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It's all about the rents, baby!

Yves has a very clear post on "rents" here:

A clever post at VoxEU discusses why financial innovation isn’t what it is cracked up to be, and typically leads to what economists call “rent seeking” and mere mortals call “ripoffs”. ...

Finding that “innovation” is mainly, if not solely, beneficial to the new product pushers seems so obvious in the light of the developments of the last twenty years of the financial services industry that it scarcely seems worthy of mention. However, the post by Bruno Biais, Jean-Charles Rochet, and Paul Woolley offers another insight:

We describe the evolution of a financial innovation and show how rents rise progressively to the point where the agents end up capturing the bulk of the return from the innovation. The key assumption of the model is the presence of information asymmetry; the agent has more information than the principal and the agent’s interest and objectives are not necessarily aligned with those of the principal.

Despite being based on a single innovation, our analysis can be used as a metaphor for the financial sector as a whole. The model also shows how innovations and rents carry the seeds of their own destruction to the point where principals are no longer receiving an adequate return and refuse to support the innovation, which then collapses. Perhaps in line the global financial crisis, the model suggests that high and rising rents of agents offer a lead indicator of crisis.

Yves here. This is a very powerful finding. If there is a way to further substantiate this observation, it proves what many believe: that an overly large (in terms of profit) financial sector is unstable. Its real economy cost become too high and users withdraw from the particularly abusive products. This would give arguments to rein in the financial services more heft. ...

The article also refers to some empirical work by Thomas Philippon and Ariell Reshefalong similar lines:

Their study observes a burst of financial innovation in the first half of this decade and rapid growth in the size of the finance sector, accompanied by an increase in the pay of managers. They estimate that rents accounted for 30 to 50% of the wage differential between the finance sector and the rest of the economy*. Philippon and Reshef point out that the last time this happened on a similar scale was in the late 1920’s bubble – also with calamitous consequences. It is significant that a high proportion of the net revenues of banks and other finance firms went to the staff rather than shareholders.

While correlation is not necessarily causation, the pattern is awfully persuasive.

And these rent-seekers are the very same ones who installed Obama in office, were bailed out by him, to this very day are operating with complete impunity, and will cause another crisis.

NOTE * Remember, the financial system has been pulling away from the rest of "the economy" since the Conservative Ascendancy began in the mid-70s, so this percentage differential has been compounding. I wonder how much of today's extreme income inequality is due to it?

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