Grasping Reality with Both Hands

Grasping Reality with Both Hands: "financial markets have six useful purposes:

*to aggregate the money of people who ought to be savers into pools large enough to finance large-scale enterprises. [This permits economies of scale without requiring that one person finance each large-scale enterprise. Even Bill Gates couldn't finance Microsoft by himself and it is a relatively small enterprise.]
*to channel the money of people who ought to be savers to institutions and people who ought to be borrowers.
*to spread risks so that no one individual finds herself ruined by the failure of any one investment or the bankruptcy of any one company or the slow growth of any one region. [Individual small investors can enjoy high return investments that are diversified so that although each part is risky, the whole is much safer than each of its parts.]
*to keep managements efficient by upsetting and replacing teams and organizations that have outlived their usefulness. [If share prices plummet, managers get fired and/or companies get liquidated.]
*to encourage savings by creating liquidity—the marvelous fact that one can own a piece of an extremely illiquid and durable piece of social capital (an oil refinery, say) and yet get your money out quickly and cheaply should you suddenly have an unexpected need for it.
*to take the money of rich people who like to gamble and, by providing some excitement for them as they watch their gains and losses, use it to buy capital equipment that raises the wages of the rest of us (at the price of paying a 20 percent cut to the Princes of Wall Street). This is a superior use for the rich—and for the rest of us—than, say, taking their wealth to the craps tables of Vegas.

Wall Street innovations and practices are useful only insofar as they promote these six useful purposes. Call them aggregation, accumulation, diversification, efficientization, liquiditization, and casinoization.

By these standards, the current compensation scheme on Wall Street—large annual bonuses based on annual marked-to-market results—is absurd. It helps achieve none of these six goals, and it greatly increases the chance of a crash by providing everyone with an incentive to help their friends by marking up value, marking down risk, and ignoring the impact of their actions on the long-term survival of the enterprise. Silicon Valley compensation schemes seem much better: no large payouts until assets have reached maturity and portfolio strategies have proved their value in all phases of the business cycle.

...In the future, we need to change the culture of Wall Street by changing how top-earning financial professionals are paid, changing the assets they trade to make the markets less opaque, and changing the risks they run by taking capital requirements very seriously once again.

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