The expensive zero-sum game of financial services

According to Jeremy Grantham

My previous argument in the Economist debate* was that the 3% of GDP that was made up of financial services in 1965 was clearly sufficient to the task, the proof being that the decade was a strong candidate for the greatest economic decade of the 20th century. We should be suspicious, therefore, of the benefits derived from the extra 4.5% of the pie that went to pay for financial services by 2007, as the financial services share of GDP expanded to a remarkable 7.5%. This extra 4.5% would seem to be without material value except to the recipients. Yet it is a form of tax on the remaining real economy and should reduce by 4.5% a year its ability to save and invest, both of which did slow down. This, in turn, should eventually reduce the growth rate of the non-financial sector, which it indeed did: from 3.5% a year before 1965, this growth rate slowed to 2.4% between 1980 and 2007, even before the crisis.


One of my nastiest shocks in 45 years was the realization one day in 1985 that we had been ripped off by our then favorite broker on one of the early program trades we were doing. We had supposed we had developed a trusting relationship. We had certainly done many incentive trades that were successful from our point of view. Perhaps, with hindsight, our strong incentives might have merely motivated them to rip off some other client.

So there is an irony in incentive payments. When institutions, for example, pay 20% of their profits to a hedge fund, they are presumably paying a market-derived competitive rate. But what the institutional industry in total misses is that it is a zero-sum game. All of the profits the hedge fund makes are extracted from the market at someone’s expense, let us say, to oversimplify, another institution’s expense. One part of the collective institutional fund universe is paying a large group of hedge fund managers to squeeze gains out of another part of the total pot and then is sharing these gains in a rather cannibalistic way. The incentive payment is designed in a way that encourages and maximizes this extraction of gains at their own collective expense. One institution pays a fee to encourage another institution’s loss, and then participates in the loot. The logic is acceptable only because it is obscured by a fallacy of composition: we always forget that we are the market, and that all costs are a reduction in our returns.


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