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American Capitalism: Profit, But Fairly

posted by Adam Levitin

Adam Davidson wrote up an interesting apologia for Wall Street in the NY Times last week, which I think is ultimately a call for better regulation, rather than bank-hating.  I missed the piece originally, but Yves Smith found it and has nothing good to say about it. I think Yves is a little too harsh on Davidson. I've got issues with parts of the piece, but on different grounds, namely that it efuses to engage on the real issue. The problem isn't financial intermediation.  That's a perfectly fine thing that plays a useful role in society.  

Instead, the problem is when financial intermediaries do not treat the intermediating parties (meaning consumer and investors) fairly. The history of US financial services is nothing short of a history of scandals involving financial institutions variously ripping off investors and consumers. I'm not just talking about those scandals we remember, like Milken or Madoff or the recent slew or even the second tier ones like the Salad Oil scam or all of 1920s mortgage bonds. The history of US financial services is largely a history of unregulated innovation resulting in abuse and then follow-up regulatory reform. Lather, rinse, wash, repeat. 

Davidson argues that the reason to "hate the banks" is that 

Wall Street firms enforce the cold rules of capitalism: hostile takeovers, foreclosures, fee increases, defaults. But those rules clearly do not apply to the largest banks themselves. 

Davidson misses the mark here a bit. It's not just that the banks get bailed out, meaning that the rules of market discipline don't apply to them. It's that the banks frequently break the rules when applied to others.  It's fine to do foreclosures or hostile takeovers or sell consumers speculative securities. But it's not ok to foreclose without following the law or to profit on insider knowledge on hostile takeovers or or to sell investors "safe" assets when you know they are junk.

The fundamental rule of American capitalism is "profit, but fairly." Whatever one thinks is "fair", I don't think there should be much disagreement that Wall Street too often disregards the second part of this dictum to focus on the first. But take away the "but fairly" and society quickly becomes a Gilded Age baronial kleptocracy, a post-Soviet (or pre-Soviet) Russia. If we want capitalism to work--meaning that there is social stability, pace OWS--market players must play by the rules. This is where the debate needs to be focused:  ensuring that our financial intermediaries play by the rules. 

Davidson could use a little work on his history.  Consider his arguments about the importance of Wall Street for fighting poverty, innovation, funding socially beneficial projects, and for the existence of the middle class.  All seem quite debatable to me.

The Poor Would Stay Poor?

Davison argues that Wall Street has helped the poor:

In the U.S., we use credit cards, mortgages, credit scores, securitized loans and other Wall Street innovations to do the miraculous: to persuade some institution with a lot of money to hand it over to someone who doesn’t have that much. 

This is just ridiculous. First, the poor still generally do not get credit and when they do, it is of dubious value to them. For the poor, credit may help with today's problem, but it becomes tomorrow's problem, not least because of the terms on which it is offered, which are often based as much on market power, not risk-based pricing. Second, it often isn't Wall Street that's funding the loans--it is investors, with Wall Street taking a commission, meaning no skin-in-the-game. The result is what we saw in the housing bubble--Wall Street fleecing investors by brokering unsustainable loans to homeowners. Finally, Davidson presents no case that any of these innovations help the poor. If you want to look at programs that have been successful at raising living standards and eradicating poverty in the US, you need to look at government programs like the TVA (which for all of its controversy resulted in electricity and employment and a decline in malaria in the Tennessee valley). 


We have seen some innovation in consumer finance over the past century, no doubt. As for innovation, how much has really benefitted consumers, as opposed to benefitting Wall Street? No doubt we have much greater convenience in payments due to plastic and ACH. But what else? The payment-option ARM?  Yes, an innovation.  But a good one?  Credit life insurance?  Cash-out refinancings?  We have Paul Volcker's famous comment that the last major innovation in consumer finance was the ATM. I'd say that's more or less correct. Consider the cutting edge innovations of today--mobile payments, contactless, etc. None of them are game changers.

Beyond that, let's give credit where it's due. Some of the greatest innovation has been by the government, not by Wall Street. Securitization, in its modern form, is a government invention (Ginnie Mae!). Likewise, the 30-year fixed-rate mortgage is a government creation (a genesis from the HOLC to the FHA to the VA). Suburban housing--financed originally by the FHA. Other innovations have been made possible only because of implicit governmental backing (e.g., money market mutual funds, which also benefit from an accounting treatment exception). Par clearing payment systems (meaning when you pay $100, the payee gets $100 credited, not $90), are a function of the Federal Reserve.

No Awesome Things?

Davidson is on his strongest ground when he argues that but for Wall Street, lots of cool projects would never be funded. No Facebook, no Apple, no mobile phones, etc. I can't disagree with him that businesses need funding, and that financial intermediation by Wall Street enables this to happen on a much larger scale than otherwise. But whether it is being done fairly is another question, and that's where my issue lies. 

This is not my particular area of academic focus, so others may have better examples, but consider IPOs, which are the intermediation par excellence, of shifting funding from limited private sources to public sources. That's fine, but the intermediaries frequently engage in insider trading on the IPOs. And again, remember that government plays a role in all of this, with support for small businesses, ranging from tax breaks for partnerships and S-corporations to SBA-loan guarantees and industry specific (e.g., solar) loan guarantees. 

No Middle Class?

What about the "there would be no middle class" meme? This is a very debatable counterhistory. Consumer credit enabled greater consumption by the middle class, but consumer credit isn't free. It just shifts consumption between time periods. The US had a well-established middle class by the end of the 19th century (and arguably much earlier). It grew substantially in the 20th century, but the GI Bills and post-War employment boom and unionization had as much to do with that as anything. 

Still, consumer credit played a role, but that role can't be attributed solely to Wall Street. The original consumer credit wasn't Wall Street. It was companies like Singer Sewing Machines or Sears Roebuck and employer- and community-based credit unions. Banks didn't do consumer finance for quite a while. If you look at the source of mortgage loans historically, the "household sector" was a major provider well into the 1950s, meaning that you would get a mortgage from the rich guy down the street or from your uncle, etc., rather than from a bank. As for other financial services, they can, have been, and are often provided not by the private sector, but by the government. Recall that we had a US Postal Service Bank from 1911-1968, that at one point had 20% of deposits and innovated deposit by mail (the postal bank was the Republican counter-proposal to federal deposit insurance!). Most of the rest of the world still has postal banking systems. (Yes, I'm working on a project about this.) The government supports payment systems via the Fed, and housing finance via deposit insurance, FHA, VA, FHLBs, and Fannie/Freddie.

This is hardly a system of pure private capitalism. And if government is going to be assuming some of the risks, it will, not surprisingly dictate some of the terms on which services are offered, both to manage its risk and to further its policies; government support comes with strings attached.

Bottom line here is that the benefits of increasingly specialized financial intermediation are questionable, and the role of government in financial intermediation and development is often overlooked. Privatized financial intermediation often means privatization of gains and socialization of losses, as we have recently seen. More critically, though, absent vigorous regulation, it easily dissolves into a system of profit über alles, in which rules of fair play (and we can debate just what those should be) are disregarded as inconvenient. For capitalism to work in a democracy, it is necessary that everyone play by the rules of the game. 


"The fundamental rule of American capitalism is 'profit, but fairly.'"

Where is this written? Why did we invent terms like caveat emptor if everyone agreed that all business matters should be fair?

Please don't misunderstand me; I am not a hard-nosed conservative out to defend the excesses and mismanagement of Wall Street, nor do I subscribe to a laissez-faire economic theory as the best option. But it is folly to impose such a moral imperative on business; what is a fair profit margin?

Regulation should be based on recognizing the deficiencies of an unregulated free market (which has large inefficiencies due to the fact that humans are not, unfortunately, rational actors) and correcting them for the overall positive benefit of the nation.

Reform should be based on rationality, not morality.


I think you're misunderstanding the "but fairly" part. This isn't about making a "fair profit margin." It's about making the profit fairly. In other words, this isn't about capping profits, but about ensuring that when market actors make money they do so legally and without taking undue advantage of other parties.

This isn't a morality move. It's a legality move. "Fairness" is encapsulated in the law in statutes that ban "unfair and deceptive acts and practices." It's often very hard to define what those practices are in the abstract, of course, but that doesn't mean that we can't recognize an unfair act when we see it (and that's no more a morality move than outlawing theft). We might argue at the margins about what is or is not fair, but I would hope there is a broad consensus on rule of law. Indeed, I don't think there's anyone who is really going to argue that in democratic capitalism, profit-making activity is always circumscribed by the requirement of following the law.

Also, remember that caveat emptor is NOT the default rule in the area of sales of goods. UCC 2-316 has an implied warranty of merchantability that must be explicitly disclaimed. And the unconscionability doctrine in contract law provides some baseline in general. While these are certainly impositions on absolute freedom of contract, they arguably make markets more efficient by enabling easier entrance into markets for sellers by reducing the importance of reputational bonding and encourage more commercial activity by reducing buyers' diligence costs.

A reader tells me that my "Awesome things" examples actually cut the other way: Apple was not funded by Wall Street or VCs; Steve Jobs got financing against vendor orders. Similarly, mobile phone development was not Wall Street financed. And Facebook was started in a Harvard dorm room without Wall Street financing. While these entities may all currently be financed by Wall Street, Wall Street financing isn't the incubator of awesome things.

A comment on the last comment:
It seems when something in finance goes bad, "Wall Street" is blamed for it. When something that goes good is financed, all of a sudden it becomes important to clarify that the financing did not come from "Wall Street". Yet when you look at what is alleged to be wrongdoing, it more often than not involves lower level people who don't work on "Wall Street" or anywhere near it. The worst subprime lenders were non NY based, and the worst foreclosure practices are committed by persons - often lawyers or clerical personnel - far away from any New York City zip code.

A comment on the article generally: while obviously it's correct at the level of generality it is pitched at, it's equally true that "the rules" are hardly the paradigm of widely shared, even handed norms that the argument implies. The left would certainly agree with that, the Pintos and Wallisons would as well, but even from an intermediate perspective, it is clear that bank capital regulations and housing policy were designed, knowingly or not, to foster the creation of "junk" loans and their securitization to third parties. I think the notion that a small greedy group of "Wall Street" bankers were breaking a set of simple widely applicable rules is a little simplistic. When a highly regulated nationwide industry has a problem, the regulations are as much a cause as the regulated.

MT--if you look at the Davidson piece, which is what I'm referencing, you'll see that he doesn't mean "Wall Street" as downtown NY financial institutions. He is referring to large financial institutions (banks, insurance companies, etc.) in general, irrespective of their geographic location. '

You'll get no argument from me that bank capital rules (e.g., the 2002 risk-weightings change for MBS) and federal mortgage regulation going back to DIDMCA in 1980 were designed to foster mortgage securitization. But securitization of mortgages isn't evil. It's a perfectly legitimate transaction. Unfortunately, it is a transaction that offers lots of opportunities for financial intermediaries to misbehave at the expense of both investors and consumers. To me that's not the fault of regulations encouraging securitization. It's the fault of regulators for not making sure that the regulations and enforcement thereof guarded against malfeasance by intermediaries.

In any case, my point here isn't just about mortgages. The mortgage debacle is only the latest sorry chapter in a long running history. We all seem to have forgotten that in 2007, it was credit cards, not mortgages, that were the issue of the day--look at all the practices specifically prohibited by the Credit CARD Act. Is the application of payments to the lowest rate balance so different than what Walker-Thomas Furniture was doing to Ms. Williams, namely pro rata application of payments to all lines of credit?

Hi Adam -

Thanks for responding to my post. You say that reform is about making the profit fairly. My response is: what is fair about a poker game? Bluffing is certainly taking unfair advantage of another party, yet it is neither moral nor immoral in a business context where all parties are equal; it is part of the game. I freely admit that if a player finds a way to rig the game so that he always wins and everyone else always loses, then we should change the rules; that is valid reform.

My point is merely that you hook up proposed reform (or the rule of law, as you say) to a concept of fairness, and I am fine with that, as long as your definition of fair does not include "that which helps the poor" or "created the middle class", both of which are moral concerns that are cited as arguments for or against Davidson's article.

I would argue that a business profits fairly as long as it plays by the rules, and that anything within those rules is fair game until the rules are changed.

I know that caveat emptor is no longer the norm in many circumstances, but that does not mean it should not be our baseline, to be modified as appropriate. My complaint was that you seem to want to shift the baseline to a vague definition of "fair business". And business has not, and never will be, fair.

I generally agree with Yves, and I do here too, although I would not put it in the same terms (The Wife would not approve.). I think if you looked up "sycophantic" or "unctuous", there would be a link referencing Davidson's article. Wall Street plays the crucial role of intermediation? Is that what Goldman Sachs was doing with ABACUS 2007-AC1?

With all due respect, Adam, the only rule of capitalism is "profit." "Fairness" is a standard imposed by law, which is a separate institution, and let's face it, merchantability and unconscionability are incredibly low standards of fairness. On top of that, the victim has to discover the unfairness and front the costs of correcting it. That's where the regulators are supposed to come in, but they're wholly owned by the industry they're supposed to be regulating.

I think I've come up with a fair analogy of how the game has been played. You're walking down the street, and you see a street hustler working his game. There's a cop a few feet away taking no action, so you figure the game must be reasonably straight. You lay your money down, and it's obvious you've been jobbed. You complain to the cop, but he isn't interested. You're in no position to beat your money out of the hustler, so you walk away. The next day you're walking by there again, and the game is still on, except the cop and the hustler have traded places.

How can anyone honestly argue there isn't a problem?

Seemingly, capitalism is creating an unfair system. I mean with corporate takeovers and stuff, anti-trust seems to be just an idea.

capitalism works on the concept of equitability, wherein each person gets what he works for. This work in theory though. In practice, it's whoever is the greediest.

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