I’m not dodging the issue. You asked if finance played a useful role in society, and I gave concrete examples where it did.
Those services are more profitable because they are more valuable, because they are now better at transferring risk. Sure, you can say that you don’t understand the value that a derivatives product provides, and some people are buying them when they shouldn’t, but that hardly describes the entirety of an industry. Just because you can’t imagine why someone would want borrow money in a complex way doesn’t mean it doesn’t make sense to them.
Let me give you another example where financial innovation has made people’s lives (slightly) better. Many people of my parents generation bought strange investment products with very high management fees from people like Fidelity and Morningstar. Today they’re more likely to buy a low fee index fund like Vanguard. Or a target retirement fund that reduces their risk as they get older.
I argue that the financial products still existed 40 years ago, but they were more obtuse and a worse deal.
As stated below, your general point is certainly true..
But what is the financial industry accomplishing today that they didn't accomplish 25 years ago? As far as I can see, the most useful innovation has been the ATM machine (which is indeed quite useful). The rest of it? Is the economy running better? Does the financial system allocate capital more effectively? If not, then why are they taking home so much more money?
I'm not going to argue that they're not smart -- they're plenty smart, I'm sure there are a lot of people in finance who are smarter than me. It just seems that those smarts have been applied towards rent-seeking and value extraction rather than "building things people want".
I dont have sympathy to how the finance sector has behaved historically, but this opinion can only come from ignorance. Its like a 50 year old saying working for technology companies is useless because he can live without snapchat and whats app. Finance is the study and work of value, which is enough to believe it has important applications.
I'm not sure how this is related to my post so perhaps I was unclear. I'm not talking about individual corn farmers and the choices they make, I'm talking about how we as a society and an economy allocate our resources. I'm saying that derivative financial instruments have value, for the reasons I suggested and the others described by sibling commenters, but that the finance sector is larger than that value warrants.
I'm not sure why I'm being downvoted, as I didn't think this is all that controversial. Historically, finance was a much more boring and less lucrative field than it is now, and consequently much smaller. "I'm a super smart 18 year old and I want to get rich, so obviously I should go into banking" is a relatively recent phenomenon. I agree with everyone else here that the industry has value, so presumably its recent explosion in size has brought some additional value, but it's very hard to believe that value is large enough to offset the opportunity cost of a generation of ambitious geniuses not going in to science or industry or becoming entrepreneurs.
I'm under the impression that financial innovations throughout history have generally spurred capital investment. Innovations like fractional-reserve lending have made bankers&investors wealthy, but also spurred spending on infrastructure in a way that could be a win-win for society as a whole.
The point the author was trying to get at was not that finance geeks don't provide any social utility.
Just that in any rational category of needs, the value they provide would have to rank far below the value provide by nurse practitioners (and schoolteachers, police officers, lawyers even... a zillion other working categories, in fact).
If today's financial wizards went away,
It's not just a question of "if." To all intents and purposes, the financial services sector as we know it today (both in its technical prowess, and in sheer size and scope) did not exist 30 years go. True, we didn't have Facebook or iPads then. But people managed to live healthy lives, raise children, have careers, buy houses, fight wars, etc, just the same.
So from one point of view, yes the financial services sector can be seen to grease certain wheels (like IPOs, M&A). But in the larger picture, (in the view of many) it doesn't seem to provide all that much value, in proportion to the resources (and brainpower) devoted to it. It also seems to generate no end of collateral damage (the recent mortgage crisis being just one example).
Most people here disdain finance. However, it seems to me finance is still a pretty vital industry. It's not only about making money out of "thin air" or a game of greedy shallow minds equipped with social capital. I will defend for it that it's also a means of the society to distribute the limited resource to where it sees the most promising future and payback. It's the people in finance decide that if a billion dollars will be invested in a luxury hotel or DNA sequencing research. Why do you want to leave these vital decisions to those greedy and ignorant people instead of those brightest students who may make a change with their knowledge and make wiser decisions for the society?
Yes. You can argue that it shouldn’t pay so well, or that there are bad actors, but the financial industry DOES genuinely help society. Like all businesses, they provide services that people want.
The easiest example is insurance (e.g. home or auto insurance). Paying premiums sucks, but losing your house is an unimaginable loss for most people. Finance as a whole is a risk transfer mechanism. You transfer the risk of your car getting totaled to State Farm. You might even own some State Farm stock; probably you own some exposure to the risks of American companies, and they pay you for that risk (in expected stock growth).
The other easy example is mortgages. Ask anyone from Europe or even a third world country how easy it is to get a 30-year ARM or 10-year fixed like is common in the US. Lenders might have caused the financial crisis (no disagreement here) but post-crisis Americans are able to buy homes because the financial industry is ready to evaluate and lend.
My point is not that the financial sector is unnecessary, it's that the majority of the activities are not of benefit to society, which admittedly is something hard to define.
Following on from that line of thought, it could be argued that a lot of companies don't provide any benefit to society, so the financial sector is just enabling these firms and thus of no benefit to society.
You missed the most insidious innovation of all, derivative contracts and markets :-).
Yes, fully agree that over a larger horizon financial services have been evolving and innovating (not always in a controlled or beneficial manner).
It is also true that previous digital innovations (databases, spreadsheets and... powerpoints) have been adopted (as in bought / licensed) and were instrumental to enable all these innovations on the financial side.
What the financial sector did not realize is that as the information universe coelesces and, e.g., advertisers or retailers come to invent and dominate technological platforms innovation cannot happen with rented tools.
> the ones currently shouting loudest about disrupting finance seem to have a serious lack of understanding what finance actually is
the disconnect between (digital) technical and domain knowledge is exactly what I think is the problem
My understanding, which is tiny and very limited, is that you can think of the role of finance operators as "liquidity providers". They're the grease in the wheels of capitalism; by either providing access to capital (via loans, or investment) or by matching buyers with sellers.
A classical example is you're a farmer that wants to hedge the risk that your crop will fail due to random weather events or that there will be such a glut in the market that you won't be able to sell your crop profitably. So, you enter a contract to sell your crop at a fixed rate long before harvest comes along. That's a future contract, and it's a kind of derivative.
So, derivatives can be really socially useful instruments. They can act like certain kinds of insurance, or allow you to capture different dimensions of value on assets that you already own.
However, and here's where the argument comes in, it's not clear that all kinds of derivatives provide socially useful forms of gambling. The prime example here is that of the collateralized debt obligation in which huge portions of the US mortgage market got sunk into.
Mortgage backed securities are probably not in of themselves terrible ideas but the way CDOs were structured made it impossible to objectively value the risk behind the instrument. It's just not clear how a dip in the market might affect the value of your CDO tranche. It's actually an np-complete problem - https://freedom-to-tinker.com/blog/appel/intractability-fina...
Another example is high frequency trading - where you're a day trader on steroids and have computers exchanging massive quantities of stocks based on fluctuations of fractions of cents. HFT people will argue that they provide more liquidity in the market - it's easier to sell your stocks because HF traders increase the overall volume, etc. However, it's in effect launched an arms race between different trading firms and some people say that they're literally making money by skimming off everyone else who trades stocks. There's a very reasonable argument that we don't want markets to operate faster than human perception. If you have to make a decision about selling something, placing a ground foor and minimum transaction time of say half a second isn't going to harm anyone who needs that liquidity for their business, or anything else that touches the "real economy".
To summarize: certain kinds of financial instruments seem to provide no value above and beyond letting well-connected actors to place (potentially ridiculous) bets. Using your money, one way or another - whether it's your farm, the mortgage on your house, or your pension fund.
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If we accept the above as true, we can go further on a limb and ask questions about why is the wealth that passes through financial markets so liberally redistributed to people in the industry? Some people talk about it being a function of volume, but individuals are rarely if ever liable. When do they stop providing a service, and when do they start skimming off the top?
Lots of finance people, rightly or wrongly justify their work as giving a valuable service to humanity: From "providing liquidity" to "absorbing risk" and "helping your pension grow" the list of supposed goods provided by finance is very long.
You are dodging the issue with this. These financial services you name have been available throughout my nearly 60 year life. In the past they were no where near as profitable and represented a much smaller slice of the economy. In the last 10-20 years there has been huge growth in the financial sector such that it is taking in much more money and represents a much larger portion of the economy. Was there really any genuine growth in service, or is this just a tumor on markets growing as it can? Looks a lot more like that latter.
And there appears to be a considerable amount of damage being done. Socially debt is considered an important obligation such that walking away from a loan is terrible not only for credit but also social standing and status. Yet financial services have grown to the point that they have a great ability to predict ability to pay and to use that to make loans that they know quite well will very likely never be paid back. Exactly what percentage of recent financial growth is essentially fraudulent activity?
I disagree that financial markets are the foundation of society. Instead, I think they're more near the top or to the "side". Closer to the foundation of society is more basic and primal human needs and wants, and people doing real work, making real things that other people need or want. Finance is just a very modern abstraction. It can be useful, but also just another form of gambling or parasitism. Again, not to say it's not useful to understand. Just not part of the foundation of society.
There's a well-trodden argument that much of financial innovation has little positive effect or even negative effect on the larger economy.
Jack Bogle, founder of Vanguard Group:
"The job of finance is to provide capital to companies. We do it to the tune of $250 billion a year in IPOs and secondary offerings. What else do we do? We encourage investors to trade about $32 trillion a year. So the way I calculate it, 99% of what we do in this industry is people trading with one another, with a gain only to the middleman. It’s a waste of resources."
Paul Volcker, former chairman of the Federal Reserve:
"Echoing FSA chairman Lord Turner's comments that banks are 'socially useless', Mr Volcker told delegates who had been discussing how to rebuild the financial system to 'wake up'. He said credit default swaps and collateralised debt obligations had taken the economy 'right to the brink of disaster' and added that the economy had grown at 'greater rates of speed' during the 1960s without such products."
The view that institutions make too big of a profit off too little risk isn't really relevant to that. Cars are useful no matter what profit Ford makes by making them.
Maybe we need to examine the market to make sure its working? Maybe they're duping the government? Maybe they have some hidden reason to justify those rates. I don't know. But the underlying product is useful wither way. I don't object to any of that. But none of it changes the need for credit.
The original comment I replied to is very clear: finance is not useful, it's a wealth extraction process Etc.
The world of finance makes these aspects of your life function:
* Allows you to get a mortgage
* Allows you to protect yourself with
health/car/life/home/title/etc insurance
* Pays for your highways/stadiums/schools and other public works
* Protects your deposits
* Pays for your retirement
* Funds the college fund that paid for your school
* ... Or the student loans that allowed you to attend school
* Supports the global supply chain that brings you your
iPhone, stocks the grocery store/your favorite restaurants with food, and puts the clothes on your back.
* Funds the growth of corporations large and small, giving you the job that allows you to buy an iPhone
* Funds the massive philanthropy expenditures that help those
in need everyday
* Pays the pensions of the elderly
Financial innovation make our lives more predictable and less sensitive to chance. One could argue a huge amount of human progress is owed to modern-day financial institutions.
Like a software system, it's extremely naive to think that complexity is a sign that a system is rotten. Finance is an art, not a science. Sometimes we make products that we don't always completely understand until later. But the vast majority of financial innovations are deeply ingrained in the good life that you get to enjoy every day.
Bold claims. Forgive me for saying so, but your knowledge of finance does not strike me as particularly deep!
Do you not think that use of financial instruments is vital for allocating resources in a world of imperfect information?
For me, their utility and necessity is obvious. If you think about it, making stuff that people want is actually rather complicated. The world is rife with hazards and risk; the intricate supply lines upon which production depends are all vulnerable to disasters both natural and human.
Naturally, those whose business it is to produce things and not to speculate on future events would like to be free of such risks. This is true the source of fundamental demand for financial instruments. All the derivatives markets, and zero-sum game apparatuses exist in order to transfer -- and in so doing compute a consensual value of -- these risks to those who believe they are better informed about reality.
While I understand not wanting to personally engage in this process, I claim that that the world is better that these contracts and exchange machinery exist!
Finance was invented out of necessity. People in ancient Egypt needed finance to feed people. It's not some esoteric concept. Just because you don't understand it, doesn't mean it holds no value.
Businesses have far more tools to hedge various risks (FX, commodities, etc) - thanks to the financial sector, Apple is in no danger of dying should the RMB spike.
Retail investors are capable of trading for $8 or less, and the bid/ask spread has lowered significantly.
It's now drastically easier for retailers to sell goods on credit, and it's vastly easier for customers to pay electronically. 10-15 years ago, you couldn't swipe your ATM/credit card at the grocery store.
ETFs are undercutting mutual/index funds, drastically reducing the cost of saving for retirement.
Structured products allow far more people to trade with each other than ever before.
Microfinance [1] is available to lower income people, albeit with relatively high default premiums. (Admittedly, many people criticize this.)
It's not necessarily running better - there have been harmful changes as well. The Intel IPO could no longer happen today, for instance, and in the future far more companies to go public Facebook style than Intel style. But that doesn't change the fact that the financial industry has accomplished a lot.
(Of course, I'm not denying that they also rent seek.)
[1] Maybe "minifinance" is the appropriate term. Payday loans tend to be 10-100x bigger than third world microfinance.
>Business produces goods and services.
Finance is an online multiplayer game.
But finance is also products & services.
Think of a corn farmer. It's easier to think of him adding tangible value to society because "corn == food".
In contrast, finance just seems like useless office workers copy pasting numbers around in Excel spreadsheets. (This is probably true in many cases.)
But the farmer often wants to sell "futures" which is a product & service provided by the financial industry. Instead of using the jargon of "futures", we can just say the farmer wants a product/service to give him a "guaranteed-selling-price-regardless-of-future-volatility-of-corn-prices-so-I-can-sleep-at-night".
Other examples of desirable finance products that farmers want include crop insurance and equipment loans/leases.
>They are two weakly-connected systems.
Farmers' food crops and the financial products/services of of futures is an example of how businesses making tangible products and the finance industry are strongly connected.
Those services are more profitable because they are more valuable, because they are now better at transferring risk. Sure, you can say that you don’t understand the value that a derivatives product provides, and some people are buying them when they shouldn’t, but that hardly describes the entirety of an industry. Just because you can’t imagine why someone would want borrow money in a complex way doesn’t mean it doesn’t make sense to them.
Let me give you another example where financial innovation has made people’s lives (slightly) better. Many people of my parents generation bought strange investment products with very high management fees from people like Fidelity and Morningstar. Today they’re more likely to buy a low fee index fund like Vanguard. Or a target retirement fund that reduces their risk as they get older.
I argue that the financial products still existed 40 years ago, but they were more obtuse and a worse deal.
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