What Hath Quant Wrought?

Today's Business section of the NYT has a host of malfeasance on display. A cornucopia of greed and punishment. But that's not what I came here to talk about. Jesse Eisinger has a DealB%k piece, and he's got some reporting of research which illuminates.

What was the proximate cause of The Great Recession? The answer largely depends on which end of the political/economic spectrum one sits.

The Right tale goes: "It was all those poor folks tired of living in shotgun shacks (and wanting McMansions) who came to the overly solicitous and naive` mortgage companies and banks demanding oddly structured subprime ARMs, the parameters of which they dictated to the naive` mortgage companies and banks. Who, being naive`, reluctantly devised such loans. Of course, the loans eventually went South, victimizing the mortgage companies and banks."

The Left tale goes: "The Banksters (mortgage companies, banks, rating agencies, and the Trilateral Commission) set out to gut the 99% and get rich in the process by creating mortgages which enticed the naive` poor folks into believing they could leave their shotgun shacks for McMansions. When said mortgages eventually collapsed, the Banksters kept their ill-gotten gains, and the poor folks retreated to their shotgun shacks, now paying more in rent than they did before the whole sorry tale happened." (Aside: private-equity, hedge funds, and God knows who else are slurping up housing and becoming absentee corporate landlords. That will not end well for communities.)

The truth, to the extent that anyone can be objective, lies mostly with the finance industry/sector growing into Jabba The Hut. One of the earliest themes of these endeavors is that Greenspan is Patient Zero in the epidemic. By crashing interest rates, he set in motion the effort to generate other vehicles of "risk free, high return". There are no such vehicles, of course, but since finance was about as unregulated by 2001 as it's ever been, there was no adult driving the train. "Let's see how fast we can make the choo-choo go, Mary!!" And it went fast.

While I can't claim to be the first to suggest it (although my recollection is that finding others, in the pundit class, who expressed the notion followed my coming to the conclusion), the problem with the financial engineering brigade, i.e. raptor-quants, is that they don't want finance to be simple and boring. Convoluted and opaque is better. And the reason it's better is that profit from finance comes not from value added, but sucked out of the moolah stream twixt savers and borrowers. Better to hide the shenanigans.

Which brings us to Mr. Eisinger today. He reviews some of Jack Lew's, the newish Treasury secretary, earlier pronouncements, along with data produced by outside researchers. It is these concrete facts which are of interest.

The way to really solve "too big to fail" is not by tinkering with the existing system, which leaves the great and fundamental problem still with us. The economy has become overly "financialized."

GE's profit percentage from finance had reached 50%. Other companies saw a quick buck, and took to shuffling paper and sucking moolah from the, what looked like, tidal wave of moolah to be processed.

Historically, finance's share of the economy has been at about 4 percent. Today, it's about twice that. And the peak occurred not in pre-bubble 2007, but in post-crash 2010, at just under 9 percent, according to research from Thomas Philippon of New York University. That represents a shift of more than $600 billion of wealth a year, as Wallace C. Turbeville, a former investment banker-turned-financial reformist, has pointed out.

The result is obvious:

Despite technological innovation, finance costs more than it used to, even though prices have fallen for things like trading stocks.

The Banksters suck their profits from the stream. Even Eisinger has the gonads to be plain:

The financial sector has become a self-sustaining perpetual motion machine that extracts money from the rest of the economy. Shouldn't it be a goal of society -- Mr. Lew's focus -- to restore the financial industry to its traditional role as an intermediary between companies that need capital and savers who have it?

In simple words: finance should be simple, dumb, and transparent. And cheap. It is after all, little more than Marrying Sam, putting savers and borrowers together. All the fancy quant does is extract ever more from the stream for the quants and their bosses. The quants would be more productive in marine biology and such.

Research from Professor Philippon shows that financial activities have gone up in the deregulatory era, and now cost about the same as in 1900, the last Gilded Age. In other industries, like retail, technological innovation has led to lower prices and therefore decreased the size of the sector. In finance, the opposite happened.

The tail is wagging the dog.

(Go to the web page to follow the links to the underlying research.)