The Efficiency Debate: Why Is Finance Making So Much Money?

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Our old corporate finance professor used to love to torture his classes with the question: will increased efficiency and better information technology make Wall Street firms more or less wealthy. If you think that the capital markets have been getting more efficient, the answer seems obvious: hedge funds, investment banks and private equity firms are making even more money than ever. So more capital market efficiency means more money for finance right?
Not so fast. Witness a recent debate on the Marginal Revolution blog, an oddly popular website run by economist Tyler Cowen. In a rather small item on the site, Cowen favorably quoted another blogger called “Jane Galt”—the Ayn Rand allusive pen-name used by the Economist ‘s Megan McArdle on her own blog, Asymetrical Information. “To the extent that the superrich are pulling away from the rest of us...the most parsimonious explanation seems to be the massive increase in the efficiency, and size, of American capital markets,” Galt wrote.
Both American Conservative movie critic Steve Sailer and New Yorker financial writer James Surowiecki objected to Galt’s market efficiency explanation. A massive increase in the efficiency of capital markets should work against the interests of financiers, they argue.
"Shouldn't a more efficient financial market mean that the ROI gap on the investments of the rich and non-rich should narrow, not widen?” Sailer asks. “In 1907, it helped to be as rich as J.P. Morgan to profit reliably in the financial markets because the cost of monitoring one's investments to make sure you weren't being ripped off was so great. Now, the friction cost of investments for small investors should be less prohibitive. So, I don't see this as much of an explanation.”
Surowiecki agrees. "Steve's right: a more efficient capital market is one in which there should be a smaller, not bigger, role for intermediaries. So it seems peculiar to argue that the greater efficiency of capital markets is responsible for making all these intermediaries incredibly rich," Surowiecki writes.
But there’s no disputing the fact that “these intermediaries” are getting incredibly rich. So are the heralded efficiency gains in the capital markets illusory? In some sense, it is definitely true that financial firms are exploiting new areas of inefficiency and ignorance. Often this ignorance or inefficiency is the product of government regulations that have made the capital markets less transparent and added friction to capital movements. But is this the whole explanation?
Steve Sailer adds a clever warning against letting questions about whether finance should be theoretically profitable from getting in the way of realizing that it is a good way to make lots of money in the real world. “Back when I was taking economics courses, during Alfred Marshall's heyday, economics professors drilled into us that financial markets were efficient, and therefore you should just put your money into a no load mutual fund because even professionals can't beat the market,” Sailer wrote. “Being a trusting soul, I believed them and went into marketing research. My classmates at MBA school in the turning point year of 1982 paid no attention, went to Wall Street, and got rich.”
Sentences of Wisdom [Marginal Revolution]