Capital markets vs. Wall St.

by Russ Roberts on December 9, 2010

in Financial Markets, Uncategorized

In this post on inequality, I mentioned:

And some in the top 1% were there in 1980 and are still there because they feed at the great rent-seeking trough. Wall Street, please get a life like the rest of us where bad financial decisions have consequences.

In the comments, PDN wrote:

I agree with 99.9% of this but take issue with your snideness towards Wall Street. First, deep, broad and efficient capital markets are a critical pillar in the free market system that has delivered us our inexorable rise of living standards. It is no accident that the US, with its highly developed capital markets, has led the world in advancing living standards. Second, “Wall Street” is a simplistic term glossing over the fact that the financial services industry is a highly diverse universe where the overwhelming percent of actors DO face the consequences of their decisions. Banks failed, brokerages failed, numerous hedge funds failed, money market mutual funds failed, insurance companies failed and countless investors lost untold billions. The fact that our government panicked and felt the need to throw billions at the cascade of failure that was rolling in (and that a small number of “Wall Streeters” welcomed and encouraged the government) is not justification to take such a sweeping and dismissive attitude toward our capital markets.

Yes, “deep, broad and efficient capital markets are a crictical pillar in the free market system.” That’s why I worry we don’t have a free market system. There is no evidence that US capital markets are efficient in the way that word is used broadly in economics rather than the way it is used in finance. In the broad sense of the word, it means “undistorted” or “minimizes waste” or “encourages people to bear the full costs and benefits of their actions at the margin in order to maximize the size of the pie.” That is precisely what we do NOT have in the way financial markets are currently organized. We are right now in the middle of a giant mess at least partly if not totally because over hte last 30 years, policy-makers have systematically reduced the costs of extending credit unwisely on behalf of large financial institutions. That in turn, along with US housing policy, has encouraged leverage, especially for investments in the housing sector which encouraged trillions (with a “tr”) of dollars to go into the housing sector.

That was not efficient.

That did not enhance our standard of living. It reduced it. It also allowed politicians to justify an increase in the size of government to fight the mess we’re in.

There are parts of our financial system that I think are efficient and that enhance our standard of living. The venture capital market.

And you are right of course–there are parts of Wall Street that are subject to market forces. But as long as creditors in large financial institutions are not in that group, it doesn’t matter how many banks or hedge funds or insurance companies fail–the players in the large financial institutions will be encouraged to be over-leveraged and the decision-makers who make imprudent decisions with borrowed money will be highly rewarded as they pick up nickels in front of the steamroller.

Until the relationship between large financial institutions and Washington changes, we will have crony capitalism rather than the real thing.

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