Arnold Kling  

Falkenstein vs. Sumner

How to Tell if Public Sector W... John Goodman on Magnitude of H...

Scott Sumner writes,

I define "finance" as the business of allocating capital, which is a bit different from how it shows up in the national accounts. For instance, I believe the CEOs of major non-financial companies are being paid (in part) for the decisions they make in allocating capital...If all you have to do is churn out iron and steel and washing machines and apartment buildings, it can be done passably well with central planning...[but not] when the decisions were about whether to allocate capital to Google or Genzyme, or whether to build that auto parts plant in Detroit or Mexico or China. It's no longer about simply mobilizing capital to mass produce clearly defined output of stuff we all know consumers will want.

As the economy becomes more complex, the process of organizing production and distribution becomes more challenging. If that process consisted of central planning, the skill demands on the central planners would be much higher today than they were 50 years ago, or even 25 years ago. If that process consists of market mechanisms, then the rewards for key players in the market should be much higher today than they were 50 years ago. I think that this is an important point. To put it another way, if the task of organizing production were not a challenge, we would not have 10 percent unemployment today.

On the other hand, what is frustrating is that so many on Wall Street were rewarded handsomely for mis-allocating capital. For an explanation of how that can happen, I turn the microphone over to Eric Falkenstein.

In an expansion investors are constantly looking for better places to invest their capital, while entrepreneurs are always overconfident, hoping to get capital to fund their restless ambition. Sometimes, the investors (dupes) think a certain set of key characteristics are sufficient statistics of a quality investment because historically they were. Mimic entrepreneurs seize upon these key characteristics that will allow them to garner funds from the duped investors. The mimic entrepreneurs then have a classic option value, which however low in expected value to the investor, has positive value to the entrepreneur. The mimicry itself may involve conscious fraud, or it may be more benign, such as naïve hope that they will learn what works once they get their funding, or sincere delusion that the characteristics are the essence of the seemingly promising activity. The mimicking entrepreneurs are a consequence of investing based on insufficient information that is thought sufficient, but they make things worse because they misallocate resources that eventually, painfully, must be reallocated.

Remember, I think we live in a world in which people want to issue risky, long-term liabilities and hold low-risk, short-term assets. Finance consists of meeting those desires by taking on a balance sheet of the opposite shape--issuing assets that are less risky and of shorter term than the underlying projects.

The way I look at it, there are five ways to make money in finance, which, as Falkenstein points out, includes some of the decisions made by executives of non-financial firms.

1. Have superior ability to select projects in which to invest

2. Make use of diversification to improve the risk-return trade-off.

3. Be able to signal that you can provide people with the assets that they want.

4. Get lucky with bets. This can include the "picking up nickels" strategy that is equivalent to writing out-of-the-money options and having the good fortune not to suffer from a rare event, so that you collect insurance premiums without having to pay claims.

5. Exploit government subsidies, such as the too-big-to-fail subsidy.

Note that if you cannot do (3), that is signaling, you are not likely to get to deploy other people's money, no matter how good you are at any of the other strategies. On the other hand, if you can do (3) really well, you might be able to deploy other people's money without having other skills, at least until things go bad and you get exposed.

How did men in finance get especially rich in the last twenty years? I see Sumner as arguing that it is because of (1). I see Tyler Cowen as arguing that they exploited (4) and (5). I see Falkenstein as argung that many in finance exploited (3). He suggests that finance is inevitably opaque, and thus it will usually be possible for people who are not really creating value to learn to do a credible imitation of those who are creating value. As a result, there are going to be repeated episodes of capital misallocation, although each bubble will have its own unique characteristics.

COMMENTS (7 to date)
Philo writes:

You complain that "so many on Wall Street were rewarded handsomely for *mis*-allocating capital." But you are setting the bar rather high, relying on hindsight. If you want to see *real* mis-allocation, you must look to a communist country (mostly a 20th-century phenomenon). (Falkenstein is a typical Monday-morning quarterback.)

"How did men [and even the rare woman] in finance get especially rich in the last twenty years? I see Sumner as arguing that it is because of . . . superior ability to select projects in which to invest." But Sumner is not saying that recent financiers have been *more superior* to the general run of people than were financiers of the more distant past. He is trying to explain why their superiority--assumed *constant over time*--is producing greater relative returns now than it did in the past.

josh writes:

Yes, banks allocate capital. Guess what else, banks are fundamentally government institutions with a license to print capital allocation permits.

Keith Eubanks writes:


What role has money inflation played in the financial sector receiving a higher share of the nation's income?

Money inflation, even moderate levels over an extended time (decades), transfers wealth via the mechanism that not all prices change at the same speed: i.e., commodities and equities tend to adjust quickly while wages tend to adjust slowly. Those whose prices are adjusting slowly are constantly transfering wealth to those whose prices are adjusting quickly. Understanding this simple transfer mechanism, it seems logical to ask whether money inflation has played a role in the financial sector becoming such a large and profitable sector?

Hyena writes:

What if these models are entirely incorrect?

The assumption in all of them is that the financial services industry provides value to producers through investment allocation. What if that's not its function at all?

What the financial services sector seems to do a lot of is run very high leverage ratios which are hard for even high net worth individuals to operate under. The sector might make a lot more sense if its primary arbitrage isn't securities but leverage itself. The financial sector allows people to (vicariously) take on far more leverage than they otherwise would have.

Steve Sailer writes:

Don't forget a sixth way to make money in finance: inside information.

rpl writes:

Philo, I think the observation Arnold was trying to make was that allocating capital poorly has lately been nearly as lucrative as allocating it well, and far more lucrative than going out and producing something. It's easy to understand why the system might reward people who do a good job allocating capital. Arnold is discussing why it seems to reward them even if they bungle the job.

Steve, Isn't inside information just another way of achieving Arnold's #1? We frown on that particular method for a variety of reasons, but at the root of it, all inside information allows you to do is to make better choices than outsiders about which projects to invest in.

Scott Sumner writes:

I've been gone all week, so this is probably too late. But Philo is right about my argument.

I'm not arguing that people didn't get rich misallocating capital in the housing bubble, I'm arguing you'd expect the returns to finance to increase even if they weren't misallocating capital.

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