Archive for September, 2010
A recent study by Kaplan and Rauh (h/t Tyler Cowen) confirms what a lot of us suspected anyway: the dominance of Wall Street (bankers, hedge fund managers etc) at the very top end of the income distribution. The presence of bankers at the top end of the income distribution is not surprising – A large portion of this blog has been devoted to the subject of how banks extract significant rents from the implicit and explicit support provided to them by the central bank. It is not surprising then that a significant proportion of these rents flows directly to bank employees. But as Megan McArdle notes, this does not explain the significant presence of hedge fund managers in this list. After all, hedge fund managers do not directly benefit from any state guarantees, implicit or explicit.
The SuperStar Effect?
It is clearly possible that there are many “superstars” in the hedge fund universe who generate genuine alpha and deserve their fat paychecks. But then the question arises as to why the prevalence of such superstars has increased so dramatically in recent times. One explanation may be the increased completeness of markets in the last quarter century which enables hedge fund managers to express a much more diverse range of market views in an efficient and low-cost manner. But this must surely be negated by the reduced supply of easy arbitrage opportunities and the increased competition amongst hedge funds.
Hedge Funds as an Indirect Beneficiary of Moral Hazard “Rents”
Megan McArdle rightly dismisses the role of tax policy on pre-tax compensation of hedge fund managers. But just because hedge funds do not directly benefit from a state guarantee doesn’t mean that central bank policy towards the banking sector is irrelevant in determining their returns. For example, in my post analysing the possible strategy that Magnetar followed in its CDO investments, I observed that Magnetar essentially chose a trade with a positively skewed distribution. As I noted then, it is not a coincidence that Magnetar chose the other side of the trade that was preferred and executed in significant size by bank traders i.e. severely negatively skewed bets such as the super-senior tranche. As I have discussed many times, this demand for negative skewness is driven by the specific dynamics of the moral hazard problem in banking, often exacerbated by the principal-agent problems that exist even between different levels in banks. Therefore, the “alpha” that Magnetar generated would likely not have existed if it were not for the skewed incentives faced by bankers which in turn were driven by the rents they could extract from the state guarantees provided to them.
Economic Rents flow to the Strong
The example of Magnetar merely illustrates a more general principle that is often ignored: the ultimate beneficiary of any economic rent may be far removed from its initial beneficiary. The final distribution of rents is determined by many factors, most critically the competitive dynamics of the industry in question. In the context of our financial sector, the rents flow initially to the banks but are ultimately distributed between bank shareholders, employees, creditors and their clients/counterparties. The specifics of this distribution depends upon the bargaining power of each group and crucially the bargaining power of each group is uncertain and dynamic. So at the height of the economic boom when both equity and debt capital were cheap and plentiful, it is likely that a large portion of the rents was captured by employees, clients and counterparties such as Magnetar. Correspondingly, during the comparatively uncompetitive banking environment that emerged post the bankruptcy of Bear Stearns and Lehman, more of the rents could flow to the capital holders.
It is instructive to examine a couple of instances where the differing competitive dynamics result in dramatically different distributions of the rents flowing from socialized finance. The same moral hazard argument that I have made repeatedly for the banking systems in the United States and the United Kingdom applies in an even stronger fashion to the banking system in Germany which is dominated by a multitude of state-backed institutions. Yet Germany is one of the most unprofitable banking markets in the world – the ultra-competitive nature of the market means that almost all the rents flow out of the banking sector to their clients (depositors and borrowers such as the formidable Mittelstand).
Fix the System, Don’t Blame The Individuals
I have used the language of games and intentional agent adaptation above but the same outcome could easily arise simply via the various groups reacting to local incentives or even via selection mechanisms arising from principal-agent dynamics – Indeed I have argued that active deception on the part of economic agents is unlikely to be selected for. All of which which implies something that I have repeatedly emphasised on this blog: Fix the system, don’t blame the individuals.
The increased completeness of markets means that banks and hedge funds can implement almost any payoff they desire. Attempts to make markets less complete are futile and any attempts to do so can and will be subverted by economic agents. In such an environment, the system will evolve to a state which maximises the rent extracted from “insurance commitments” by the central bank or other state agencies. To deny this is to assume that economic agents are omniscient as well as angelic. Even angelic agents who only possess knowledge of their local incentives rather than the bigger picture will act no differently from what I’ve sketched out above – An economic system that demands such omniscience on the part of its agents contradicts the very essence of a decentralised market economy.
There are two schools of thought on the primary cause of our current unemployment problem: Some claim that the unemployment is cyclical (low aggregate demand) whereas others think it’s structural (mismatch in the labour market). The “Structuralists” point to the apparent shift in the Beveridge curve and the increased demand in healthcare and technology whereas the “Cyclicalists” point to the fall in employment across all other sectors. So who’s right? In my opinion, neither explanation is entirely satisfactory. This post is an expansion of some thoughts I touched upon in my last post that describe the “persistent unemployment” problem as a logical consequence of a dynamically uncompetitive “Post Minsky Moment” economy.
Narayana Kocherlakota explains the mismatch thesis as follows: “Firms have jobs, but can’t find appropriate workers. The workers want to work, but can’t find appropriate jobs. There are many possible sources of mismatch—geography, skills, demography—and they are probably all at work….the Fed does not have a means to transform construction workers into manufacturing workers.” Undoubtedly this argument has some merit – the real question is how much of our current unemployment can be attributed to the mismatch problem? Kocherlakota draws on work done by Robert Shimer and extrapolates from the Beveridge curve relationship since 2000 to arrive at a implied unemployment rate of 6.3% if mismatch were not a bigger problem and the Beveridge curve relationship had not broken down. Jan Hatzius of Goldman Sachs on the other hand attributes as little as 0.75% of the current unemployment problem to structural reasons. Murat Tasci and Dave Lindner however conclude that the recent behaviour of the Beveridge curve is not anomalous when viewed in the context of previous post-war recessions. Shimer himself was wary of extrapolating too much from the limited data set from 2000 (see pg 12-13 here) This would imply that Kocherlakota’s estimate is an overestimate even if Jan Hatzius’ may be an underestimate.
Incorporating Uncertainty into the Mismatch Argument
It is likely therefore that there is a significant pool of unemployment that cannot be justified by the simple mismatch argument. But this does not mean that the “recalculation” thesis is not valid. The simple mismatch argument ignores the uncertainty involved in the “Post-Minsky Moment economy” – it assumes that firms have known jobs that remain unfilled whereas in reality, firms need to engage in a process of exploration that will determine the nature of jobs consistent with the new economic reality before they search for suitable workers. The problem we face right now is of firms unwilling to take on the risk inherent in such an exploration. The central message in my previous posts on evolvability and organisational rigidity is that this process of exploration is dependent upon the maintenance of a dynamically competitive economy rather than a statically competitive economy. Continuous entry of new firms is of critical importance in maintaining a dynamically competitive economy that retains the ability to evolve and reconfigure itself when faced with a dramatic change in circumstances.
The “Post Minsky Moment” Economy
In Minsky’s Financial Instability Hypothesis, the long period of stability before the crash creates a homogeneous and fragile ecosystem – the fragility arises due to the fragility of the individual firms as well the absence of diversity. Post the inevitable crash, the system inevitably regains some of its robustness via the slack built up by the incumbent firms, usually in the form of financial liquidity. However, so long as this slack at firm level is maintained, the macro-system cannot possibly revert to a state where it attains conventional welfare optima such as full employment. The conventional Keynesian solution suggests that the state pick up the slack in economic activity whereas some assume that sooner or later, market forces will reorganise to utilise this firm-level slack. This post is an attempt to partially refute both explanations – As Burton Klein often noted, there is no hidden hand that can miraculously restore the “animal spirits” of an economy or an industry once it has lost its evolvability. Similarly, Keynesian policies that shore up the position of the incumbent firms can cause fatal damage to the evolvability of the macro-economy.
Corporate Profits and Unemployment
This thesis does not imply that incumbent firms leave money on the table. In fact, incumbents typically redouble their efforts at static optimisation – hence the rise in corporate profits. Some may argue that this rise in profitability is illusory and represents capital consumption i.e. short-term gain at the expense of long-term loss of competence and capabilities at firm level. But in the absence of new firm entry, it is unlikely that there is even a long-term threat to incumbents’ survival i.e. firms are making a calculated bet that loss of evolvability represents a minor risk. It is only the invisible foot of the threat of new firms that prevents incumbents from going down this route.
Small Business Financing Constraints as a Driver of Unemployment
The role of new firms in generating employment is well-established and my argument implies that incumbent firms will effectively contribute to solving the unemployment problem only when prodded to do so by the hidden foot of new firm entry. The credit conditions faced by small businesses remain extremely tight despite funding costs for big incumbent firms having eased considerably since the peak of the crisis. Of course this may be due to insufficient investment opportunities – some of which may be due to dominant large incumbents in specific sectors. But a more plausible explanation lies in the unevolvable and incumbent-dominated state of our banking sector. Expanding lending to new firms is an act of exploration and incumbent banks are almost certainly content with exploiting their known and low-risk sources of income instead. One of Burton Klein’s key insights was how only a few key dynamically uncompetitive sectors can act as a deadweight drag on the entire economy and banking certainly fits the bill.