Krugman nailing it

I don’t always agree with Krugman, especially when it comes to politics.  But on economics he’s dead on, and this column nails it.  The point: people on Wall St. get paid far too much, not because no one deserves that kind of cash, but because the way they “earn” it is not really providing a valuable service.

First, the free market determines Wall St. compensation, so it must be adding value to the economy, right?  Wrong.

But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion.

Consider the hypothetical example of a money manager who leverages up his clients’ money with lots of debt, then invests the bulked-up total in high-yielding but risky assets, such as dubious mortgage-backed securities. For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses.

Ok, so a few guys got rich and that is unfair.  What is the cost to us?  Well, the cost is in wasted resources.  Money invested that does not bring a return is lost.  It’s the equivalent of an agrarian society taking a storehouse of grain and lighting it on fire in the expectation that it would bring rain.  When the rain doesn’t come, the grain is still gone forever.  How much grain did we burn for rain that is never coming?

We’re talking about a lot of money here. In recent years the finance sector accounted for 8 percent of America’s G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing — and it probably was — we’re talking about $400 billion a year in waste, fraud and abuse.

I read somewhere that something like 60% of growth in profits in the U.S. over the last 3 years was in financial services.  An accurate figure on this is needed, but even if that’s close, it’s bad news.  It means that most of our “profits” were zero.

Then there is the demographic effect…

Meanwhile, how much has our nation’s future been damaged by the magnetic pull of quick personal wealth, which for years has drawn many of our best and brightest young people into investment banking, at the expense of science,public service and just about everything else?

If half of the minds that went into developing derivatives had gone into, say, alternative energy, where would we be?

And finally, the corruption of reason effect…

Most of all, the vast riches being earned — or maybe that should be “earned” — in our bloated financial industry undermined our sense of reality and degraded our judgment.

Think of the way almost everyone important missed the warning signs of an impending crisis. How was that possible? How, for example, could Alan Greenspan have declared, just a few years ago, that “the financial system as a whole has become more resilient” — thanks to derivatives, no less? The answer, I believe, is that there’s an innate tendency on the part of even the elite to idolize men who are making a lot of money, and assume that they know what they’re doing.

The laws of economics are very simple and straightforward.  Incentives and self-interest rule.  Markets favor two kind of innovation — innovations of production (new, useful ideas) and innovations of deception (new ways to make people think you have useful ideas).  If you see the market lavishing rewards on someone, it tells you they’re really good at at least one of these things, but it doesn’t tell you anything about which one.

No, wait, actually it does.  Truly brilliant, useful ideas are rare.  Brilliant ways to deceive are, depending on the environment, not so rare.  As we all know, there are times and places where it is easy to lie and get away with it.  So when lots of people start making atom-splitting money, it’s a good bet that their innovation is in the craft of bullshit.