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1 November 2013 CFA Institute Journal Review

Finance: Function Matters, Not Size (Digest Summary)

  1. Rich Wiggins, CFA

The author explores whether the financial sector is too large from a welfare analysis perspective, which requires determining whether the given resource allocation is efficient. Economics is meant to explain behavior; the author revisits a number of puzzling aspects of the world for which real life behavior does not appear to follow economist predictions.

What’s Inside?

When studying markets, economists want not only to understand how prices and quantities are determined but also to be able to calculate how much value markets create for society. During the last 30 years, there has been seemingly oversized growth in the financial services sector; the author explores the repercussions of this growth. He discusses a number of examples that are at odds with traditional economic analysis (referred to as distortions), with special attention to instances in which a divergence occurs between reality and what economists consider to be more socially desirable outcomes.

Supply and demand, in an ideal world, would lead the finance industry to maintain a proper and socially beneficial size, but identifiable market distortions suggest the need for regulation. The author explores this issue as well as the reasons for high fee persistence in asset management, whether real estate agents are worth their fixed-percentage commissions, and the puzzle of information trading.

How Is This Research Useful to Practitioners?

The recent literature suggests that there is a connection between economic volatility and the size of the financial sector. Studies on this topic include quantitative models that suggest—with great detail—that the financial sector in the United States is about twice as large as is ideal.

But the author uses no mathematics, relying instead on an entertaining and breezy writing style to address the strength of—and intellectually dissect—various arguments that pass judgment on the proper size of the finance industry and whether individuals are dramatically overpaid. He communicates an appreciation of the need for humility in economics and potentially makes some progress toward explaining how the world actually works.

How Did the Author Conduct This Research?

The author’s research is a response to the work of Robin Greenwood and David Scharfstein (Journal of Economic Perspectives 2012), which reflects the widespread opinion that finance is too big. The author opens by noting that the United States spends $150 billion a year on seemingly worthless advertising and Kim Kardashian earns $600,000 just for showing up at a nightclub in Las Vegas. Both expenditures seem silly, but questioning the rationality behind them is pointless; they are probably worth it, or they would not be made.

Along the same lines, economists can argue that real estate agents are not worth their percentage-of-the-sales-price fees, but arguing that these contracts are suboptimal ignores the fact that architects and contingency fee lawyers charge percentage fees; even corrupt officials take percentage bribes. In theory, only naive uninformed investors would pay the high fees associated with hedge funds and private equity, but ironically, the University of Chicago’s endowment is invested in these high-fee products, despite a long history of published academic reports by its own faculty in support of passive approaches. Interestingly, the portfolio has delivered 500 bps of alpha with an approach that bears no resemblance to the standard portfolio theory taught in the university’s classrooms.

Abstractor’s Viewpoint

The financial sector was at the heart of the 2008 global financial crash, but with the big banks gobbling each other up again after the crisis and bonuses on the rise, it is not surprising that analysts would look for indications that Wall Street learned a lesson or that the financial sector will be in better shape when the next recession hits. The author concludes that the size of the financial sector is not important; furthermore, the world is neither as ordered and precise nor as rational as economists pretend, but it seems to work. Markets are not perfectly efficient, but they are effective. This conclusion has public policy implications that suggest that government regulation is probably unnecessary, serving a special interest, or counterproductive.

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