Everyone knows Wall Street is just a racket, soaking up large portions of the surplus and stuffing the pockets of wealthy bankers. That’s especially true since the spectacular crash of 2007-08, when millions lost their jobs and homes.
But many people also harbor the illusion, based on the relentless campaign from mainstream economists and financial journalists, that perhaps Wall Street bankers, even if they’re not doing God’s work, are at least doing something—anything—that is useful for the wider society. Why else would they have been bailed out with taxpayer money and, then as now, be paid such a fortune?
The defense of Wall Street rests on three major arguments, and Lynn Stout (Distinguished Professor of Corporate and Business Law at Cornell Law School) convincingly gives the lie to all of them.
Argument #1: Wall Street helps companies raise capital
If we look at the numbers, it’s obvious that raising capital for companies is only a sideline for most banks, and a minor one at that. Corporations raise capital in the so-called “primary” markets where they sell newly-issued stocks and bonds to investors. However, the vast majority of bankers’ time and effort is devoted to (and most bank profits come from) dealing, trading, and advising investors in the so-called “secondary” market where investors buy and sell existing securities with each other. In 2009, for example, less than 10 percent of the securities industry’s profits came from underwriting new stocks and bonds; the majority came instead from trading commissions and trading profits (Table 1219). This figure reflects the imbalance between the primary issuing market (which is relatively small) and the secondary trading market (which is enormous). In 2010, corporations issued only $131 billion in new stock (Table 1202). That same year, the World Bank reports, more than $15 trillion in stocks were traded in the U.S. secondary market–more than the nation’s GDP. Yet secondary market trading is fundamentally a zero sum game—if I make money by buying low and selling high, it’s money you lost by buying high and selling low.
Argument #2: Wall Street provides liquidity (e.g., the ability for investors to sell their investments relatively quickly)
The problem with this line of argument is that Wall Street is providing far more liquidity (at a hefty price—remember that half-trillion-dollar payroll) than investors really need. Most of the money invested in stocks, bonds, and other securities comes from individuals who are saving for retirement, either by investing directly or through pension and mutual funds. These long-term investors don’t really need much liquidity, and they certainly don’t need a market where 165 percent of shares are bought and sold every year. They could get by with much less trading—and in fact, they did get by, quite happily. In 1976, when the transactions costs associated with buying and selling securities were much higher, fewer than 20 percent of equity shares changed hands every year. Yet no one was complaining in 1976 about any supposed lack of liquidity. Today we have nearly 10 times more trading, without any apparent benefit for anyone (other than Wall Street bankers and traders) from all that “liquidity.”
Argument #3: Wall Street trading helps allocate society’s resources more efficiently (by ensuring securities are priced accurately)
This argument is based on the notion of “price discovery”–the idea that the promise of speculative profits motivates traders to do research that uncovers socially useful information. The classic example is a wheat futures trader who researches weather patterns. If the trader accurately predicts a drought, the trader buys wheat futures, driving up wheat prices, causing farmers to plant more wheat, helping alleviate the effects of the drought. Thus (the argument goes) the trader’s profits from speculating in wheat futures are just compensation for providing socially valuable “price discovery.” Once again, however, this cheerful banker “just-so story” turns out to be unsupported by any significant evidence. Let’s start with the questionable premise that the average trader earns profits from doing good research. The well-established fact that very few actively-managed mutual funds routinely outperform the market undermines the claim that most trading is driven by truly superior information.
But even more significantly, the fact that a trader with superior information can move prices in the “correct” direction does not necessarily mean that society will benefit. It’s all a question of timing. As famous economist Jack Hirshleifer pointed out many years ago, trading that makes prices more accurate when it’s too late to do anything about it is privately profitable but not socially beneficial. Most Wall Street trading in stocks, bonds, and derivatives moves information into prices only days–sometimes only microseconds–before it would arrive anyway. No real resources are reallocated in such a short time span.
So, if Wall Street doesn’t help raise capital, provide liquidity, or help allocate resources efficiently, what does it do that benefits society?
Doctors and nurses make patients healthier. Firefighters and EMTs save lives. Telecommunications companies and smart phone manufacturers permit people to communicate with each other at a distance. Automobile executives and airline pilots help people close that distance. Teachers and professors help students learn. Wall Street bankers help—mostly just themselves.