Posted by: Jeff | April 23, 2010

When Innovation and Growth are Part of the Problem

I’m hoping to make next week “financial regulation week,” and I’m already prepping some posts on the subject. In the meantime, the CEO of J.P. Morgan is warning that new regulations of derivatives – a key part of the financial reform bills – could reduce his companies profits. Ezra Klein’s reaction brings up a theme that I suspect will be popping up regularly in my future posts on the subject.

“You’ll note that what’s missing from Dimon’s argument is any kind of compelling reason we should care about this,” comments Matt Yglesias. “What he’s saying is that this measure to enhance the stability of the system will take a firm with $11.73 billion in 2009 profits and turn it into a firm whose profits might be as low as $9 billion.”

I’d actually take this a step further: We should actively want that to happen. What Dimon is saying is that the complexity and opacity of the current derivatives market lets his firm skim billions of dollars in revenue from other business. Some of those business are hedge funds and professional investors and if they want to hand money over to J.P. Morgan, more power to them. But some of them are actual corporations that make actual things and are trying to hedge legitimate risks. It would be a good thing if the market weren’t structured such that J.P. Morgan could take them to the cleaners.

One of the most basic principles of capitalist economics, which a lot of people who claim to be pro-capitalism tend to skim over, is that large profit margins are generally an indication that something is wrong. In a properly functioning market with robust competition, profit margins should be extremely slim. And slim profit margins are good for consumers, because they mean low costs. (As an aside, this is one example of how market competition – properly aimed and channeled – can be a humane and progressive force.) But Wall Street’s profit margins have been absolutely enormous. Just prior to the 2008 crash, profits from the financial sector accounted for 40 percent of all domestic corporate profits. So what gives?

Certainly, the problem is not a lack of competition. (And there have been some interesting arguments of late that maybe finance is one market where lots of competition is actually a net negative.) Rather, as Klein notes, the problem is information asymmetry. Financial markets and the financial products they deal in are really complex, and firms like J.P. Morgan tend to understand that complexity (to the extent anyone does) better than the other individuals and companies they trade with. That gives them an economic advantage and, hence, huge profits. So it’s no surprise that Wall Street is not excited about financial reform’s push to end, or at least reduce, the amount of complexity and opacity involved in financial trading.

The worse problem is that complexity and opacity in the market are arguably a big part of what caused the crash in the first place. No one was able to properly assess the amount of risk the system was taking on or how that risk was distributed. So we have a situation in which profits encourage complexity and complexity encourages crashes.

The upshot of all this is that significantly reducing Wall Street’s ability to profit isn’t just a side effect of regulatory reform, or just a satisfying indulgence of populist anger; it’s actually an intrinsic part of making the system safer. It’s a standard trope in debates like this that while we want well-designed regulation, we don’t want to hamper innovation and economic growth. Financial reform is looking like one instance where that trope gets it wrong.

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