On Finance

In certain quarters it’s being said that finance serves “essentially a back office function” and, to make matters worse, that much of the industry is “detracting from rather than contributing to economic wellbeing”.

There’s no denying the evidence that an excessively large financial sector distorts the economy.  Worse, by fomenting a toxic combination of political corruption, popular cynicism about markets, and thickets of ineffective (albeit well-intentioned) regulation, the industry perpetuates its own bloat while getting further away from its central job of funneling capital toward its most productive uses.

Given all this, it’s become fashionable to tar those taking jobs in finance (apart, apparently, from the banker protagonist of It’s a Wonderful Life) as engaging in socially pernicious “wheeling and dealing”.  The only surprise is that the “gnawing ennui within the financial industry” hasn’t curdled into the near-suicidal temperament of, say, the legal profession.

The risk, however, is that this unfocused animus entrenches a myopic and detrimental attitude towards a broad industry that, with no overstatement, serves as the control room for modern society.


Start with the common critique, usually involving the lazy slur “speculation”, of financial activity that doesn’t explicitly and plainly channel savings into productive investment.  Whether its adherents realize it or not, this view implies a value spectrum with investment bankers (who underwrite stock and bond offerings) and, I suppose, bank loan officers on the “useful, if not loved” side.

On the “useless and hated” side sit the men and women working for asset managers, hedge funds, venture capital firms, private equity shops, and on bank trading floors, whose day-to-day mainly involves buying and selling equities (stocks, or whole companies), debt, commodities, and other pre-existing assets.

What does all this shuffling around do for society?  It’s mankind’s best (albeit imperfect) mechanism for setting accurate prices for stuff.  Financial markets determine and disseminate values for airlines, natural gas, tech startups, coffee, apartment buildings, electricity, canola, and (in the form of discount rates applied to future cash flows) for time itself, not only in absolute terms but also relative to all the other things.

Why are pricing signals so important?  You can’t funnel capital towards its most productive uses without a reliable way of pricing risk and return.  At best, well-set prices allow capital and labor to be allocated across firms in a way that minimizes the total costs of production, letting us produce more of what we want using less time and fewer resources.  At worst, disallowing markets from setting accurate prices results in misallocation and shortages (see: water in California, just about everything in Venezuela).

Superior “micro” pricing signals are a crucial factor behind wealthier economies’ “macro” productivity advantage over developing countries.  Accurate prices allow individuals, companies, and governments to quantify seemingly subjective yet crucial trade-offs between consumption and investment, work and leisure, among potential locations and formats for housing, between vegetables and meat, caring for older generations and nurturing the youth, the thrill of an extravagant vacation today and the comfort of a secure nest egg decades from now.

So financial markets are perfectly efficient?  Hardly.  In the long run, to cite Benjamin Graham, markets are weighing machines: sober appraisers of underlying value.  In the short run, they are voting machines: irrationally exuberant during booms and preposterously pessimistic during lean times.  They act as an accelerant on both the upside and the downside, funnelling gobs of money to growing firms while hastening the demise of those that have passed their prime.

Speculative enterprise, “though sometimes productive of temporary mischief, yet leaves behind it lasting benefits”, from transcontinental railroads to plentiful fiber-optic bandwidth.  Even 2008’s skyrocketing oil price (a key contributor to that year’s crisis) “de facto funded and implemented the sort of global energy tax that collective government action failed to institute”, accelerating the shift to renewables and buying humanity more time to figure out how to deal with climate change.


Moving on to the belittling of finance as a “back office” incidental to the real movers-and-shakers of the economy: the corporate titans and (God help us) politicians who actually steer the investments and policy actions that determine the course of history.

The C-suites of ExxonMobil, Google, and the like are responsible for momentous decisions, from aggressively disrupting complacent broadband providers to undertaking transformative cross-border investments, that are informed by and impact workers and consumers across industries and nations.  They are, in other words, a big deal.

How are investors and traders a bigger deal?  They set the terms of the whole game.  Based on a relentless, ruthlessly competitive re-appraisal of a nearly infinite set of variables, from the anticipated timeline for solar grid parity to confidence in the Japanese Prime Minister, they dictate the incentives that steer corporate honchos and the criteria used to grade their performance.

Their moves establish the tariff on German coal emissions, the value of executive compensation, the spur for planting a marginal acre of soybeans, the trade-off between building something in-house and buying out a competitor, and the penalty for botching up a mission to resupply the International Space Station.  They operate a real-time referendum (in the form of forex markets) on the political economy of virtually every nation (or dysfunctional supranation, in the case of the Eurozone), determine the valuation premium attached to exceptionally capable managers, and assign the cost of capital for everyone from Russian phosphate miners to Pakistani scooter-buyers, not to mention the heavily-armed insurance conglomerates we call governments.

So all finance is valuable and good?  Nope.  While one might expect an increasingly affluent, complex, and interconnected economy to require a larger financial sector, that doesn’t mean that the people currently employed in finance have a monopoly on effective capital allocation, that the megabanks shouldn’t be broken up, that ever-rising stock buybacks (which implicitly shift a greater share of investable cash from companies to investment professionals) are a Good Thing, or that it makes any sense to assign SnapChat a valuation equal to that of Chipotle.

It certainly doesn’t mean that everyone should entrust their savings to an investment manager; logically, “the universe of active investors cannot possibly outperform the index (even before fees), as every dollar of outperformance must be equalled by a dollar of underperformance”.  While professional fund managers can plausibly still beat the market, basically by taking advantage of retail investors or otherwise exploiting (thereby correcting, at least in part) the market’s inefficiencies, most people, to borrow a line from Busta Rhymes, should just invest up in a mutual fund (or, even better, a basket of low-cost ETFs).

What does it mean, then?  Finance is the control room atop the boiling reactor chamber of the modern economy, establishing more precisely than any codified regulation, in much greater detail than any electoral ballot, quicker than any opinion poll, more holistically than any supercomputer, how society values anything at any given time.  It is a potent, essential refraction of base emotions, a high-stakes clash of greed and fear that happens to be a majestic apparatus for mankind’s progress.

Upcoming musing:  Why finance is perhaps the only type of work humanity may never want to completely outsource to machine intelligence.