Social value of investment banking.

Inspired by numerous pub conversations by now.

In my social circle it is too easy to be critical of modern finance these days and investment banking is perceived especially negatively.

The way I see it, however, is that financial banking is incredibly useful.

Take commodity trading for example. Factories need to plan their expenses ahead because they produce things in batches. Daily fluctuations of prices of commodities is an inconvenience to such planning. However by acquiring various derivates factories can make their long-term planning much easier.

If it weren’t for the investment banks, the factories would have to resort to keeping cash reserved in order to pay their workers on time. However then various questions would arise, e.g. how big such reserves should be? These days factories needn’t worry about things like that since we have highly intelligent people trying to derive accurate future prices for various commodities.

Commodity derivate pricing in the above example is similar to insurance modelling: factories pay a small premium to protect themselves from a potential big loss in case of large unexpected price fluctuations. Thus even in such hostile market conditions factory workers still take their pay home subsidised by an investment bank.

Using the above example I am going to generalise that modern finance, akin to futarchy, utilises prediction markets to guide important decisions. And this is incredibly good because predictions markets is our current best shot at modelling the future.

Another aspect of modern finance is the scope of it. If a trader is working with government bonds then he/she contributes to determining the rates at which the government should borrow. And even if the trader is only a small cog in a big wheel, once we take into account the size of a budget of a country, even a tiny cog carries a lot of financial weight.

However, whilst believing in all of the above, I can still make a case that investment banking provides negative social value.

Because of the above reasons we absolutely needs modern finance in order for the current system to function. Thus it brings a gross positive social value: without it, we’d be screwed. The world we live in now is, by historical standards, incredibly prosperous and investment banks are a necessary component of the current system.

But once we start splitting the current system into components and start attributing value to each component, we soon discover that finance is actually losing money: the cost of the 2008 crisis is now estimated at $12.8 trillion in lost output (in USA) - that’s almost one year’s worth of output!

Of course the finance contributes positively almost every year but occasionally it blows up massively wiping out all previous positive contributions.

So from now on, I will assume that finance is a net negative.

And once I made a distinction between a gross positive and a net negative the question became much easier to reason about.

If I could compare our current capitalism to some income-generating car (e.g. a taxi), I’d attribute the role of brake fluid to modern finance. Overall necessary but requires constant investment to maintain and every time it malfunctions it leads to a total disaster.

So what is our current investment into finance? The investment is our brightest minds, minds that are toiling away trying to predict things that we just can’t predict at best, devising financial instruments that are hard to regulate and police at worst. In any case, those minds could have been doing something else had the incentive structure been different.

Going back to the car analogy, it is as if we buying the most expensive brake fluid on the market only to find out it’s less reliable than a simple cheap one.

Thus if modern finance is a net negative, we should instead be working on how to contain and mitigate it. And not having geniuses run the show might actually make it easier to regulate: which has broad implications on a variety of policies.

For example, one might argue that having caps on bankers’ salaries will decentivise clever people from going into investment banks.

And it is at this point I must stop my analysis. Hopefully my future pub convesartions on the subject will be more clear from now on. Till later.