Is finance parasitic?

Finance Professors have been ignorant of the practices in the financial industry for years. Like magicians they have only shown us the bright side of their occupation. It required a crisis like in 2008 to break all these myths of a well functioning efficient market mechanism. All doyens of financial industry were seen indulging in practices which make all the previous money making frauds and tricks look so lame in comparison.

But then guess what? The aura of the industry and its soothsayers has not just remained but increased manifold. It is a classic case of bad behaviour continuing to be rewarded by the society. For instance this story of a young person really excited on getting a job offer from one of the doyens only to end in a really bad tragedy.

So such posts comparing the sector to a parasite is interesting to read:

We all know what a parasite is: an organism that attaches itself to another organism and derives nourishment from the host organism and in so doing weakens the host possibly making the host unviable and thereby undermining its own existence. Ayn Rand and her all too numerous acolytes were and remain obsessed with parasitism, considering every form of voluntary charity and especially government assistance to the poor and needy a form of parasitism whereby the undeserving weak live off of and sap the strength and the industry of their betters: the able, the productive, and the creative.

In earlier posts, I have observed that a lot of what the financial industry does is not really productive of net benefits to society, the gains of some coming at the expense of others. This insight was developed by Jack Hirshleifer in his classic 1971paper “The Private and Social Value of Information and the Reward to Inventive Activity.” Financial trading to a large extent involves nothing but the exchange of existing assets, real or financial, and the profit made by one trader is largely at the expense of the other party to the trade. Because the potential gain to one side of the transaction exceeds the net gain to society, there is a substantial incentive to devote resources to gaining any small, and transient informational advantage that can help a trader buy or sell at the right time, making a profit at the expense of another. The social benefit from these valuable, but minimal and transitory, informational advantages is far less than the value of the resources devoted to obtaining those informational advantages. Thus, much of what the financial sector is doing just drains resources from the rest of society, resource that could be put to far better and more productive use in other sectors of the economy.

So I was really interested to see Timothy Taylor’s recent blog post about Luigi Zingales’s Presidential Address to the American Finance Association in which Zingales, professor of Finance at the University of Chicago Business School, lectured his colleagues about taking a detached and objective position about the financial industry rather than acting as cheer-leaders for the industry, as, he believes, they have been all too inclined to do. Rather than discussing the incentive of the financial industry to over-invest in research in search of transient informational advantages that can be exploited, or to invest in billions in high-frequency trading cables to make transient informational advantages more readily exploitable, Zingales mentions a number of other ways that the finance industry uses information advantages to profit at expense of the rest of society.

Further:

A couple of xamples from Zingales.

Financial innovations. Every new product introduced by the financial industry is better understood by the supplier than the customer or client. How many clients or customers have been warned about the latent defects or risks in the products or instruments that they are buying? The doctrine of caveat emptor almost always applies, especially because the customers and clients are often considered to be informed and sophisticated. Informed and sophisticated? Perhaps, but that still doesn’t mean that there is no information asymmetry between such customers and the financial institution that creates financial innovations with the specific intent of exploiting the resulting informational advantage it gains over its clients.

As Zingales points out, we understand that doctors often exploit the informational asymmetry that they enjoy over their patients by overtreating, overmedicating, and overtesting their patients. They do so, notwithstanding the ethical obligations that they have sworn to observe when they become doctors. Are we to assume that the bankers and investment bankers and their cohorts in the financial industry, who have not sworn to uphold even minimal ethical standards, are any less inclined than doctors to exploit informational asymmetries that are no less extreme than those that exist between doctors and patients?

Another example. Payday loans are a routine part of life for many low-income people who live from paycheck to paycheck, and are in constant danger of being drawn into a downward spiral of overindebtedness, rising interest costs and financial ruin. Zingales points out that the ruinous effects of payday loans might be mitigated if borrowers chose installment loans instead of loans due in full at maturity. Unsophisticated borrowers seems to prefer single-repayment loans even though such loans in practice are more likely to lead to disaster than installment loans. Because total interest paid is greater under single payment loans, the payday-loan industry resists legislation requiring that payday loans be installment loans. Such legislation has been enacted in Colorado with favorable results.

The worst part of all this research on finance is it is just rehashing of age old principles. All today’s modern scholars have done is complicate the age old lessons by adding a lot of math and make it look something new and exotic. Much of financial history is full of booms, busts, frauds and development. There is nothing really new to all this. Just that the soothsayers do not think so and need a crisis to get back to basics.

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