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Why Wall Street Isn’t Useful for the Real Economy

It’s time to challenge the idea that Wall Street trading helps allocate society’s resources more efficiently

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By Lynn Stout

Bank executives frequently proclaim that Wall Street is vital to the nation’s economy and performs socially valuable services by raising capital, providing liquidity to investors, and ensuring that securities are priced accurately so that money flows to where it will be most productive. There’s just one problem: the Wall Street mantra isn’t true.

In the wake of the 2008 crisis, Goldman Sachs CEO Lloyd Blankfein famously told a reporter that bankers are “doing God’s work.” This is, of course, an important part of the Wall Street mantra: it’s standard operating procedure for bank executives to frequently and loudly proclaim that Wall Street is vital to the nation’s economy and performs socially valuable services by raising capital, providing liquidity to investors, and ensuring that securities are priced accurately so that money flows to where it will be most productive. The mantra is essential, because it allows (non-psychopathic) bankers to look at themselves in the mirror each day, as well as helping them fend off serious attempts at government regulation. It also allows them to claim that they deserve to make outrageous amounts of money. According to the Statistical Abstract of the United States, in 2007 and 2008 employees in the finance industry earned a total of more than $500 billion annually—that’s a whopping half-trillion dollar payroll (Table 1168).

Let’s start with the notion that Wall Street helps companies raise capital. If we look at the numbers, it’s obvious that raising capital for companies is only a sideline for most banks, and a minor one at that. Corporations raise capital in the so-called “primary” markets where they sell newly-issued stocks and bonds to investors. However, the vast majority of bankers’ time and effort is devoted to (and most bank profits come from) dealing, trading, and advising investors in the so-called “secondary” market where investors buy and sell existing securities with each other. In 2009, for example, less than 10 percent of the securities industry’s profits came from underwriting new stocks and bonds; the majority came instead from trading commissions and trading profits (Table 1219). This figure reflects the imbalance between the primary issuing market (which is relatively small) and the secondary trading market (which is enormous). In 2010, corporations issued only $131 billion in new stock (Table 1202). That same year, the World Bank reports, more than $15 trillion in stocks were traded in the U.S. secondary marketmore than the nation’s GDP. Yet secondary market trading is fundamentally a zero sum game—if I make money by buying low and selling high, it’s money you lost by buying high and selling low.

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So, what benefit does society get from all this secondary market trading, besides very rich and self-satisfied bankers like Blankfein? The bankers would tell you that we get “liquidity”–the ability for investors to sell their investments relatively quickly. The problem with this line of argument is that Wall Street is providing far more liquidity (at a hefty price—remember that half-trillion-dollar payroll) than investors really need. Most of the money invested in stocks, bonds, and other securities comes from individuals who are saving for retirement, either by investing directly or through pension and mutual funds. These long-term investors don’t really need much liquidity, and they certainly don’t need a market where 165 percent of shares are bought and sold every year. They could get by with much less trading—and in fact, they did get by, quite happily. In 1976, when the transactions costs associated with buying and selling securities were much higher, fewer than 20 percent of equity shares changed hands every year. Yet no one was complaining in 1976 about any supposed lack of liquidity. Today we have nearly 10 times more trading, without any apparent benefit for anyone (other than Wall Street bankers and traders) from all that “liquidity.”

Finally, let’s turn to the claim that Wall Street trading helps allocate society’s resources more efficiently by ensuring securities are priced accurately. This argument is based on the notion of “price discovery”–the idea that the promise of speculative profits motivates traders to do research that uncovers socially useful information. The classic example is a wheat futures trader who researches weather patterns. If the trader accurately predicts a drought, the trader buys wheat futures, driving up wheat prices, causing farmers to plant more wheat, helping alleviate the effects of the drought. Thus (the argument goes) the trader’s profits from speculating in wheat futures are just compensation for providing socially valuable “price discovery.” Once again, however, this cheerful banker “just-so story” turns out to be unsupported by any significant evidence. Let’s start with the questionable premise that the average trader earns profits from doing good research. The well-established fact that very few actively-managed mutual funds routinely outperform the market undermines the claim that most trading is driven by truly superior information.

But even more significantly, the fact that a trader with superior information can move prices in the “correct” direction does not necessarily mean that society will benefit. It’s all a question of timing.  As famous economist Jack Hirshleifer pointed out many years ago, trading that makes prices more accurate when it’s too late to do anything about it is privately profitable but not socially beneficial. Most Wall Street trading in stocks, bonds, and derivatives moves information into prices only days–sometimes only microseconds–before it would arrive anyway. No real resources are reallocated in such a short time span.

So, what does Wall Street do that benefits society? Doctors and nurses make patients healthier. Firefighters and EMTs save lives. Telecommunications companies and smart phone manufacturers permit people to communicate with each other at a distance. Automobile executives and airline pilots help people close that distance. Teachers and professors help students learn. Wall Street bankers help—mostly just themselves.

Originally published at Promarket.org.

2016 September 1


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  • Dick Burkhart

    Right on!

  • For example, I want to trade some exotic thing, where do I find the market service for it? “Wall Street” usually creates it. Also, the question is what is “Wall Street”. There are many firms that don’t even reside in NY. probably you should talk about “crook” banks, not some mythical “Wall Street”. If all trading could be made by “robots” and government owned firms, the information advantage probably can be removed from “crook capitalists” and odds can be more even.

  • Hmm. A couple of issues. First, if “Wall Street is providing far more liquidity… than investors really need” why do people voluntarily pay that $500B? Could at least some of that be due to requirement imposed by the government (rightly or wrongly)? For example, to satisfy demand for products that meet banks’ capital requirements by structuring new financial products.

    Second, it is unclear what the argument against price-discovery is? Is it that firms invest too much in research relative to the value? If so they are mostly hurting themselves and there are already adequate incentives not to behave so inefficiently. IN any event that does not seem likely to be a big social problem.

    Let me suggest an alternate explanation for at least a significant part of the $500B spent on finance: people in all sorts if situations highly value the ability to to manage risk. If I want someone else to take on the risk of a Chinese meltdown (or innumerable other possibilities) using the financial markets I am able to do so. This ultimately let’s me concentrate on my business or my life with reduced costs of financial distress or worry about financial distress. This has significant value for many people and they are willing to pay for it.

    This is not to suggest that we live in the best of all possible worlds, simply that this piece ignores perhaps the biggest service the financial markets provide.

    • Some truth in what you say, but also a major issue in terms of risk.
      Using money as a universal measure of value tends to decouple people from the actual effects of their spending decisions. All risk gets melted into a pool of “money” and great reliance is placed on actuarial tables of past behaviours to determine what risk is present.

      That entire approach fails in times of rapid exponential change across multiple domains simultaneously.

      Most people fail to understand that in many cases of low probability high impact risk the low probability only refers to its occurrence in any particular year, with a sufficiently large time-frame, the probability of occurrence asymptotically approaches unity.

      These two different domains of higher dimensional risk cannot be dealt with in the incentive structure available in market systems.

      So while at the first order abstraction your argument appears sound, at the next order it fails completely, and actually turns into a risk multiplier.

      To me it is clear, beyond any shadow of reasonable doubt, that our societal reliance on markets as a measure of risk is now actually the greatest existential risk to us all.

      • I still think a nuclear or EMP event is “now actually the greatest existential risk to us all.” 🙂

        • That’s a biggy – for sure.
          As are direct hit by a large CME, novel virus with a slow double time but high fatality, etc.

          And the danger of thinking in terms of money does actually seem worse to me, as it is so deeply hidden from most people, and once it spirals out of control could be the trigger for the one you mentioned, and a rather too large a set of similar things.

  • All true enough, and added to the fact that any market based system is incentivised to actively work against universal delivery of any good or service, even when the technology for such universal abundance exists, and we have something of a perfect storm across economics, ethics, politics and culture more generally.

    There is a way out, and it does essentially involve ending our reliance on markets as a measure of value, and adoption individual life and individual liberty as the prime values in society, supported by fully automated production and delivery of all essential goods and services.

    The technical difficulties are trivial in comparison to the social issues involved in changing paradigms of understanding.

  • “Most Wall Street trading in stocks, bonds, and derivatives moves information into prices only days–sometimes only microseconds–before it would arrive anyway.”

    I’ve read law. I started studying monetary economics about 10 years ago. This supposed science of economics is, these days, all about teaching “front-running” the search for yield anywhere and everywhere.

    With NIRP and negative bond yields the, competitive, chase for yields has come to a screeching halt. There are no more spreads to be found, for this is how successful this chase for yields has been.

    We are now entering a new era where central banks dominate the whole of the financial markets for they can print money for free, and will only pass on the crumbs to team players.

    I’ve not seen economists discuss the subject like this, how sad is that.

  • ari9999

    Thanks to Lynn Stout for pointing out that the Wall Street emperor has no clothes and essentially is stealing everyone else’s.

    Dr Stout notes 2007-08 data that finance industry employee earnings totaled $500 billion a year. According to a 2013 National Institute on Retirement Security study, at least 38 million US households have zero assets held in retirement accounts. That leaves about 80 million households that may hold at least a few dollars. (The NIRS reported that working-age households held an average of $3,000 in retirement accounts — near-zero in terms of retirement security.)

    Let’s do a chainsaw rough-cut: finance industry compensation came to more than $6,000 a year for each of those 80 million households. Or, if you prefer, $2,000 a year for every adult in the US, including tens of millions of adults who don’t even have a bank account, let alone savings.

    I know, this calculation is flawed a dozen different ways. Regardless, I think it provides a general sense of scale — the scale of the Grand Scam that Wall Street perpetrates on the rest of us suckers.

    • SLDI

      State of the World Economy: The Emperor Has No Clothes
      by Sustainable Land Development Initiative
      September 1st, 2011

      “While today’s existing global power structure continues to try to conduct business as usual and insist that the economy is in good standing, there is no question that existing systems are unsustainable. The economic value of all of our assets and resources are at stake and dealing with the symptoms of the problem rather than their root causes, while delaying the consequences and numbing the public to their real effects, only exacerbates the inevitable results.” – http://www.triplepundit.com/2011/09/state-world-economy-emporer-clothes/

  • Jim Hultman

    NOTHING will ever exceed the combination of population control and supply/demand until nature deems it time for the human race’s extinction. ’nuff said. In the interim, there will be a lot of misery

  • Noscibilis

    In 1970 the average lifespan of a company in S&P 500 was 30 years or so. Technological and social change was slow and it did make a lot of sense to have long – perhaps several years – portfolio holding periods.

    Things are different now. The average lifespan of an S&P 500 company is only 10 years or so. Technological and social change has accelerated immensely. Opportunities and industrial landscape change quickly. Shorter holding periods (and more trading as a result) make more sense.

    When an asset manager (e.g. pension fund etc) decides to rebalance its portfolio all it needs is abundant liquidity at a reasonable price. That’s what Wall Street supplies.

  • blogospheroid

    For a genuinely more pro-market perspective, please check out J.P.Koning’s equity deposit idea.

    http://jpkoning.blogspot.ca/2016/01/even-cheaper-than-etf.html

    https://alternativeeconomics.co/blogline/30670-the-social-function-of-equity-deposits

    If there is value in your argument, then the equity deposit should pick up as a product.

  • David Moskowitz

    Having been an entrepreneur trying to raise capital for the past 20 yrs, I can say that Wall St is worse than useless. It attempts to de-risk investing to the point that no useful investments are made at all. (Silicon Valley seems less risk-averse, but computer science is man-made and not as complex and unpredictable as biology). In biotech, scientific dogma rules–surely the wrong approach for funding breakthroughs. Wall St uses successful biomedical researchers as consultants to vet investments. To be successful in science, one must get NIH grants. So the consultants Wall St uses evaluate an investment possibility just like the NIH would. It’s not exactly crony science, but it’s close. Revolutionary technology that eliminates diseases is what patients desperately want, but it’s not what Wall St delivers. Here are a couple of examples involving dialysis (1) and cancer (2).
    1. http://genomed.com/images/guyot_dec09nl.pdf
    2. http://genomed.com/pdf/precision-medicine.pdf

  • Patrick cardiff

    Thank you Lynn Stout for delving into the particulars regarding Wall Street’s role in our economy. My opinion about high finance has always been that making money on the margins of other people’s money is rather … distasteful, not really a way to “earn” one’s keep, and “probably not, in general, productive for society; not beneficial.” You put firepower behind that opinion but it remains for us all to realize it and do something about it, to gain some political power, to change it.

  • MilkywayAndromeda

    https://uploads.disquscdn.com/images/4c7b52c3c3ee06985d5d17df3c26ac9ff3658f7b12cfa42ff7946e83c9abfeb9.jpg

    Brilliant!
    [ As famous economist Jack
    Hirshleifer pointed out many years ago, trading that makes prices more
    accurate when it’s too late to do anything about it is privately profitable but not socially beneficial.]
    […Teachers and professors help students learn. Wall Street bankers help—mostly just themselves.]

  • GaryReber

    This is an excellent article by Lynn Stout, the Distinguished Professor of Corporate and Business Law at Cornell Law School. Stout challenges the notion that Wall Street helps companies raise capital. “If we look at the numbers, it’s obvious that raising capital for companies is only a sideline for most banks, and a minor one at that. Corporations raise capital in the so-called “primary” markets where they sell newly-issued stocks and bonds to investors. However, the vast majority of bankers’ time and effort is devoted to (and most bank profits come from) dealing, trading, and advising investors in the so-called “secondary” market where investors buy and sell existing securities with each other. In 2009, for example, less than 10 percent of the securities industry’s profits came from underwriting new stocks and bonds; the majority came instead from trading commissions and trading profits (Table 1219). This figure reflects the imbalance between the primary issuing market (which is relatively small) and the secondary trading market (which is enormous). In 2010, corporations issued only $131 billion in new stock (Table 1202). That same year, the World Bank reports, more than $15 trillion in stocks were traded in the U.S. secondary market–more than the nation’s GDP. Yet secondary market trading is fundamentally a zero sum game—if I make money by buying low and selling high, it’s money you lost by buying high and selling low.”

    When I write about broadening productive capital asset ownership, I am advocating that EVERY child, woman and man be empowered to acquire NEW stock issues, representing the formation of new productive capital that generates its own earnings to pay for itself. As binary economist Louis Kelso noted: “The pre-tax yield of corporate assets of prosperous companies varies from 25 to 60 percent. The yield on secondhand securities is around five or six percent. Sure, with capital gains, you can get a little more, but don’t forget, that’s a zero-sum game; for every gainer, there’s a loser. Wall Street doesn’t fly any airplanes or raise any corn or do anything else in the way of producing products and services. It just plays games with your dough. And when you take it out in pensions, you’re going to get less than the company put in for you. You have to; that’s the dynamics of it.”

    Unfortunately, the vast majority of Americans have been ill-educated and ONLY think in terms of a job to earn an income or government subsidies such as an Unconditional Basic Income. They have been kept from understanding how real wealth is created and how the system facilitates the already wealthy constantly acquiring ALL new productive capital wealth.

    Conventionally, most people do not have the right to acquire productive capital with the self-financing earnings of capital; they are left to acquire, as best as they can, with their earnings as labor workers and the pledge of past savings. This is fundamentally hard to do and limiting. Thus, the most important economic right Americans need and should demand is the effective right to acquire capital with the earnings of capital. Note, though, millions of Americans own diluted stock value through the “stock market exchanges,” purchased with their earnings as labor workers, their stock holdings are relatively minuscule, as are their dividend payments compared to the top 10 percent of capital owners. Statistically, stock market wealth is held by a relatively small number of the most affluent. In reality, most Americans don’t have any stocks to their name. In fact, many Americans don’t even have any savings to their name. Pew Research found that 53 percent of Americans own no stock at all nor any retirement accounts, and out of the 47 percent who do, the richest 5 percent own two-thirds of that stock. And only 10 percent of Americans have pensions, so stock market gains or losses don’t affect the incomes of most retirees.

    What historically empowered America’s original capitalists was conventional savings-based finance and the pledging or mortgaging of assets, with access to further ownership of new productive capital available only to those who were already well capitalized. As has been the case, credit to purchase capital is made available by financial institutions ONLY to people who already own capital and other forms of equity, such as the equity in their home that can be pledged as loan security — those who meet the universal requirement for collateral. Lenders will only extend credit to people who already have assets. Thus, the rich are made ever richer through their continuous accumulation of capital asset ownership, while the poor (people without a viable capital estate) remain poor and dependent on their labor to produce income. Thus, the system is restrictive and capital ownership is clinically denied to those who need it.

    Thus, as Kelso asserted: “The problem with conventional financing techniques is that they address only the productive power of enterprise and the enhancement of the earning power of the rich minority. Sustaining or increasing the earning power of the majority of consumers who are dependent entirely upon the earnings of their labor, or upon welfare, is left to government or governmentally assisted redistribution of income and to chance.”

    At Agenda 2000 Incorporated, the advocacy firm I founded with Louis Kelso, and the Institute For The Pursuit Of Economic Justice at Berkeley, we believed that the business corporation, which holds its capital assets in the form of stock ownership, was society’s greatest social invention and that its executives had a fiduciary responsibility to exercise its vast power and finance capital growth in ways that took in the corporation’s natural constituency of employees and consumers as stockholders. We recognized that industrialization established the business corporation as the dominant organizational force of modern America. We saw the business corporation as an untapped, unimagined potential entity for solving the very economic problems that defective corporate strategy has created. We advocated Kelso’s financing tools and economic proposals, while devising other practical ways designed to correct the imbalance between production and consumption at its source, and broaden ownership of productive capital in conformance with private property free market principles, simultaneously with the growth of the economy.

    Unfortunately, pursuing economic democracy has been frustrated by the systemic concentration of economic power and exclusionary access to future capital credit to the advantage of the wealthiest Americans. The so-called 1 percent rulers of corporations have rigged the financial system to enable this already rich ownership class to systematically further enrich themselves as capital formation occurs and technological industrialization spreads throughout the world, leaving behind the 99 percent to depend on income redistribution through make work “full employment” policies, government boondoggles, excessive military build-up and dependence on arms production and sales, and social welfare programs due to the lack of an alternative to full employment and the growing economic helplessness and dependency. The unsatisfied needs and wants of society are not in that 1 percent or for that matter the 5 percent; those people are not the ones who are hurting.

    Once the national economic policy bases policy decisions on capital ownership-broadening economics, productive capital acquisition would take place through commercially insured capital credit, resulting in a quiet revolution in which economic plutocracy will transform to economic democracy.

    What others and I at Agenda 2000 and the Institute For The Pursuit Of Economic Justice advocated was embracing the goal of teaching working people, the 99 percent, to become capital workers, those who contribute productively through their privately owned capital, which is employed in production to supplement their being a labor worker or replace the wage income from their labor entirely. The goal into the future is for all Americans to be capital workers (applying the “tools” they OWN to produce) and not be labor workers dependent on labor earnings too much of our lives. We should all be productive and produce products and services in a way in which the current state of technology permits. Not only is our right to life denied if we don’t have effective access to the ownership of capital, our liberty is denied because without economic power our political power is useless. Thus, the national economic policy should be universal participation in the ownership of productive capital, alongside full employment of the labor workforce as a direct result of building a future economy that can support general affluence for EVERY citizen.

    The purpose of production in a market economy is the consumption of products and services by the consumers who make up the economy. But without income, the non-capital ownership class, the 99 percenters, cannot afford to purchase the products and services they desire. But when incomes rise among consumers who have the need and desire to improve their material standard of living, the market demand for products and services strengthens, which in turn increases production and results in a growth economy that, as a byproduct, creates REAL jobs, not the government style make-work that has become so prominent.

    Bottom line: we need to focus on CAPITAL OWNERSHIP CREATION as the solution to economic inequality. Every government policy must be structure to optimally promote creating new capital owners simultaneously with the growth of the economy, without resorting to redistribution of wealth and income.

    The end result would be that citizens would become empowered as owners to meet their own consumption needs and government would become more dependent on economically independent citizens, thus reversing current global trends where all citizens will eventually become dependent for their economic well-being on the State and whatever elite controls the coercive powers of government.

    For specifics of how to finance future capital formation projects and simultaneously create new capital owners see my article “What Is Needed To Resolve The Destruction Of American Jobs Problem?” published by The Huffington Post at http://www.huffingtonpost.com/entry/593adb89e4b0b65670e569e9.

    Support Monetary Justice at http://capitalhomestead.org/page/monetary-justice.

    Support the Capital Homestead Act (aka Economic Democracy Act) at http://www.cesj.org/learn/capital-homesteading/, http://www.cesj.org/learn/capital-homesteading/capital-homestead-act-a-plan-for-getting-ownership-income-and-power-to-every-citizen/, http://www.cesj.org/learn/capital-homesteading/capital-homestead-act-summary/ and http://www.cesj.org/learn/capital-homesteading/ch-vehicles/.

  • Braz Mainato

    O like that program