Financial Magic

A lot of people are very skeptical of the merits of modern finance. After all, financiers pay themselves obscene amounts of money, devise complex schemes to fraud people, and periodically self-destruct while calling for public bailouts. On top of that, they don't made anything you can touch or drop.

It's easy to question whether the best marginal talents headed to Wall Street are really worth their paycheck. Not too long ago, about 40% of corporate profits among companies in the S&P 500 went to the financial setor--a figure which surely represents the extraordinary level of leverage going on, combined with various asset bubbles. This share will certainly go down. But it's also true that finance is an important and value-adding portion of the economy.

Consider an economy without a robust capital market. One of Indira Gandhi's more disastrous policies was nationalizing India's banks. Lending was no longer conducted on the basis of profit, and was rather directed at unprofitable but politically sensitive areas of the economy. India also maintained very high interest rates for a long time. From one perspective, economic development is all about expanding the productive part of the economy, and an efficient financial system is necessary to funnel capital towards the productive sectors and firms. McKinsey estimates that there is a massive gap between India's most and last productive firms, and that closing the gap would yield enormous results. They also find large gains in financial sector reforms. See the Rajan proposal for what that might look like.

Making financial markets ever more efficient brings diminishing returns, but even some of the newer complex products are useful. In general, derivatives allow people to manage the uncertainty and risk inherent in dealing with goods traded on a macro level. The markets for currency, interest rates, equities, and commodities are highly volatile, yet firms and individuals are able to use derivatives to limit potential losses, amplify gains, hedge risks, or guarantee a solid stream of income. Airlines rely on fuel derivatives to control costs, while extraction companies ensure consistent profits amid large shifts in the prices of commodities. Credit default swaps enable people to make investments in corporate and government bonds--giving funding to risky companies and governments that would never otherwise raise capital. Argentina is getting funding exactly because complex finance exists--no one would fund them without protection in the case of default. Even Shiller envisions more complex mortgages--ones that would automatically forgive payments in bad times--as a way to prevent future mortgage crises. Sulpur trading schemes dramatically reduced their emissions in America, and a financial marketplace for carbon is one of the few feasible ways to deal with global warming.

But Warren Buffett calls them weapons of destruction. Well, he also holds long-term equity puts, some credit default swaps, as well as currency positions on his books. Their collapse in market value destroyed his recent profits, but he is likely to profit significantly from them in the long-term. It's long been more profitable to do as Buffett says rather than follow his statements.