It's easy for Occupy Wall Street protesters to assume that bankers and traders are just greedy jerks, but the services they provide benefit all of us
"Wall Street is wrong and evil." This was one of the (many) angry responses I received to a critical post I wrote about the Occupy Wall Street movement. Although protesters are unhappy for reasons dealing with issues from taxes to pollution to poor health care, they direct special rage towards Wall Street. After all, they began by occupying Lower Manhattan for a reason. Is their anger appropriate? Does Wall Street serve any purpose that makes society better, or does it just make everything worse?
Due to Wall Street's complexity, defining it isn't easy. For simplicity, let's consider Wall Street to be investment banks, hedge funds, private equity funds, and other firms that are geared towards finance. For now, we won't worry about retail banking. Wall Street firms provide a number of important functions in the economy. Let's consider some of them.
Raising Capital for Firms
How They Do It: One way banks raise capital is through pricing and selling stock to investors on behalf of a company. Another is by selling corporate debt to investors. Investment firms also help companies raise money in other ways, like by selling assets.
Why It's Important: Without capital, firms can't grow. It's an investment bank's job to bring together investors and businesses. Without their assistance, some firms would grow slower and others would fail altogether.
Why You Should Care: Growth benefits all of us. It creates jobs and promotes technological progress. Capital formation is essential to achieve robust growth.
Funding for Debt Markets
How They Do It: Banks need to get the money for loans from somewhere. A portion is provided by bank deposits. But these days, that's not enough: they must also rely on investors. So banks have several ways through which they take loans provided to both consumers and businesses and make them more attractive to investors, such as securitization.
Why It's Important: People just don't keep much money on deposit at banks any more -- and certainly not enough to accommodate all of the credit needed for the U.S. economy to function smoothly. Investors are essential.
Why You Should Care: That credit card you use, the house or apartment you live in, and car you drive was probably funded indirectly by an investor. So the loan was ultimately made possible by the presence of an investment bank. At best, credit would be more expensive without Wall Street's influence. At worst, credit would dry up entirely for many consumers and businesses.
How They Do It: A number of firms hire investment banks for their expertise. They advise firms on a number of different sorts of financial transactions, like mergers and acquisitions.
Why It's Important: If firms couldn't rely on Wall Street for its expertise, then large financial transactions would be far more difficult and sometimes impossible. Again, this would inhibit growth.
Why You Should Care: As mentioned before, growth should matter to everyone. But these transactions also have great economic benefit at times. Mergers can make the economy more efficient, and some acquisitions can prevent troubled firms from failing entirely, causing the loss of jobs and money.
How They Do It: Wall Street creates derivative securities by identifying a financial arrangement attractive to two or more parties. For example, if a flour producer wants to hedge its exposure to wheat prices rising, then the firm can hire an investment bank to find an investor who is willing to take on that exposure and price the resulting contract accordingly.
Why It's Important: Derivatives help businesses reduce risk and market volatility. In the example above, a drastic temporary price increase could put that flour producer out of business. But with a hedge in place, some of that price increase will be cushioned.
Why You Should Care: Ultimately, consumers and other businesses are also affected by how prices and interest rates rise and fall. If gasoline prices rise significantly, you might not see as big an increase in the price of your plane ticket if the airline had a hedge against oil prices rising. More generally, less volatility means a more stable economy. It also results in economic shocks having a weaker impact.
Making Markets and Providing Liquidity
How They Do It: What about stock traders? They benefit the economy in a couple of ways. First, they help to make markets. If someone is looking to sell a stock, for example, then a bank trader may be willing to buy it. Then, if someone else wants to buy it, that trader can sell it. This results in better market liquidity, meaning that it's easy to buy and sell securities.
Why It's Important: Without traders, buying and selling stocks would be far more difficult. Instead of occurring in seconds, the process could take hours or days. Pricing the security would also be difficult.
Why You Should Care: If investing was less efficient, then it would be more costly. This would mean that investors wouldn't be able to afford to dedicate as much capital to investing. Firms would receive less of that capital and growth would be slower. This means a slower economy, fewer new jobs, and less innovation.
How They Do It: Wall Street firms provide advice to businesses and individuals with capital who want to invest it.
Why It's Important: If these parties didn't have the expertise of investment managers to rely on, then they would have to do the work themselves. In many cases, these firms and individuals wouldn't invest at all, because they would fear that their lack of expertise would make the likelihood of losing their money very high. In other cases, investment would occur, but it wouldn't as effectively be ushered towards investments that will benefit the economy the most. Good investment managers will put their clients' money in the securities of firms that have the most potential, which means the money should benefit everyone.
Why You Should Care: Through investment advisors, growth is maximized because wealthy firms and individuals are comfortable putting their money at risk, and it is provided as funding to investments with the most potential. Again, everyone benefits.
But Are They Overpaid?
So maybe by now, you're convinced that Wall Street actually does serve a number of very important functions in our economy. But maybe you don't think that's the point. It's not that the work they do isn't important: it's that they're overpaid for it.
This is certainly a valid opinion: you can always feel free to believe that one worker is paid too much and another is paid too little. But opinion has nothing to do with it: the market dictates outcomes. Investment banking isn't a new profession -- it's been around for decades. So if there was some way that competition could reduce the cost of investment banking services, then it would have done so. According to the market, the expertise they provide is worth the fees that they are paid.
Of course, many in the OWS crowd would say that the market is wrong and that these individuals should be taxed at a higher rate to remedy an injustice. That's fine as a subjective view. But objectively, if you tax a certain profession at a higher rate, then it would result in fewer people pursuing that profession. The OWS crowd would probably be perfectly fine with that outcome. But as the above analysis explained, the services that Wall Street provides are actually essential and very beneficial to the economy. So reducing Wall Street's presence will also reduce the effectiveness of the important work that it does.
But What About the Financial Crisis?
Even if you're convinced that Wall Street serves a legitimate purpose and that its pay is a result of its importance to the market, you might still hate it. What about all the destruction that the financial crisis caused? This question gets complicated, and entire books have been written on it. So I'll leave this one alone for now (I am actually finalizing a 10,000 word article on what caused the financial crisis to be published later this year). Instead, I'll just end with a question. Wall Street always has and always will function to maximize profit. So what changed during the financial crisis that caused things to get so out of hand? A gigantic housing bubble was inflated and its pop sent shock waves throughout the economy. If you can get at its cause, then you will know who to blame.
Image Credit: Stephen Lam/Reuters