Krugman on Ponzi

Krugman makes a similar argument to my earlier post.

In his hand, however, it becomes a semi-coherent, less then well thought out, screed.

The excutive summary of his argument is.

The financial services industry has claimed an ever-growing share of the nation’s income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it looks as if much of the industry has been destroying value, not creating it. And it’s not just a matter of money: the vast riches achieved by those who managed other people’s money have had a corrupting effect on our society as a whole.

The excutive summary of my argument is: Krugman's obvservations are largely accurate. But he is too happy to attribute it all to "Wall Street is Evil", without looking into why wall street is what it is.

But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion.

Few would disagree with the observation that the compensation structures at Wall Street banks has radically misaligned employee incentives. People more thoughtful, or interested, then Krugman might be curious as to why this is so. If He or I owned a financial sevices company, surely we would not compensate our employees in that manner. Why, then, did Wall Street Bank shareholders allow that in the banks they controlled?

Similarly, investment manager compensation appears to often transparently misalign the interests of investment manager and client. Why do clients tolerate these arrangements?

So, how different is what Wall Street in general did from the Madoff affair? Well, Mr. Madoff allegedly skipped a few steps, simply stealing his clients’ money rather than collecting big fees while exposing investors to risks they didn’t understand. And while Mr. Madoff was apparently a self-conscious fraud, many people on Wall Street believed their own hype. Still, the end result was the same (except for the house arrest): the money managers got rich; the investors saw their money disappear.

Putting aside Krugman's childish rant (all invesments are clearly not scams), he touches on a key issue. Investors often invest without really understanding what it is they are invested in. As such they are not capable of properly managing their investments. The natural question then is why is it that people invest in things which they cannot understand and so cannot competantly manage?

We’re talking about a lot of money here. In recent years the finance sector accounted for 8 percent of America’s G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing — and it probably was — we’re talking about $400 billion a year in waste, fraud and abuse.

It seems to me that the growth of the finance sector as a percentage of GDP has a lot more to do with the outsourcing of other sectors then a dramatic increase in "waste, fraud and abuse".

At the crudest level, Wall Street’s ill-gotten gains corrupted and continue to corrupt politics, in a nicely bipartisan way. From Bush administration officials like Christopher Cox, chairman of the Securities and Exchange Commission, who looked the other way as evidence of financial fraud mounted, to Democrats who still haven’t closed the outrageous tax loophole that benefits executives at hedge funds and private equity firms (hello, Senator Schumer), politicians have walked when money talked.

Its unclear to me in which direction the corruption flowed. Certainly politics is not only corrupted by "Wall Street". I think it is, at least plausible, that the collapse of Wall Street came, ultimately, because the investment banks, corrupted by the intrusion of government into financial markets, became very good at managing regulation and legislation while their ability to manage risk withered away.

Meanwhile, how much has our nation’s future been damaged by the magnetic pull of quick personal wealth, which for years has drawn many of our best and brightest young people into investment banking, at the expense of science, public service and just about everything else?

In a sense, Krugman reveals his hand. Perhaps especially because he is professor, he is concerned that students are not choosing the professions he would choose for them.

Most of all, the vast riches being earned — or maybe that should be “earned” — in our bloated financial industry undermined our sense of reality and degraded our judgment.

Think of the way almost everyone important missed the warning signs of an impending crisis. How was that possible? How, for example, could Alan Greenspan have declared, just a few years ago, that “the financial system as a whole has become more resilient” — thanks to derivatives, no less? The answer, I believe, is that there’s an innate tendency on the part of even the elite to idolize men who are making a lot of money, and assume that they know what they’re doing.

After all, that’s why so many people trusted Mr. Madoff.

Now, as we survey the wreckage and try to understand how things can have gone so wrong, so fast, the answer is actually quite simple: What we’re looking at now are the consequences of a world gone Madoff.

This is the sort of incoherent argument one expects from Krugman. Its quite the stretch to imagine that if only pay was dramatically lower on Wall Street "important" people would have gotten an earlier handle on the crisis.

But, as I commented, I certainly see a commonality across the dynamics he observes in the inevitably adverse consequences of investors throwing their money into investments they do not adequately understand and so cannot competantly manage. As a matter of public policy, then, that ought be discouraged.