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Response to Demeter (Reply #17)

Fri May 18, 2012, 07:48 AM

71. How Did the Original J.P. Morgan Do It?

http://www.businessweek.com/articles/2012-05-15/how-did-the-original-j-dot-p-dot-morgan-do-it

The United States emerged as the world’s leading industrial nation between the Civil War and the First World War. The towering heights of American capital were dominated by a handful of investment banks, with the most prestigious firm being J.P. Morgan & Co. Despite their considerable power, the investment banks were small. Morgan had a baker’s dozen of partners with at most three clerks per partner in the early 1900s, according to J. Bradford De Long, economist at the University of California, Berkeley. Even as late as the 1960s, Wall Street comprised some 20 partnerships with an average of 500 employees and an aggregate capital base of less than $100 million, estimates Roy Smith, former Goldman Sachs (GS) partner and economic historian at New York University Stern School of Business.

Today, Wall Street companies are global behemoths with hundreds of thousands of employees worldwide. The three best-known names—Goldman Sachs, Morgan Stanley (MS), and JPMorgan Chase (JPM)—sport a combined market capitalization of some $222 billion. Over the past three decades, finance transformed itself into a growth business. The downside was painfully revealed during the global credit crunch of 2008. And an ugly reminder of the risks inherent trading just came when JPMorgan Chase announced it had lost $2.3 billion on a derivative-based profit-making strategy gone bad...

Odds are strong that financial regulations will neither hurt the economy nor dampen innovation—two traditional cautions. The reason is that the modern finance industry has become a bloated, inefficient sector of the economy. Put it this way:
“The finance industry of 1900 was just as able as the finance industry of 2010 to produce loans, bonds, and stocks, and it was certainly doing it more cheaply,” says Thomas Phillippon, finance economist at NYU’s Stern School of Business at New York University. Taken altogether, he adds, the “finance industry’s share of gross domestic product is about 2 percentage points higher than it needs to be, and this would represent an annual misallocation of resources of about $280 billion for the U.S. alone.”


...What happened in finance? It seems that much technological innovation dramatically hiked trading. The level of trading activity as a percentage of GDP is three times larger than at any time in history. Foreign-exchange trading volumes are more than 200 times greater than in 1977. Trading is a major revenue generator for the largest banks. Yet Phillippon says there’s little evidence that market prices are more informative than before or that risk sharing has improved. “We should all treat financial innovation with skepticism,” notes James Montier, a member of the asset allocation team at GMO, the Boston-based money manager. “All too often, financial innovation is just thinly veiled leverage.”

This isn’t to say there hasn’t been financial innovation in recent decades. The advent of the Standard & Poor’s 500-stock index in the mutual fund sector opened up low-cost, economically savvy investing for individuals. The ATM liberated checking accounts from bank branch hours. The rise of angel investing organizations created new capital-raising opportunities for entrepreneurs. Still, it’s striking how little financial innovation has benefited the economy and how much it has cost in recent decades. Perhaps we would all gain from a smaller financial system that played a supporting role to American business, rather than dominating it.

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