Financial “Engineers,” Rethink Your Relevance to the Society

So, you are a financial “professional” on Wall Street. You think the world owes you bazillion dollars because you are: a) very smart, and b) you have an MBA in finance, may be from Wharton, or Harvard or Columbia and therefore what you do must be good. You claim that your financial “innovations” help the economy and the society more than they hurt. Really?

This is an excerpt from a WSJ discussion forum at which Mr. Volker participated in Dec 2009.

Do Innovations Do Much Good?

MR. VOLCKER: A few years ago I happened to be at a conference of business people, not financial people, and I was making a presentation. The conference was being addressed by a very vigorous young investment banker from London who was explaining to all these older executives how their companies would be dust if they did not realize the joys of financial innovation and financial engineering, and that they had better get with it.

I was listening to this, and I found myself sitting next to one of the inventors of financial engineering. I didn’t know him, but I knew who he was and that he had won a Nobel Prize, and I nudged him and asked what all the financial engineering does for the economy and what it does for productivity.

Much to my surprise, he leaned over and whispered in my ear that it does nothing—and this was from a leader in the world of financial engineering. I asked him what it did do, and he said that it moves around the rents in the financial system—and besides, it’s a lot of intellectual fun.

Now, I have no doubts that it moves around the rents in the financial system, but not only this, as it seems to have vastly increased them.

How do I respond to a congressman who asks if the financial sector in the United States is so important that it generates 40% of all the profits in the country, 40%, after all of the bonuses and pay? Is it really a true reflection of the financial sector that it rose from 2½% of value added according to GNP numbers to 6½% in the last decade all of a sudden? Is that a reflection of all your financial innovation, or is it just a reflection of how much you pay? What about the effect of incentives on all our best young talent, particularly of a numerical kind, in the United States?

In Britain, I was just talking to a high-tech company about the immense attraction to go into finance when both Britain and the United States are suffering from a basic inability to produce things competitively, to keep up with the new economy. Is this a result of financial innovation that we should be really worried about?

Let us think about what structural changes are necessary to produce what is the heart of the problem, about too big to fail, moral hazard and the rest. As I say, I agree with many of your individual suggestions, but there were no suggestions in the area of moral hazard. It was suggested to improve regulation, and that may help, but having gone that far, it is better that you talk about some more serious structural changes.

I made a wiseacre remark that the most important financial innovation that I have seen the past 20 years is the automatic teller machine. That really helps people and prevents visits to the bank and is a real convenience.

How many other innovations can you tell me that have been as important to the individual as the automatic teller machine, which is in fact more of a mechanical innovation than a financial one?

My thoughts, exactly! When a majority of smart kids shun product-oriented engineering career paths and aspire to be financial engineers on Wall Street, it is not just sad – it is downright troublesome. A bankster dude responded:

MR. MURRAY: The financial-innovation point is the one that you are making most strongly, and there was a statement that financial innovation is tied to economic growth, which Mr. Volcker is disputing. Eraj Shirvani [who is managing director of Credit Suisse in the investment-banking division], do you want to take that on?

ERAJ SHIRVANI: It is never fun to take on Paul Volcker, but maybe I can ask a question for clarification.

So, is your hypothesis that corporate bonds, the securitization market—none of these financial innovations have done anything to help the economy? What shocks me about today is the number of people in this room who have all been architects of the economy as we have it today who have now decided that all of a sudden everything they have worked on over the past 30 years is all bad and the pendulum has swung too far.

I worry when we say that nothing good can come from innovation. Have there been excesses? Absolutely. Have there been inappropriate products? Absolutely. Are there investors who should be held accountable for buying things they didn’t understand? Absolutely. However, that does not make it right to say that innovation in itself is a bad thing.

MR. VOLCKER: I am not sure that I said innovation in itself is a bad thing. I said that I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy. Maybe you can show me that I am wrong. All I know is that the economy was rising very nicely in the 1950s and 1960s without all of these innovations. Indeed, it was quite good in the 1980s without credit-default swaps and without securitization and without CDOs.

I do not know if something happened that suddenly made these innovations essential for growth. In fact, we had greater speed of growth and particularly did not put the whole economy at risk of collapse. That is the main concern that I think we all need to have.

If it is really true that the world economy was on the brink of a great depression that was greatly complicated by financial problems, then we have a rather basic problem that calls for our best thinking, and structural innovation if necessary. I do not want to stop you all from innovating, but do it within a structure that will not put the entire world economy at risk.

[Read the whole thing here]

Nobody is saying that nothing good came out of the so called “innovation.” The good that came out of is at best marginal. However, when you pit risks against rewards, it ain’t worth it. After all, this country saw the best economic expansion in the 1960s and early 70s – despite a crippling war and barely any stock market boom, much less any financial “innovation.”

My humble request to those who compare Fraud Street banksters to pigs. Please don’t insult the pigs. When pigs are slain, you get bacon. But if you slay a bankster, you get nothing.