Parasitism, Inc.: A Deficient Markets Hypothesis

elgrecomoney.jpgAccoring to an article by Jonathan Ford of Prospect, the finance sector gobbled up nearly 35% of total corporate profits in the US and Britain in 2005. As financier-turned-academic Paul Woolley observes in the piece, “There is no economic merit in a sector that makes exceptional profits and devours capital and labour, and then justifies it on the grounds that you can get some ‘cash back.'”

Woolley’s analysis animates the article and should wake up anyone still complacent about the validity of the “efficient markets hypothesis.” Ford points out a cozy revolving door relationship between academics, regulators, and tycoons in high finance. All were complicit in a parasitic reallocation of money from the real economy to speculative games designed to enhance cream-skimming at the top:

While the efficient market idea held sway, academics viewed the expansion of finance with equanimity. . . . Financial instruments always existed for a purpose—such as to pass on risk cheaply and efficiently to the investor best placed or most willing to bear it. If that were not the case these products simply would not exist. More trading was beneficial because it enhanced liquidity, and liquidity lowers costs and promotes efficient pricing.

But, according to Woolley, the scale of derivatives trading should be seen as symptomatic of distorted markets. . . . [M]omentum causes mispricing which in turn creates an insatiable demand for active management. This then spills into the derivatives markets in various ways. For instance, the investor responds to the volatility of the equity market by hedging his risk and buying a put option (giving the right to sell shares at a pre-determined price). The seller of the put protects his own exposure by selling equities. The investor has thus brought about, at a cost, the very event he was seeking to insure against.

Both Ford and Woolley still endorse “market solutions” to the crisis, such as “lengthening the period over which performance is assessed,” so that bonuses depend less on quarterly and annual results. Dilip Abreu has proposed similar realignment of incentives for ratings agencies. But I’d like to see more public involvement in investment decisions generally–a move featured in the stimulus plan Timothy Canova has suggested.

I have one quibble with what is an otherwise excellent article. Ford tries to draw a distinction between the productive and the nonproductive economy with an unfortunate example:

Whereas companies such as Microsoft and Google have risen by devising products that have added to the productive capacity of the economy, finance provides no such final good or product. It is a utilitarian mechanism for bringing together savers and borrowers, and this has not changed markedly since the 1960s. . . .

Let’s look at Google’s profit machine a little more closely. Aren’t they, like the finance companies, a middleman? As the Google/Yahoo antitrust hearings suggested, we have little sense of how much of Google’s pricing power for text ads in search is driven by innovation, and how much by the brute fact of its control over so much of the relevant audience. (It will have about 90% of the search advertising market in the US if the “joint venture” with Yahoo goes through.) Similarly, Microsoft’s fortune was largely built on positive legal decisions regarding the copyrightability of its code (and noncopyrightability of Apple’s graphical user interface, which many claim MS copied). It’s hard to clearly distinguish between profits driven by sheer innovation and those due to fortuitous network effects or clever lobbying and legal ploys.

This misconception drives Nicholas Thompson’s otherwise excellent essay on presidential tech policy as well. Thompson writes:

John McCain is an AT&T guy; Barack Obama is a Google guy. And that’s one of the most important policy differences between the two.

Think of the Internet as working at different layers. There are all the pipes that go into your home, and then there’s all the stuff on your screen—from e-mail to eMule. The telecom companies like AT&T control the pipes; the software companies, like Google, create the stuff. In an ideal world, both these layers would be sites of great innovation and creativity. But in the United States, that isn’t so. The software industry may seem like a team of Gandalfs, constantly producing magic. But the average telecom company resembles Jabba the Hut: it moves slowly and slobbers a lot.

I have no great sympathy for the telecoms. But anyone who cares deeply about net neutrality has to think about dominant carriers and search engines together, as I try to do in this article.

I concede that companies in the finance and internet intermediary sectors have done some great things. But I fear that we have little grasp of exactly what the value of their services is–as opposed to the power they’ve accumulated via favorable regulation and manipulation of the markets they manage. Even worse, trade secrecy in both sectors may keep us from ever truly getting at the answers to these questions.

Art Credit: El Greco, Christ Driving the Money Changers from the Temple.

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