Jenny Strasburg captures the mood on Wall Street in her article in the Wall Street Journal this morning: http://online.wsj.com/article/SB20001424052748704515704575282982462922628.html#mod=todays_us_money_and_investing.
“The competition is on to scoop up Wall Street traders and portfolio managers increasingly unnerved by the likelihood of sweeping new financial regulation.
Since political momentum began building earlier this year to limit trading for profit at Wall Street firms, traders have been exploring their options, and some have already left. Outside the banks, private investment funds looking for traders have been gearing up for a hot talent market.”
You change the incentives and people change…people move.
With the situation being more mobile than ever, with the technology more available and adaptable than ever, with the future more uncertain than ever…people…and the system…can change more rapidly and in more different directions than ever before.
And, that is what is happening!
This is one thing that Congress (and others) can’t seem to understand. Even after observing fifty years of the most dramatic financial innovation that has ever taken place in the world, the members of Congress seem to believe that they can “freeze” things, return to the past, and prevent the recent financial crisis from ever occurring again.
They also seem to think that the government is blameless from creating any incentives that might have a derogatory impact on the future that they want to create.
People in the Obama administration, as well as members of Congress, seem oblivious to the fact that over the last fifty years the United States government, Republicans and Democrats alike, produced a fiscal environment that created the incentives that led to a burst of innovative activity in the financial sector that produced massive changes in the way people did business and in the composition of the American economy. A brief picture of the environment.
From January 1961 through January 2009, the Gross Federal Debt of the United States rose at a compound annual rate of 7.7%. The monetized portion of the federal debt, the monetary base, rose at a compound rate of about 6.5% from January 1961 through August 2008, just before the Federal Reserve’s balance sheet exploded in response to the financial crisis that took place in the fall of 2008. The M2 money stock grew by more than a compound rate of 7.0% during the time period under review.
Thus, money and credit variables grew relatively in line with one another. Real GDP growth during this time was about a 3.4% compound rate of increase every year.
Prices, as measured by the Consumer Price Index and the GDP implicit price deflator, increased at a compound rate of about 4% during this time period resulting in a decline in the purchasing power of the dollar by around 85%. A 1961 dollar bill could only buy 15 cents worth of goods in 2008!
Inflation breeds financial innovation and the late 20th century with its relatively moderate, yet steady increase in prices, was a perfect environment for financial innovation!
The leader in financial innovation was the federal government itself, confirming what Niall Ferguson argues in his wonderful book, “The Ascent of Money: A Financial History of the World.” Ferguson claims that governments, historically, have been the primary financial innovator because of the need to fight wars. This, he continues, spilled over into the 20th century as governments needed to expand deficit financing to incorporate spending on social programs.
My guess is that in the next five to ten years we will see the biggest change in finance that we have ever seen and this change will be worldwide. I have written a little on this in a recent blog: “Changes Continue to Shakeup the Banking System”. See http://seekingalpha.com/article/200475-changes-continue-to-shake-up-the-banking-system.
The largest twenty-five banks in the United States, who control about two-thirds of U. S. banking assets in the country, are already changing their business. Again, they have already moved beyond what Congress and the administration are doing to regulate the banking system.
More important, foreign banks are changing the banking picture in the United States. Currently, foreign branches control about 11% of the total banking assets in the country. I have already stated that this will increase to 15% to 20% over the next five years or so. We see this expansion taking place before our eyes. Yesterday “China Finds a New Market for Loans: U. S.” (See http://online.wsj.com/article/SB10001424052748703957604575273011917977450.html#mod=todays_us_money_and_investing.) Today, “China Bank IPO, Possibly Biggest Ever, Set for July.” (See http://online.wsj.com/article/SB20001424052748704875604575281690877047522.html#mod=todays_us_money_and_investing.) And, don’t forget the sovereign wealth funds, huge accumulators of money.
The world of finance is changing because the incentives affecting finance are changing all over the world. I can’t even imagine what this world will look like with instantaneous trading, further ‘slicing and dicing’ of cash flows and other financial information, greater use of information theory to detect trading patterns (see my book review of “The Quants”, http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson), and more and more information markets popping up around the world (see Robert Shiller’s book “The New Financial Order: Risk in the 21st Century”)!
In the field of Complexity Theory, researchers speak of times like this when systems go through the process they call “Emergence” and “Self-Organization.” It is during times like these that one structural system is transitioning into another structural system. The problem is that no one, before-the-fact, can predict how existing information systems combine with other information to produce the resulting system. Systems just “self-organize” and a new system “emerges” from what was formerly un-organized.
This appears to be what is happening now. The movement of “hotshot” traders is one piece of evidence of this. The restructuring of the big banks is another piece of evidence. The response of hedge funds to the Congressional threat to change how partners are paid is evidence of this. The changes in financial regulations around the world is evidence of this. The growth and increased aggressiveness of Chinese banks is evidence of this. And, so on and so forth.
Congress is just speeding this change along. However, they better be careful about what they wish for because my best guess is that what they get will be nothing like what they are planning for.