WALL STREET COMPENSATION

In the current controversy over compensation for Wall Streeters and the Obama Administration’s efforts to curtail the greed somewhat, one thing is puzzling. How does Wall Street have what appears to be excess money when Main Street is hurting?

Here’s one possible answer: Wall Street has the ability to create money, not just manipulate it, reroute it, hoard it, but to actually create it. And this is something new, at least to the extent it has been done for the last few years.

How can Wall Street create money? The computer. One consequence of the Information Age, a consequence that is little realized, is that the financial system is no longer just a lubricant for economic activity involving tangible things. The financial system and its intangible products have become ends in themselves, not just means to permit the “real” economy to function.

The Information Age is about the dominance of information, and an important form of information is money. How is money a form of information? Stripped to its essence, money is just information about supply and demand. Money has provided this information since bartering receded as the major way goods exchanged hands.

But the computer and the Information Age have provided those with the capability—the Wall Streeters of the world—to create information, and thus create money. Some might say that creation is too strong a term, that information can’t be created because it was already there, just not recognizable. Okay, but the difference between creating information and recognizing previously unrecognizable information is a minor point. Much more important is that the computer has resulted in a tsunami of information with which those with the training can do extraordinary things.

Wall Street’s creation of money takes two complementary, and often overlapping, forms: securitization and derivatives. In securitization, individual loans such as mortgages are combined, through legal paperwork, into a single financial asset. Some of the interests in the financial asset are sold to investors. But some of the interests may be combined with interests in other financial assets to create what might be called a second layer financial asset. This layering process can be repeated. The effect of the layering process is to expand the total amount of financial assets in existence. Since financial assets are in essence money, the effect of financial asset layering is to create money.

Derivatives are financial instruments whose values depend on the values of other financial instruments. Futures and options are common types of derivatives. Much more exotic derivatives, such as credit default swaps, have appeared in recent years. Just as securitization results in more financial assets and thus more money, the creation of derivatives results in more assets and consequently more money.

What does the computer have to do with securitization and derivatives? The manipulation of data and the mathematical calculations that are required in securitization and the creation of derivatives would be pretty close to impossible without the processing and computational powers of the computer.

The arrival of the Information Age can be dated to the very late 1970s and early 1980s, a period when the computer started its conquest of just about everything. Those years also saw the start of a growth period for financial assets in relation to the rest of the economy. From 1945 to the early 1980s, the relationship between total financial assets in the United States and the nation’s Gross Domestic Product (GDP) was stable, ranging between 4 and 5 times GDP. Beginning in the early 1980s, the relationship changed. As a multiple of GDP, financial assets began to increase, reaching over 10 times GDP in 2007. (Data is from the Federal Reserve’s Flow of Funds.)

In the same period, a shift also occurred among holders of financial assets. The nation’s financial sector increased its share of financial assets from between 30 and 35 percent to between 40 and 45 percent. In other words, as financial assets were growing faster than GDP, a larger share of the financial assets was falling into the hands of the financial sector.

Okay, so the financial sector of the economy has become proportionately larger and a likely cause of the growth has been the computer. So what? The so what is the volatile nature of finance, a volatility very much evident over the last couple of years. The money created by financial sector is fuzzy money, easily evaporated if conditions turn mildly arid.

The so what is also the quandary about how to get a handle on the economics of the Information Age, to understand this unknown. A few years ago, those trying to explain changes talked about new paradigms. Well, a new paradigm seems called for. Reform proposals for the financial system are being put forth, but most seem to deal with peripheral matters: oversight structure, regulatory authority, and the like. The core issue is the change the computer has brought to the financial, and ultimately the economic, system. Some examination of the fundamentals is called for. Otherwise, the events of the last couple of years might just be a prelude.