In Defense of Wall Street's Huge Profits

Income inequality has yawned to 80-year high in the last decade and out-sized profits on Wall Street are partly to blame. It's something like dogma among smart progressives and moderate thinkers I follow that bankers, hedge fund managers, and the entire financial industry make way too much money doing something of way too little social value.

So I appreciate this clear and concise defense of finance's huge profits from Scott Sumner. Think about mining, he says. Getting iron out of the ground doesn't require a terribly rare skill, but finding the iron in the ground requires a uniquely skilled geologist. So miners are paid average wages for their average skills, and super-geologists are paid specially for their special skills.

In the 21st century economy, replace Iron with Capital:

In the 1950s and 1960s it wasn't that hard to figure out where capital needed to be allocated. Capital was allocated to produce steel, and the steel was used to produce cars and washing machines. Capital was allocated to the production of aluminum, and the aluminum was used to make airplanes. The most productive members of society were those who made things, and Michigan was near the top in per capita income.

Today the most productive members of society are not those who produce things, they are those who discover the things that need to be produced...

And then there's globalization, which means decisions about allocating capital can vastly improve productivity even in the old-line industries that were dominant in the 1960s, when the rest of the world hardly mattered. Finance is not that important in an agricultural economy or even in an economy where the mass production of goods can be done with almost military precision. It becomes extremely important in an economy where it is not at all clear what should be produced, or on what continent that production should take place.

Smart stuff. But there are at least three ways to fight with it. First, the real estate investment binge in the 2000s didn't produce the equivalent of an iron-rich mine; it produced a housing bubble that nearly exploded the entire financial industry, and might have without government assistance. That leads to a second objection, that the banks aren't earning their profits; they're standing on an implicit guarantee from the government (Too Big to Fail, etc), which encourages them to make high-risk/high-reward bets where the profit goes to Wall Street and the downside is shared by both bankers and taxpayers. Finally, people have argued that the financial industry does not follow the same productivity rules as the rest of the economy because it's gotten too good at reaping billions in the boom times and off-loading the social expense of their unproductive mistakes during the bad times.

Sumner responds to some of these criticisms toward the end of his piece. And once again, I don't consider myself the right judge to separate winners from losers when the subject is finance. But rich food for thought, nonetheless.