Wall Street Actually Does Very Little That Is Useful These Days

Financial firms share of GDP has increased globally in the last few decades due to increasing financialization. In 2010, the total compensation of US financial firms came to 9% of US GDP; in the UK, that number is 10%. Please note that that is the total of profits, wages, salaries, and bonuses. It specifically does not include any assets they control. Historically, financial firms made up less than 5% of GDP until the 1980s, but have been rising ever since. And what accounts for this dramatic increase - primarily excessive trading most of which is now driven by high-speed, computer driven activity. In the mid-1970s, 20% of the outstanding shares traded in the course of a year. These days, that number is well over 150%. Back in my day, this was considered churning and was illegal if done for a customer account. Yes, it increased fees for the broker and the firm but it contributed nothing except higher costs for the customers. Considering that most investors are relatively passive, it's hard to see how all this extra trading really helps us. Wall Street will say it gives us greater liquidity and better price discovery. But most people didn't have any problems selling their shares back in the 1970s.. And these days, the increased price discovery happens in milliseconds which is hardly beneficial to most investors. The other major claim of Wall Street is that they provide the much needed allocation of capital to firms that need it and that is certainly true. Unfortunately, these days, it is only a small part of their business and only makes up about 10% of financial firms' profits. Most of the rest is taken up with all that excessive trading. So the question remains, what are we really getting for all that money that Wall Street is making? Well, Lynn Stout at the Stigler Center at the University of Chicago Booth School of Business answers that question far better than I just have. And that is why I am posting her answer here in full:

Does Wall Street Do “God’s Work”? Or Even Anything Useful?

Posted on August 31, 2016 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).

There’s just one problem: the Wall Street mantra isn’t true.

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 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.

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.

(Note: Lynn Stout is a Distinguished Professor of Corporate and Business Law at Cornell Law School)

Disclaimer: The ProMarket blog is dedicated to discussing how competition tends to be subverted by special interests. The posts represent the opinions of their writers, not those of the University of Chicago, the Booth School of Business, or its faculty. For more information, please visit ProMarket Blog Policy.