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How Wall Street's profits can be the economy's loss

We talk a lot about profits in this country. But we don't talk a lot about the value of different types of profits. For instance: If I steal $20 off your dresser (let's not ask how I got there), I'm $20 richer, but the economy isn't any better off. If I invent a cure for diabetes, a lot of people actually are better off. I'm obviously stacking the deck here. Theft is bad, but it can hardly bring down the whole economy. Nobel prize winner Robert Solow is being much more unfair by bringing up the financial sector:

Take an extreme example. I have read that a firm such as Goldman Sachs has made very large profits from having devised ways to spot and carry out favorable transactions minutes or even seconds before the next most clever competitor can make a move. Deep pockets in a large market can make a lot of money out of tiny advantages. (Of course, if you have any such advantage the temptation is irresistible to borrow a lot of money to enlarge your bets and your profits. Leverage is good for you, until it isn’t. It is not so good for the system.) A lot of high-class intellectual effort naturally goes into trying to invent ways to find those tiny advantages a few seconds before anyone else.

Now ask yourself: Can it make any serious difference to the real economy whether one of those profitable anomalies is discovered now or a half-minute from now? It can be enormously profitable to the financial services industry, but that may represent just a transfer of wealth from one person or group to another. It remains hard to believe that it all adds anything much to the efficiency with which the real economy generates and improves our standard of living.

You can take that a step further: Because Wall Street pays insanely high salaries as compared to, well, doing anything else, it attracts a lot of talented individuals who then spend their days creating absolutely no value. In that way, it's worse than simply moving money around. It's actively taking potential money out.

By Ezra Klein  |  January 12, 2010; 2:30 PM ET
 
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Comments

Easy solution--make these kinds of rapid trades less profitable by having a financial transaction tax (with retirement accounts exempted) that makes these small variations not worth trading.

And then reprogressiveize the tax code so that multimillion dollar bonuses are subject to a 50-80% surtax starting at 1 million or so.

Why facilitate wasting talent on arbitrage that doesn't help the economy?

Posted by: srw3 | January 12, 2010 2:52 PM | Report abuse

Its not that finding opportunities for arbitrage is not valuable. It should disseminate information between markets and make prices more "correct", so it is valuable, just not very valuable.

Then again, we may be selling these techniques short. Sticky prices can be blamed for a lot of economic failures, including the current recession. If the technology they use spread to other industries, we might end up with a *much* more efficient economy.

The biggest problem that I see here is that Goldman has an incentive to keep these techniques secret, so that this sort of innovation may never make it to the broader economy. This is exactly the type of technology that would benefit from stronger business patent law.

That said, my feelings on business patent law are generally quite mixed.

Posted by: zosima | January 12, 2010 3:00 PM | Report abuse

To suggest a very useful example of a possible application of Goldman's technology. Imagine a world where a company could engage in "wage arbitrage"; engaging in deals that would adjust wages to economic conditions near-instantly by making deals across markets; maybe workers would be induced to accept these deals by accepting a percentage of the profits from the arbitrage, maybe clauses to allow this to happen would be written into workers' contracts so that their wages would constantly be adjusted and the profits would be accrued and returned to them over their pay period.

What would be the results of this policy? #1 The economies of many currently depressed countries, for example Ireland and Spain would quickly return to flush. #2 Workers salaries might go down unexpectedly, but the drop in their salaries would assumedly be accompanied by the drops of the prices of goods elsewhere from abritrage applied to 7-11 and walmart so their buying power would stay constant, and when accounting for the profit percentage from the arbitrage, their effective buying power would go up; accruing buying power from the gains in economic efficiency.

In other words, this technology has the potential to be *extremely valuable* in the long term; Eliminating many of the economic inefficiencies that plague modern economies. The problem is that it is not applied broadly enough.

Posted by: zosima | January 12, 2010 3:10 PM | Report abuse

@zosima--What contracts? The vast majority of people work for companies that can change their conditions of work without notice or recourse, except for quitting.

And why would employers give any money to workers if they did engage in wage arbitrage? If everybody was unionized and had contracts that specified working conditions and salaries that were bargained for collectively and were in force for a stated period of time, it might be a benefit, but for most workers, its just another way to squeeze more out of them for less money.

Posted by: srw3 | January 12, 2010 3:35 PM | Report abuse

Goldman Sachs didn't "figure out" how to find out about stock movement before everyone else. They paid good money to make sure they get the tips first, probably using packet sniffers (http://www.bloomberg.com/apps/news?pid=20601039&sid=aFeyqdzYcizc).

If it were a case of "figuring out" then as soon as Goldman "figured it out" everyone else would know how to do it too.

Posted by: pj_camp | January 12, 2010 4:33 PM | Report abuse

@srw3

Wages are sticky. This is economic fact.

Read this, then talk to me again:
http://ingrimayne.com/econ/Labor/Sticky.html

If as you say, companies are legally able to change wages at a whim and pocket the profits from improved efficiency, it doesn't matter. For one reason or another, they don't actually do that.

This is economics 101. You don't need a contract or union to negotiate benefits or pressure your employer.

The only novel thing in my post, is the suggestion that Goldman Sach's technology could help us achieve the goal of decreasing price and wage stickiness if it were more widely applied.

I don't think this is unreasonable, but I'll admit that this part is speculative.

Posted by: zosima | January 12, 2010 7:19 PM | Report abuse

i actually think that as much as wall street's obscene profits are not justified by their value added, wall street's sucking of intellectual talent is even worse. The number of very smart people I met in college who ended up investment bankers (as opposed to doctors, professors, or technocrats) is staggering. Law does a pretty good job of sucking up the best and the brightest too.

Posted by: Levijohn | January 12, 2010 9:47 PM | Report abuse

I'm not so sure all these "talented individuals" that Wall Street pulls in would otherwise be making the world a better place.

More likely, they'd be robbing banks or finding better ways to dump waste surreptitiously into upstream rivers. And drowning puppies ... but, of course, everyone needs a hobby.

Posted by: dpurp | January 12, 2010 10:36 PM | Report abuse

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