Comparative Advantage Creates Value

April 2, 2009

Rortybomb has a post up where he argues that the financial sector creates no value. But then strangely he goes ahead and argues that the finacial sector exists because of imperfections in the market.

Now what I esoterically read the MM Theorem as teaching us is that we can say that the financial sector here is only adding value if and only if it is resolve a market imperfection. There is asymmetric information – the factory knows it’s profitability better than the Doctor does, and could rob her. So we hire analysts to keep an eye on the investments. There are coordination problems – the factor might need 1,000 doctors to each give $1,000 before it can make its profit. There are costs associated with having to declare bankruptcy and there are benefits to having debt – you can write it off your taxes. As such, you’ll want to hire some corporate finance people to set up your company correctly.

Taking his logic forward, we would find that no intermediary creates value, of course provided there are no market imperfections. But even in perfect markets there is a need for intermediaries such as retailers, distributors, transactors.

The reason for this is simply that they do create value due to the comparative advantage they bring to the table of doing a particular job better than someone else. Whether it is providing convenience, reducing search costs for customers or simply being a trusted third party to the transaction.

He displays a chart showing how the financial sectors profits are an outsized portion of the overall profits

Financial Sector Share of Profits

Financial Sector Share of Profits

But a simple way of looking at this, is simply that the comparative advantage of the rest of the economy with respect to finance is lesser. Manufacturing gets outsourced to China and Mexico, support services get outsourced to Philippines and India and consequently moving a percentage of the profits in these businesses offshore.

Financial services simply have a structural advantage in the US economy and their share of profits simply reflects that. As structural changes take place and comparative advantage of firms changes, this will also change.

Alchemy of Finance

March 18, 2009

Steve Waldman riffing off on a statement by Arnold Kling that the key job of the financial system is to intermediate, to transform long term risky capital into short term liquid capital. As he rightly points out, there is no magical way to do this except through a misdirection of people and an implicit government guarantee of all capital.

This goes to the heart of the current financial crisis, that an intermediary could take on all sorts of risks funded via capital which they classified to their investors as risk-free.

Steve Waldman goes on to list a number of suggestions of what can be done in the future such as dis-intemediate, through equity arrangements rather than debt. But even equity arrangements need intermediaries and as long as people are not aware of the risks that they are undertaking or the intermediary obfuscates the risk.

A big reason for this is the bank depositors, house buyers, investors, insurance buyers have been innured to the fact that they are carrying any risk. Most people don’t expect to sell their cars or electonics at a higher price than what they bought it for. These are not seen as store of value, but rather consumption goods.

What a majority of people want it a store of value which will protect them against rising cost of consumption in future. The government should issue Inflation adjusted bonds and go on a campaign that this is the only reliable store of value. In every bank branch there should be signage just like there is on cigarette packets that there money is at risk with photographs of people made destitute by foolish investments. Everytime someone buys any asset which they buy simply because they think it will go up in value, governments should proactively start a Public service campaign which talks about how asset prices tend to fall after they have gone up. They do it for cigarettes, AIDS, STDs, flu epidemics, so why not for financial epidemics. It’s not bullet proof but atleast a counter-balance to the irational exuberance of people.