Monday, July 08, 2013

A really great example of highly profitable, but socially destructive, financial sector activity

Today's New York Times has the latest on a recent story that grabbed my attention because it is such a perfect exemplar of how the rise of the financial sector over the last twenty years has involved vast profits that often have no social utility whatsoever - and indeed that can make the country as a whole worse off.

"Over the last several years, an exclusive group of investors has paid a steep premium to receive the results of a closely watched economic survey a full two seconds before its broader release. Those two seconds can mean millions of dollars in profits for the investors, who practice a computer-driven strategy called high-frequency trading.

"On Monday, the company providing these investors with that lucrative edge, Thomson Reuters, is expected to announce that it will suspend the practice, yielding to pressure from the New York attorney general, according to a person with direct knowledge of the matter."

Needless to say, these profits have come at the expense of other investors.  It's pure rent-seeking.  (OK, I'm leaving aside the fact that financial markets get to incorporate the new information into prices two seconds faster.   But if that's a good thing, why not let everyone else have the information two seconds sooner still, and so on back to the first moment that anyone knows anything about the economic survey's results.)

Rent-seeking is socially neutral insofar as some people win and others - the suckers who don't get the early head's up - lose.  But it directly wastes the resources that people devote to engaging in it, and in addition can create a pervasive sense of a rigged game that can be very destructive to the proper functioning of financial markets.  And actually doing things that are valuable - but hence inevitably riskier and requiring greater skill - can end up being crowded out at the top by the returns to playing these silly games.

Then of course the people who get rich this way tell themselves (and everyone else) that they are the "makers" who are leading us all to greater prosperity.

Okay, this is just one unusually raw example of non-productive but highly profitable financial sector activity.  But if you look closely at activity in the sector, a lot of it is really no better.  Think of keeping financial products opaque so customers won't understand or be able to price them well.  Or playing games with LIBOR.  In the corporate takeover realm, think of cases where the profits come, not from economic rationalization (improving business operations and shutting down bad ones) but from added interest deductions, reneging on implicit long-term labor contracts, defaulting on pension obligations, and finding bank officers with badly structured incentive compensation who are willing to make sketchy loans.

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