How much is just right?

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Finding the Value in Finance

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Does finance create value? Does it just siphon money from some people and give it to others? Does it destroy value? I see people asking these questions all the time for a pretty obvious reason: there has been broad public suspicion of finance for as long as the industry has been around. But if  we want to try answering these questions, there are some tricky issues we need to think about.

First, “finance” is actually a lot of different things. There’s retail banking, investment banking, money management, mortgage lending, consumer finance, venture capital, private equity and a whole host of other pieces of the finance industry. Asking whether finance creates value is a little like asking whether people in Albuquerque, New Mexico, are nice. Some probably are, some probably aren’t. (Apologies to Albuquerque for using you in this example!)

There’s another big problem with the question, though. “Creating value” isn't a well-defined concept. There are different notions of value. In this case, the biggest distinction is between total and marginal.

Asking whether finance creates total value is the same as asking whether we’d be better off with no financial industry whatsoever. When you put it that way, it’s pretty clear that finance does create total value. Without some kind of financial industry, our rich, modern, industrial civilization simply couldn't exist. Some form of finance is needed to get capital from those who have it to those who can put it to use. So when critics characterize the financial industry as nothing more than a rent-seeking, parasitic enterprise, they are telling us to ditch modernity itself. Bad idea.

But the more interesting question is whether finance creates value on the margin. Basically, it’s the question of whether the financial industry -- or any of its various pieces -- is too big or too small.

And that’s a really tough question. Believing in capitalism means believing that economies are basically natural systems -- that if someone finds a lasting way to make money, they are usually doing something of value. That means that if we want to look at a durably profitable industry and say “There’s too much of this,” we need some compelling reason, especially if we’re going to use the inevitably inefficient tools of government power to curb that activity. (The narcotics trade might be such an activity.)

In the case of finance, there are definitely certain pieces of the industry that seem like they might be wasteful. Take high-frequency trading. Companies make their capital budgeting decisions on long time scales. Do securities trades that cancel each other out over the course of a millisecond really do anything to change corporate budgeting decisions?

There are theoretical reasons to think that this activity really just consists of a bunch of investors racing to beat each other to the punch. In 1971, the famed economist Jack Hirshleifer wrote a paper spelling out how investors can waste resources trying to grab information quickly. If they just waited, the information would come out anyway, and they could have saved all that effort with no economic cost.

Think of all the math and science Ph.D.s who have dedicated their lives and their powerful intellects to HFT. Think of the miles of fiber-optic cable that have been laid, the computer infrastructure that has been built. If HFT is just a Hirshleifer-type tournament, then those brains and those computers represent wasted resources. The case isn’t open-and-shut -- some researchers claim HFT adds value by improving markets in subtle ways -- but it certainly makes HFT look suspicious.

Another example is the private-equity industry. A number of studies have shown that private equity, in the past at least, has created big productivity improvements at the companies it acquires. But some allege that much of private equity’s profit survives only because of tax breaks. For a list of tax breaks enjoyed by the private-equity industry, see this excellent post from 2013 by Victor Fleischer.

Private-equity tax breaks mean that in many cases, investors can receive higher returns from owning a company indirectly, through a private-equity firm, than directly, by owning its shares. That means that some of the resources -- intelligence, time, effort -- that we put into the private-equity industry might only be ways to get around taxes. From a social point of view, it would be better to either close the loopholes, or just cut the tax rates and find the revenue elsewhere.

So there are two examples of pieces of the financial industry that, for very different reasons, seem like they might be too big on the margin. But the real point here is how complicated and difficult the question is. Don’t just assume that finance is a worthless activity. If you want to prune it, you need to do the hard work of checking it piece by piece. And the case for using government power to shrink one of the pieces needs to be a pretty solid one.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net