The Third Rock Forum - Economics

Another, most interesting brain teaser from Paul G. about bankers making money. He writes:

"We usually expect those who make money to invent something, or to make something or to offer something rare and exceptional or to add value to something….. It seems to me that investment bankers, especially those dealing in derivatives, don’t meet any of the above criteria for high financial rewards… (YET), It is generally true that, in normal circumstances, banks, in particular investment banks, can make enormous amounts of money."

 

The reason why this is absolutely true is that there is one more way to make money; not by human effort or creation but by money itself. How? Investments by gambling on future developments of one kind or another. House price rises, world crop shortages, climate change, developing perceived consumer needs, to name a few of the areas of such gamble.

Paul goes on: "Many commentators have drawn the parallel between investment banking and gambling.   Well, in that both seem to be activities divorced from the real world in which luck plays a critical role, the parallel holds good."

 

This is where the premise applied by Paul G  is unrealistic. There are gamblers who gamble on nothing else but a lucky outcome. They normally lose and lose their own money.

Investment bankers do not trust, let alone use, luck as the basis of their actions. Rather, they analyze the real world, with all its foibles and momentum and place informed, calculated bets. They can and do lose, but, more often than not, they WIN vast sums of money, because of  their knowledge of the real world.  Example, George Soros has made 1 billion pounds by accurately predicting what British politicians will do in a crisis of Stirling in a particular given situation. He needed to know the world financial tensions applicable, and needed to know what politicians will hold more important, the country’s economy or their reputation.

So, Paul G asks," What kind of economic system provides the greatest rewards for those who gamble with the wealth created by the inventors, manufacturers and service providers but who themselves do not invent or make anything?"

 The question is valid if there were only those ways of making money Paul G lists. Again, the economic system provides the greatest rewards for those who make the greatest amounts of money – but not from the activities selected by Paul G. The reason is obvious and right.

Governments are deeply in trouble financially as they spend far more than they can afford by buying votes to win elections. They are desperate for tax revenue regardless of the harm their tax policies cause in the real economy. (Example, in Hong Kong having a tax take of between 12-15 % there appeared to be little need for social benefits.)



Investment banks are a source of vast sums of tax revenue even when they cheat the Treasury. This is not a fault of the capitalist system but a characteristic of it, especially in a democracy. What effect all this makes on the real economy is much more dependent on politicians than bankers. Politicians make the rules of the game the bankers play them.

Consequently, Paul G’s proposed answers are really directed to politicians rather than bankers. It must be born in mind that the bankers’ reckless landing practices of the first decade of the 21st Century fuelled seven boom years with huge beneficial impact on everyone’s economic wellbeing. No-one, not even bankers, wanted or could stop that euphoric disaster that followed. That was a hell-of-a distribution of wealth in practice!

In my view, the most practical answer to all this is for everyone, from a pimp to a Prime Minister to create a world where everyone will live within their means and concentrate on wealth creation only. Everything else will fall into place.

Georgebundle

I more or less understand how bankers make their money.  My question is why.   When George Soros made a $1 billion out of betting against sterling, he obviously made himself extremely rich, or even richer than he was before.  But did he increase the world's wealth?  Not at all.  He simply transferred money from other people's stock of money to his own.  

The premise behind my question is that there is a connection between productive economic activity and wealth, that there is some kind of a relationship between the world's productive economic activity and the world's stock of money.   When Dyson designs a better vacuum cleaner he fulfils a number of economically desirable goals.   He puts money to work; he makes or buys manufacturing equipment; he employs production staff, marketing staff, adminstrative staff.   People buy his improved vacuum cleaner.   They clean more effectively, happily and probably more quickly.  They have more leisure time.   This is all good.  

When George Soros places his bet, none of this happens.  Dyson makes money and Soros makes money but there is a difference.   One is creative and constructive; the other is neutral and parasytical.  

I realise I have simplified things a bit (as ever a master of understatement).  I know governments print money regardless of the wealth-producing economic activity.  But I guess my real point is very clear.   For capitalism to work well, we need Dysons; we don't need Soroses.   Of course, while the system is as it is, there will always be Soroses.  We need a way to tune the system so that there are no opportunites to make a $1 billion without putting in any amount of work that could possibly justify even 1% of $1 biiilon.  I know I'm asking a lot but, let's face it, the existing system came close to screwing the entire global economy (indeed it may have come closer than we think) so the rewards for recalibrating capitalism are enormous.

Paul G. understands how investment bankers make lots of money. He asks: but WHY?

I made the mistake in my earlier reply to his original article to have  referred  to Mr. George Soros and his adventure with the Treasury. I simply meant to illustrate the point how easy it is for money to make money with the knowledge of the components involved in a transaction. Nothing more. Even in the case of Mr. Soros, the money made was not made for him but for several thousand smaller investors who have become members of Mr. Soros's investment platforms. How that money, then, made to function in the real economy was upto  those who spent it or re-invested it.

The answer to Paul G.'s question, why? lies in the method of how wealth creation is funded. The simple chain is like this: no dyson can produce a widget, provide employment and contribute to the funding of the government and the pension funds of the next generation without a banker funding his activities. No banker can fund such activities without having funds available to him. No banker will ever be able to fund all the wealth creating activities in a modern economy out of monies that are deposited in the bank by savers or current account holders. That world is gone. Now, if we think it fair, advisable, necessary to restrict bankers to make huge sums of cash by  speculation on the financial markets, who is going to reduce, in turn, their own requirements for cash support? Governments? Industry?Dysons? House purchasers? Future Pensioners? Who?

Just because the investment banker does not need to use the same muscles as a producer of widgets his activities are not less required in the world economy than anyone else's efforts. Now, when their activities are encouraged  by political objectives (abolishing boom and bust, for example) allowing them to throw money away by the bucketful into everyone's pocket, (instant distribution of wealth) things can get terminal. Every one of us were delighted to enjoy the benefits of "mannah from heaven" and did not want it to end untill the catastrophy became visible. Now, typical to human uproach to problems of their own making, we all shout: "Bloody bankers, they nearly ruined the world"! Why should they be rewarded by sums of money for this performance that a widget producer can only dream of? Because they were not only allowed to do it but enouraged to do it by those who write the rules. Quess who they are!

I think I understand the need for capital as investment in the real economy, just as I think I understand how bankers make money.   My problem is that the bankers make so much money without contributing to the real economy.   I suppose I’m concerned that

a)      the free market model of capitalism (which seems so elegant and appealing in theory) frequently doesn’t work in practice

b)      in a global economy, bankers have seized the opportunity to conduct business in a world so distanced from the real economy that they can effectively skim off much of the world’s wealth into their coffers without making any useful contribution to the creation of wealth.

OK.  So you could argue ‘what does it matter?’   The bankers have to invest or spend the money they appropriate so the money doesn’t disappear.   But it does matter because they are not motivated to use the money for the benefit of the real economy; their drive is to make more money in the ‘casino’ world of derivatives and obscure financial instruments which even they don’t fully understand.  So we can end up with a situation where innovative start-ups or successful companies needing loans have no chance of getting finance from banks simply because it’s much easier for the banks to make money by buying and selling packages of debt in an investment market where no one knows what the package of debt contains.  Note: the bankers make money; they don’t create wealth.

Because of the ease with which investment bankers can make money in their ‘casino’ world, increasingly they have no understanding at all of how the real economy works.   It’s a dangerous mentality.  (it’s a slightly irrelevant example but I recall going into my NatWest branch - part of RBS - at the height of the crisis, when RBS had just posted the biggest loss in corporate history, to see a sign in the bank offering the services of NatWest financial expertise to help me run my business.)

So what am I suggesting?   I think we can now clearly see flaws in the capitalist system. It’s not a perfectly logical, closed system.   It is a useful but open-ended system where the components can easily get out of balance.  So what! you say;  we now all recognise the need for regulation.   But I don’t think regulation will do it.   We need to adjust the system itself so that banks are relocated in and refocused on the real economy.   Of course we need banks.  But we need banks to contribute to wealth-creation; not to impede it.

How do we do this?  I guess it’s obvious  that I don’t know.  I’m suggesting, as a start,  we make investment bankers invest in the real economy of companies, not in clever but impenetrable financial instruments; and that they should be held personally and corporately accountable financially for the wisdom or folly of their decisions.   So let’s ban trading in arcane financial instruments; and let’s find a way, through legislation or taxation,  to correlate the money banks and bankers make with the success or failure of the real wealth-creating economy. 

Now that Paul G., has arrived at the main point of his eariler deliberations, I can stop playing the 'devil's advocate'.

Ever since the Naked Ape developed villages and cities and discovered agriculture, some 6000 years ago, unlike during the hunting periods in his existence, it encountered a 'surplus' of  food which was over and above immediate requirements. That surplus, which we now refer to as 'profit' has become a tradable entity. Fast forward to the 21st Century and we find that we are trading a huge variety of 'surplus' world wide. Call it capitalist, call it socialist, call it Fred. It does not matter. In recent decades there were, indeed, two types of economy that were compared by the chattering classes: capitalist and socialist economies. As one Trade Minister from the socialist camp put it in a radio interview in the UK, when asked what was the difference, said: "Well, the basis of the Capitalist Economy is the process of men exploiting men. In the case of Socialist Economy, it is the other way round".

Bankers, who had to employ a person to deliver a deal accross the street, later, who were able to send a fax to secure a deal were only able to make money when they supported economic activities in the wealth creating processes. Once, digital technology enabled them to make thosands of deals all over the world in minutes, opportunities have arisen to make money on transaction deals alone. This was closely followed by the appearance of new financial instruments with 'surplus' value to be traded. Derivatives were created. The world of wealth creation and money making have parted. Is there a way back? Do not attempt to answer yet. Have a look at what has happened since?

Latest digital technologies allowed the creation of fast frequency traders. That means a new way of making money, even without trading derivatives or anything else.  Fast frequency traders are able to lock onto any substancial trade instructions and get to the target faster than the instructions itself,  buying up the target entity then change the price only by a fraction of a cent or penny and re-sell the entity to the original requester of the deal. This takes place in milliseconds. This process  is imperceptable to both the buyer and the seller. Depending on the size of the deal the fast frequency dealer can make a substantial sum of money on each deal and can make hundreds of deals in an hour.

Banks arre no longer the culprit. They are probably as much of the target as anyone else. Paul G., and all of us are now looking for a solution in the wrong place.

I am most grateful to Paul G. Although, I do regularly solve the world's problems single handed, this is the first time I have actually been invited and encouraged to do so. So, here it goes.

By far the greatest volumes of speculatory money is invested  in the Forex markets. That is, buying and selling currency. Now, cash rich people and organisations hate having cash in the bank. They want cash to be working. So, to redirect the huge amount of cash away from currency deals to wealth creating processes, we need to make the currency market unsuitable for speculative investment. How? Well, how was this situation existing before 1971? The values of most leading currencies were pegged to the value of gold. That's how.

What is the difference? Since the value of all currencies were stopped being linked to the value of gold, they have become confetti money without inherent value. Their assumed value is what the market from time to time believe it is. That goes for the us dollar, sterling, euro, whatever. In otherwords, it can be manipulated by market movers. Peg the value of most currencies to the value of gold - or salt, liver sausage, porridge, what ever you like - and the value difference between currencies will not be tradable. So, this vast cash avalanche moving the Forex market will have to go somewhere else. Where this new area of investment be? The answer may be hidden in another area of consequence. The impact on the relative GDP performance of competing countries.

The relative performance of competing countries in the field of import/export will still flactuate, but will always balance out in the long term. That would allow the development of internal wealth creating processes, in each country, to be more encompassing and not simply focusing on those supplying the export market.  In a word, divest the economic systems round the globe of insanity, complexity and waste.

How is that to get on with?