively unfamiliar with this stuff, but do you really think GDP can grow exponentially? It looks like we're at the bottom of the skyrocket to the moon on your graph.
Ummm, growth is still happening in the U.S., and has continuously happened aside from a few quarters here and there. The point is not if we're growing, but how much faster we can grow. This is very basic economics.
"The growth has been primarily in the financial industry."
Completely false and absurd. Supply follows demand. GDP has grown throughout every industry that hasn't seen a decrease in its demand (e.g. railroads, newspapers, etc.). That includes technology, consumer goods, and technology. The economy doesn't exist in a vacuum. The finance industry provides capital to all industries.
If the financial industry hadn't been bailed out, it would have contacted. In its case, supply hasn't followed demand. Supply is artificially high, because demand has been produced by force.
Article is totally absent of any substantive suggestions to "fix the problem". The real issue is that if you look at the risk-adjusted reward of doing or working at a startup, it doesn't compare well with working on Wall Street.
And then there are those who say, let me do a few years on Wall St and then I'll pursue the startup thing. What happens during that time is they lose their entrepreneurial edge (they become corporate dull) or they take on a lifestyle (nice house, cars etc = high fixed costs) which makes startup life less feasible.
Of course, in startup land, you have your occasional stellar upside scenarios a la Zuckerberg, but if economics is the main motivator, Wall St is a logical, rational choice esp if you work to live (and not live to work).
I say all of this as an NYC startup who feels this pain at times (although I think it is overblown and more of an excuse). I just don't think bellyaching about it achieves much.
The title is a suggestion. Discourage your friends from putting their energies into creating financial products of dubious value and instead encourage them to engage in substantive work that makes a clearly positive contribution.
Yes, yes, I know you want a secure source of income. Well, try think about ethics first, if not only.
It's not even about a secure source of income. Unless you're a founder, simply low-single-digit employee number doesn't give you enough equity to beat even a low-end finance job. Simple math: if you do your business, 9-to-5 only, you'll be in the 150-200k range within 5 years of graduation. If you decide to manage and make it up a rung or two, join a financial startup, or just make "tech lead/architect" double that income.
Unless you're a founder, having a five-year startup exit strategy that pays out similarly to the income you could have obtained in a straightforward manner in finance is a microsoft/google/facebook/twitter-style long shot. And, the latter two haven't even IPO'd yet to allow full vested share liquidity...
All my friends consider it a fairly soulless industry. Though they joke about patent troll/NPE firms in the way most techies joke about financial firms.
These generalizations about finance being unethical are misguided and misinformed.
A bank/VC that gives a loan/investment to small business/startup. That's finance. Hardly unethical.
Allowing people to get a car today while paying for it over time (instead of paying upfront). Hardly unethical.
Yes, there are bad actors in finance as there are in every space. Don't the Zyngas and others of the world via their offers engage in "ethically questionable" tactics?
A lot of the financial industry though today works so many layers above actual loans it's hard to see how they contribute and even harder to see why they make so much more money than everyone else. I'm not an expert, I'm sure there is some justification, but it's not obvious to most people and that's why, sometimes, we the laypeople wonder.
I agree with you to some degree. There is a lot that happens well out of public (and sometimes regulatory) purview. I just think views that "finance is bad" or "startups are the best" are myopic, don't advance the discussion and ultimately fail to realize the inter-related'ness of all these different forces.
Ultimately, we live in a pretty free agent society and if Wall St can pay more (no matter the reason), the rational engineer whose primary motivation is money should take that job. There is nothing wrong with that. The engineer who is motivated by money and other factors (building something valuable, being his/her own boss, etc) also has avenues a la doing a startup.
This would be true if the losses from the last crash hadn't been socialized.
If the financial industry had actually had to bear the consequences of the risks they take in the same way that entrepreneurs do, the decisions would be rational. As it is, the finance sector is protected by the government whereas startups are not.
When the collapse of Facebook presents systemic risk (or the illusion of system risk depending on your perspective) to the US, I'm sure it will get a "bail out" as well.
Seriously? You're saying that it's fine for the financial industry to hold the country hostage when they fail because there's equal opportunity for other industries to do that too if they too can become large enough?
Not justifying it, but when people think the whole system could break down, crazya$$ isht happens. The rightness or wrongness of what was done is not what I was getting into.
Merely commenting on your point as to why the "finance sector is protected by the government whereas startups are not".
Right - but the finance sector wasn't chosen at random to receive a bailout because of 'craziness'. It was bailed out because it's dysfunctional. And now, people in the financial industry expect it to get bailed out when it screws up, since that's what's happened time after time. Whereas people joining startups have no such expectation.
If you don't seriously expect Facebook to get bailed out it's not a particularly meaningful thing to bring up.
I am guessing (and apologies if I'm wrong) that you've not worked in finance else I don't think you wouldn't paint the entire industry with such a broad brush. I don't disagree with you that a lot of stupid, ignorant and misguided things happen in the industry, but in general, I find that the "Wall St is bad" rhetoric is easy to get wrapped up into because it is fashionable and easy to do.
But nevertheless, I'll go back to my original point. If the gov't thought that Facebook (or any startup) presented systemic risk, it'd likely get bailed out. I'll leave it at that.
On the topic of straw men, I don't think you'll find me saying anywhere that the financial industry is "stupid, ignorant, or misguided", nor did I say that "wall street is bad". I'm not painting the people in the industry with any kind of brush at all. You make it sound like I'm kicking a puppy.
I believe that there's a systemic problem with the industry and its role in society and that it is damaging our future prosperity.
Yes, any sufficiently powerful institution could, in principle pose such a problem, but why distract ourselves with imaginary problems when we have a real one sitting in front of us?
Please explain how the government is "stealing money" for the banks. That is completely absurd. Monetary policy keeps the system in check to stabilize the economy.
The government took money from people that were putting it to productive use and gave it to people that weren't. If they had allowed the banks to fail, their resources would have been auctioned off to the banks that didn't make poor decisions. Those banks would now be running the financial system, not the ones that destroyed it.
On the contrary, it encourages disfunction. "Let us remove the consequences of your failures." Gee, I wonder if that memory will make them so grateful that they'll be more careful next time? Sure. It's not like their whole industry is about predicting risks and rewards based on past experience.
Bah. The mistakes will be repeated and the bailout question will arise again. And it will be worse next time.
We should have had the guts to say "fail and die." It would have sucked, but not as much as crushing debt and a sequel.
You guys are hilarious with your chests puffed out screaming about death to the financial players who were in trouble. Have you considered the massive negative shock to liquidity that would have resulted?
Goldman Sachs, JPMorgan Chase etc. deal with an inordinate amount of the world's liquid assets. If they had failed, the problems wouldn't have been a few quarters of negative GDP growth--we could have seen the collapse of financial markets everywhere along with prolonged global depression. Should we have had the guts to deal with that too?
OK. What reason do the bailed-out institutions now have to avoid such irresponsible behavior in the future? Previously, they had "it might ruin us." Now?
If we've merely postponed this problem and are waiting for Round II, then yes, we should have had the guts to have a depression resulting from irresponsible investments rather than a depression resulting from irresponsible investments AND governments up to their nostrils in debt.
Perhaps not. But not everyone has their chests puffed up about this. As it stands, they were rewarded for taking excess risk and are doing it again. What should be done next time?
Let's speculate a bit more. There are two possible outcomes to letting a large bank/financial institution fail:
1. Financial institutions cannot transfer funds between each other as usual and they cannot accurately predict who might fail next, so they pull back credit access. Spreads blow up as money supply decreases, causing a sharp decline in equipment investment and a big rise in consumer interest rates. Shit gets worse from there.
2. Banks die and, in conflict with everything we know about liquidity, money continues to flow perfectly. Banks are not afraid of failure so credit flows freely.
What do you see as more likely? Can you sum it up in a one-word answer?
You're probably right - if they'd just been allowed to collapse we'd be in serious trouble.
However we're still in serious trouble because of the moral hazard created. Banks have been given the greenlight to take similar risks again because they know they'll be bailed out in future.
Frankly, without also taking steps to force banks back into smaller entities that we can afford to let fail, all we've done is compound the problem and delay it until later when it will be worse.
Is it better to force banks into smaller entities, exerting government control over the marketplace, or let their investors lose their pants when the banks take stupid risks, allowing the marketplace to correct itself?
Well personally, I'd prefer the latter, but if it really was going to crash the economy completely, then the former might be necessary. But the only point in forcing them into smaller entities would be so that in future they would be allowed to fail.
the quant finance that takes the best and the brightest (as opposed to the bankers and sales traders), uses informational and computational advantage to make money.
How are internet startups any different?
Also, even the bankers and sales traders are providing a service that apparently people want. If you can judge them as not creating societal value, why can't I say that the Nth photo sharing website is not creating value?
People generally won't use your site unless it helps them in some way. It makes their life easier, it helps them move information around, or they enjoy it. It's debatable whether the specifics represent a net good for humanity (cough Zynga cough) but there's at least a decent chance that you're helping folks out.
Some financial organizations provide important liquidity. They offer you a loan when you need one. But many exist only to shuffle around money in a clever way, so that some percentage of that money goes into their coffers. And it seems like the smarter the employees, the less likely they are to actually be providing any real services to people. After all, smart employees are the ones who can make truly spectacular exploits of the game... exploits that are lucrative but pointless.
And I don't know anything about the details, but I can't help but wonder... when you write a brilliant algorithm that scrapes money out of the markets... or you set up a clever instrument that lets you capitalize on structural regularities in the market... whose hide does that money come out of? I honestly have no idea, but my instinct is that it's coming from people who are already disenfranchised.
people generally won't trade with you unless it helps them in some way
Not necessarily. People engaged in real trade set up financial institutions, but once these institutions are set up, a game is in place. That game may be beneficial overall to the businesses, but individual players aren't necessarily beneficial... even if they are participating according to the agreed upon rules.
It's like cashing in a Groupon deal and then never returning to that business. The company loses money on you and they only agree to serve you because it works for them at scale. But at the micro scale you are hurting them.
People who do so have every right to, but they are not contributing to the economy. They are just making a lot of money by making other peoples' lives more difficult.
Ok, then, how does stealing sound? You can't really win this argument, man. No matter how you dice it, the FED is stealing from the American public to hand it over to financial institutions who then sell us back our stolen goods.
People are forced to trade, here is how: When the government needs a loan to cover its budget, they get it from the Federal Reserve. The Federal Reserve are charged to coin new money to provide the government (see wikipedia Federal Reserve, subheadings: 'Elastic Currency', 'Lender of Last Resort' & 'Central bank'). As the Federal Reserve increases the money supply, the value of the dollars in your pocket/matress/bank account go down.
Since the value of currency evaporates, the only way to maintain your savings is to have it in a non-currency form. Stocks are a pretty liquid asset. This pushes people away from savings and into speculation (the stock market), where many lose their shirts.
Most people buy mutual funds, which take a nice fee for doing work a dart-throwing monkey could do (no exaggeration). It would make more sense for people to buy a random sample of the S&P 500, but try telling them that.
If I wanted long-term exposure to the S&P 500 then I would indeed do that. I have bought and shorted SPY (which has a fee attached) as a part of short-term pairs trades.
My point is simply that for years, fund managers such John Bogle have made a big deal about the fact that an efficient market doesn't allow stock picking funds to beat the cheaper index funds, etc, etc. True enough, but the next logical step is to drop the index funds and manually reproduce their trivial work.
Someday, a smart brokerage is going to offer a service to do this automatically, with cut-rate commissions. This would save people billions and billions of dollars.
SPY is the largest ETF, and follows the S&P 500, which is why I mentioned it. I trade lots of ETFs. Short term, they allow individuals to use hedge fund-style strategies. Long-term, they are essentially the same as mutual funds. Very-short-term, they allow quants to make money on arbitrage. There is no good reason for their existence, honestly.
When you say things like "Very-short-term, they allow quants to make money on arbitrage.", it makes me think you really don't understand the role of market makers, proprietary traders, or quants.
Let me ask you a very basic question: why do market makers (the people you trade against when you buy or sell SPY) make money? They aren't stealing from you. They are providing you the service of liquidity. Market makers connect people who want to buy/sell now with people who want to buy/sell in the future. In the interim, they take on the risk of holding that position that you didn't want. On average, they are compensated for that risk.
The way you say "they allow quants to make money on arbitrage" implies that the quants are just "extracting money" from the markets without doing any good at all. This is the complete opposite of the truth, and more people need to understand this.
If you don't derive value from them, why do you trade them?
You are absolutely right. ETFs are basically mutual funds, but with greater liquidity and lower fees. That's the reason for their existence - mutual funds, but better.
I only said 'many' lose their shirts, but that might have been harsh.
Many investors are just looking to store their savings. They're not Warren Buffets, they don't study markets to make educated decisions, they just go into index funds and hope for the best.
But it's like having your bank in the lobby of a casino. You don't have to play --- but you're already there, and look at the flashing lights...
Well, we don't transfer our pensions, salaries and every bit of capital and risk through startups. If we did, I'd say we need to watch startups a lot more carefully.
The equivalent to today's finance world was the .com boom and crash. When that crashed, the world continued and the S&P500 recovered just fine after a brief hiccup. The .com universe deleveraged and stayed so, but it just didn't affect the rest of the world that much.
During the latest crash, the rest of the world went into a huge recession. House prices and new-house sales have just hit multi-year lows again, two years after the event. The job market only looks better because so many have left it so aren't counted as job-seekers anymore! The non-finance world is still paying the bill for the latest recession, even though the big banks have forgotten about it and are paying bigger bonuses than ever.
Only way you compete with Wall Street is you increase the utility of expected payoffs, not just the wage. People who are going to WS have different risk profiles than entrepreneurs. You can have low participation in entrepreneurship as long as participating ones are competitive and innovative. It is better use of talent and time if those who would have failed anyways (because they don't have the guts, etc) go and make themselves useful elsewhere.
I think you have it backwards. It's not about max_a U(E(a)), but of max_a E[U(a)]. Otherwise insurance wouldn't work.
Let's illustrate with an example. Suppose you buy theft-insurance, there's 10% chance of being robbed and the cost of robbery is $100000. Then, E[a] = 0.1 * -100000 = -10,000. So you'd be maximizing U(-10000). This is different from maximizing E[U(a)] because in this case it's 0.1 * U(-100000) + 0.9 * U(0).
The real challenge underlying Wadhwa's article is how to incentivise traditional engineering careers to counter the lemming run to investment banks and hedge funds that the best technical minds make these days. Because high finance careers offer lucrative compensation according to market demand for talent, perhaps the demand itself needs to be adjusted.
Another roundabout approach to counter this phenomenon is greater regulation to curb non-transparent / overly risky / exploitative instruments. Arguably, better regulation will help flatten the casino-eque boom (and bust) fortunes that we've been seeing in recent years. In turn, this may eventually translate to more moderate compensations in financial careers and may eventually reduce the outsized finance field demand for engineering talent. The rub is that government regulators are simply no match for the sharp pointy minds and enormous resources high finance firms can muster - the financial regulations of today will be easily be circumvented by the clever finance and accounting tricks of tomorrow.
Were it implementable (fantasy), the people who create and subsequently sell these fancy financial products should be paid with their own products and be required to hold them until maturity.
> If high frequency trading is so needless, why does the entire market go into shock when the traders panicked and left on may 6th 2010?
Because HFTs, who enjoy the privilege of walking away from the market at the worst possible moment, had largely displaced traditional market makers who make expensive commitments not to do that. Nobody specifically chooses to do business with them, they're exploiting flaws in the way trades clear to front-run them and become unwanted middlemen.
...they're exploiting flaws in the way trades clear to front-run them and become unwanted middlemen.
Could you explain the mechanics of how this works?
Near as I can tell, the only way to become a "middleman" is to offer a better price than your competitors or to offer the same price at an earlier time. Is there a "front-run my competitors" FIX command I'm not aware of?
http://blog.themistrading.com/wp-content/uploads/2009/01/tox... describes a predatory algorithm deliberately making inconsequential trades solely to discover a buyer's limit, then selling short at that limit only to cover after the dip they themselves caused. This is basically scalping, a strategy designed to steal the surplus value from both the buyer and seller. Such abuses were even more egregious back when most exchanges offered flash orders, which is more like poker with certain players allowed to see your cards.
When a HFT buys and sells with a holding time in milliseconds, they are in no way guiding the correct allocation of our economy's resources, they are merely bleeding those who are. That they can do so profitably is showing us what we should fix about the way trades clear.
Huh. So basically, before HFT, the clever institutional trader could use HFT techniques to buy a bunch of shares from less sophisticated retail investors at $20.00 in spite of high demand.
On net, the institutional trader is gaining $0.01 at the expense of retail investors.
Now, in a world with professional HFTs, the institutional investor can't do this as easily and must pay the retail investors $20.01. How horrible!
It's hard to see why you are calling the HFT an "unwanted middleman". I mean sure - the institutional investor would love to keep taking money from the retail investors. But the retail investors want to keep their pennies - they certainly want the HFT to be present.
As I said, the only way to become a middleman is to offer a better price than your competitors.
Can you tell me more about these commitments and what makes them expensive?
No one may explicitly choose to trade with HFT firms, but that doesn't mean they don't value their presence
"Although Vanguard does not engage in "high
frequency trading" and does not operate a "dark pool," we believe much of the public
concern over "high frequency trading" is misplaced and believes such activity,
appropriately examined, contributes to a more efficient market that benefits all investors."
He is probably referring to NASDAQ market makers, who are obligated to have a quote at the NBBO at least 10-15% of the time. Of course, there is no obligation that their 10-15% include the 1 hour or so of the flash crash...
Finance firms put 100% of their time and energy into finding ways of making money out of existing money without producing any other value.
Entrepreneurs do a little of this too, but foolishly allow themselves to be distracted by an irrational desire to also make novel and valuable contributions to society.
Eventually the entrepreneurs will learn that a part time effort won't cut it and they can't beat the guys who give it 100%
All needed bankers to get them access to capital and grow faster, helping them hire more employees and contribute to our economy's growth and standard of living. I'd highly recommend you rely your points on empirical evidence over populist talking points.
What does that even mean? Economic growth has grown consistently. Technology now makes up a large portion of our GDP when it hasn't in the past. Why attack the finance industry when you could also attack the technology industry?
There's more demand. Therefore, there's a larger supply. Simple, basic, very elementary economics.
The financial industry makes up a much larger portion of GDP growth. Artificial growth that would have contracted if it hadn't been bailed out. Demand for the financial industry has been produced by force, not through the marketplace, unlike other industries.
Your simple, basic, elementary economics don't apply when an industry is being protected by the government.
First, it is an ethical problem. The idea of producing things is not taught in elite colleges, nor is the idea that it is possible to make a positive contribution to society (e.g. rms) without becoming superrich (no offense to those for whom this is their primary motivation).
Second, a lot of the products of which the GDP percentage is based upon simply involve repackaging and selling debt. (e.g. http://ow.ly/1sf8Rp ). In other words, a lot of the economy is based upon accounting tricks.