The rise and fall of Wall Street

It is a much discussed issue these days and also Mr. Obama mentions that it is no loss if not every individual with analytical skills is headed for Wall Street. How right he is. There is nothing wrong with working in the financial area and I happen to be interested in it as well. I remember when I was choosing my study subject that I went with my guts, I have had a passion for economic topics early on and I went with it. That’s what many do and I was convinced it is best to choose according to your talents and interests, not where the job prospects are best or the highest salaries are waiting. Others might, of course, opt for the direction where the money is and seldom has the choice been so clear and easy: Finance is where the money is.
Well, it used to be the dot-coms before and I am too young to know what it was before that. However, this time even those who didn’t decide with their briefcase in mind in the first place got a second chance. Either they were lucky enough to be in some natural science field or if not, whatever you did before, you could go to a horrendously expensive business school for your MBA (I always wonder how expensive a year of education can be; if Paul Krugman explains international trade theory to me I might have sort of a headstart, but only to certain extent and I am not sure if I didn’t also get it those days with my old, rather unknown professor – but ok as an economist I should know – it’s just supply and demand). So it was comparatively easy to get into finance and even if it hadn’t been your passion, the prospect of big money was convincing enough. Together with a positive sentiment in society towards those who amounted material riches the smartest and the most ambitious went into finance. The talents helped making banks more and more inventive and exploit every smallest opportunity to make profits. Such talent involved obviously not only those who could crunch numbers, but also well connected political lobbyists that helped soften financial oversight. As a result, the boom in finance was alive for an unusually long time. Economic reasoning would suggest that one sector cannot uphold overly competitive salaries for an extended time because more and more talent will stream into those sectors and drive down wages. This did not happen this time and high-paid jobs remained plentiful.
However, the boom happened in a very sensitive economic sector. Financial institutions always walk on dangerous grounds and a failure of one institutions carries the risk of causing a collapse of the whole system. Exactly that happened and instead of regulating itself by decreasing wages the system fell apart. It is only natural that the people involved in finance want to go back to their old ways. The reason why those employed in finance made so much money is owing to an intrinsic characteristic of banks: they can take on huge risks promising them enormous gains in the case of success but may drive them out of business otherwise. Since nobody owns a bank personally and is only an employee, it is quite natural that too much risk is taken on. If the bets don’t win, the bank fails and the taxpayers needs to come up for the bill and if everything works out the jackpot is waiting. So the upside is on your personal account and the downside on somebody else’s. The problem is called moral hazard. Of course, for somebody in finance this is a good deal and why not continue with it after society paid the bill for the last disaster and pocket some money until we send them the next invoice.
There is nothing wrong with paying high salaries to top executives for that they are achieved leaders carrying lots of responsibility. However, the way to get rich should not be open to any newly graduated that can place some bets and ultimately risk taxpayer money.

Risk aversion and economic growth

The concept of risk aversion is crucial for many basic theories in finance and portfolio theory. To give an example: Stock A has an expected return of 10 % per year with a standard deviation of 15 % and stock B has the same expected return and a standard deviation of 10 %. The term standard deviation expresses the risk of the stock; the higher the standard deviation the higher the risk. As a result, stock B offers the same expected return as stock A, but is less risky. A risk averse person would now prefer stock B over stock A. Depending on the individual risk aversion a person is willing to give up a certain amount of expected return in exchange for lower risk. Generally, people are assumed to be risk averse and few scholars doubt that the vast majority of individuals would opt for stock B in that example. Unfortunately, the world does not always present itself in such a clear, straightforward way. A lot depends on how such a decision problem is presented and how complex it is.

I want to present another, quite hypothetical example. Assume there are two economies A and B. Both have an expected annual growth rate of 3 % (I’m optimistic here). In line with the example from before, economy A has a standard deviation of 2 % and economy B of 4 %. That should express that the growth rate of economy A is in average much closer to the expected, average growth rate than economy B. Which economy would you rather live in? How much growth would you be willing to give up in exchange for a more steady economic growth? Again, the world is not that simple as in that problem and it is not that easy to choose or create economies in the proposed way. There are a multitude of factors that influence how sensitive an economy is to the boom and bust cycles that appear naturally in capitalist economies. Recently one major factor has drawn much attention: regulation and oversight of the financial system.

The world has learned again, the painful way, how important appropriate regulation of the financial system is. There is apparently a clash of the more risk tolerating Anglo-Saxon tradition and the Continental European tradition of more state control and intervention. It does not come as a surprise that all parties are fiercely rallying for their stance on how regulation should be shaped in the future. In the past it was much easier for each country to model its own regulatory framework and decide on how much risk the financial system is allowed to carry. Today, this is not possible anymore. The system falls with its weakest element. The interconnections of global finance and trade are so strong that no single country or block can isolate itself from a financial meltdown as the current one. Most Asian countries have healthy financial systems – still they suffer from the failures in the U.S. and Europe. Therefore, it is logical that those interested in a more conservative and restrictive approach on regulation are concerned that their efforts at home are in vain if other important actors do allow for lax regulations. Ask the German or French governments which have been pushing for stricter regulation long before the crisis started; they could not prevent that their banks (especially the big corporate ones in Germany making up only about 25 % of the market) got caught up in the turbulences and mounted huge losses the taxpayer has to pay for ultimately.

At the end of the day there is nothing the international actors have to agree on and there most probably will be no comprehensive regulation package guaranteeing global oversight as the more conservative nations wish for. They will rightly perceive that as a setback since they cannot achieve their desired, risk averse regulatory framework. As a matter of fact the Anglo-Saxon world has more pull in that issue not because they are bigger or more important but if they do not put financial institutions on an equally short leash they will almost inevitably drag others into a more risky sphere. From the Continental European point of view this appears like a classical prisoner’s dilemma where they pay the cost in terms of slower growth and others profit from their efforts to decrease the risk for the global economy. This is, however, not such a clear case as e.g. the environmental question where everybody at least acknowledges the common goal (that doesn’t necessarily trigger appropriate action). It is rather a clash of culture, attitude, and believe when it comes to economic policy and there is no right or wrong – at least not necessarily.

To bring in a personal note, I believe that most individuals would opt for a more steady economy if asked the question from before directly – which they are, of course, never confronted with that way. A quite complex structure of socio-economic and political factors builds what I described as an economy carrying more or less risk. Taking into consideration what happens right now on a global scene – riots in various European countries, migrant workers lightly forced to go back home, not least to mention the poorest and most vulnerable on this planet struggling for bare survival – is in my opinion evidence enough to opt for a tighter approach on financial regulation. The wealthy people of this world can wait another year to buy a second home or scale back on some other luxury whereas for the weaker actors of the world economy such a meltdown as the current one is an existential thread. And even the wealthy western world might sleep better knowing that their jobs will most likely exist the next day and they can provide a steady home for their families.