How Does The Finance Industry Generate Real Economic Value?
Note: This piece will use “capital” in the popular sense, i.e. as a synonym for “money”.
Plenty of people argue that some or all of the modern finance industry is engaged in zero-sum games. In particular, speculators, high-frequency traders, and broker-dealers are frequently vilified in this manner.
I don’t particularly care about moralizing, but as someone who’s interested in making money from the capital markets, I’d much rather play a positive-sum game than fight over a fixed-size pie. If there’s real economic value to be generated, then I don’t necessarily have to outsmart everyone else in order to turn a profit. Thus the question: does the high finance industry generate real economic value, and if so, how?
The following sections explore ways to create real economic value through finance. Each section starts with a way to create value in a more intuitive market (grain), and then moves to capital markets by analogy.
I will omit the standard explanations of both banking and insurance, since they are explained just fine elsewhere. That said, bear in mind that the functions of both banking and insurance are not exclusive to institutions with “bank” and “insurer” on their business cards—both borrowing/lending and risk pooling occur in capital markets more generally, and real economic value is created accordingly.
Gains From Trade
Let’s start with the simplest possible econ-101 example.
A farmer grows some grain, and wants money. A consumer is hungry, has five dollars, and for some reason has a hankering for unprocessed wheat. A bushel of wheat is worth more than five dollars to the consumer, and five dollars is worth more than a bushel of wheat to the farmer. They trade, and each is happier—real economic value has been created.
What’s the analogous scenario in a capital market?
A company wants some capital, e.g. to buy a new oven. Somebody saving for retirement has some money, and wants to invest it. The company issues some stock to their newfound investor, in exchange for the money.
Now it starts to get interesting. With the farmer’s wheat, it was pretty clear how both sides benefitted from the trade: the farmer had lots of wheat, the consumer was hungry. But what about the stock example? In order for the company to benefit, their capital investment (e.g. the oven) must boost their earnings enough to justify the new stock issued. So for instance, if the company had to issue 1% more stock in order to raise capital for the oven, then the oven must boost their earnings by at least 1% to be a worthwhile investment.
On the other side, in order for the company’s stock to be a good investment for our hypothetical retirement-saver, the company’s earnings (using their new oven) must yield some return.
The main takeaway is that capital markets generate gains from trade by taking some capital that isn’t being used—e.g. retirement savings—and using that capital for something useful—e.g. a new oven. This is the basis of all value creation in finance, including all of the examples to follow. If you’re ever unsure whether some part of the finance industry is creating real value, remember: at the end of the day, it’s all about using spare cash to finance investments in real business assets. Follow the capital flow, and see what it’s ultimately invested in.
So there’s definitely gains from trade in capital markets. But this scenario completely omitted the actual finance industry—they’re mostly middlemen. How do the middlemen add value?
Consider the middlemen in an oversimplified grain market. They buy grain from farmers, and sell it to consumers. Their value add is straightforward: they save farmers the hard work of finding a buyer, and they save consumers the hard work of finding a seller.
The finance industry is no different.
When a company issues stock, lining up buyers is a lot of work. Investment banks typically handle that work. Same with bonds, mortgage securities, etc. Just like middlemen in any other market, these institutions create value by saving companies the work of finding capital-sellers, and saving investors the work of finding capital-buyers.
That said, these particular middlemen have some SERIOUSLY entrenched rent-seeking. Imagine that all the grain middlemen managed to form an industry group, lobbied a bit, and their industry group was given the legal power to regulate their own industry—that’s FINRA. Unsurprisingly, they made it illegal for would-be investors to sell capital directly to companies without going through the FINRA-member middlemen, and also made it difficult for new middlemen to enter the space. They still offer SOME real economic value, but they’re also getting a lot by rent-seeking.
Anyway, those are just the most direct middlemen—those who sit directly between companies and investors. There are others, too.
Ever since ancient times, people have stored grain. It can be quite a good business: buy grain right after the main harvest when it’s abundant and cheap, store it for a while, and sell it when grain supplies run low. This can create huge amounts of real economic value, e.g. by preventing a grain shortage (a.k.a famine).
Most of the players we think of in the stock market are in the business of storing capital. They buy capital when it’s abundant (i.e. sell stocks when prices are high), store that capital, and sell it when the capital supply is low (i.e. buy stocks when prices are low). This can be a bit confusing, since buy/sell are kind of backwards compared to how we usually think of them. Fundamentally, that’s because capital is the product, whereas usually the other thing is the product and capital is just a means of exchange. But it’s the same concept as warehousing grain, and it creates value in the same way: by preventing a capital shortage (a.k.a. market crash and economic recession).
Different kinds of investors do this at different time scales. Unlike grain, there’s very little overhead when warehousing stocks, so day traders and high-frequency traders can warehouse small amounts for short times. This sort of activity prevents small market crashes—more day traders and high-frequency traders means less volatile prices on short time scales. Larger investors do the same thing at longer time scales—pension funds warehouse stocks for months or years at a time.
This is also where the information aspect of markets first kicks in. If you’re in the business of warehousing, then anticipated future abundances or shortages of capital (and of financial assets) is key to producing real economic value—and to making a profit. Again, this is counterintuitive at first. In the futures markets, for instance, we’re used to thinking about making money by forecasting abundances or shortages of commodities. To understand capital markets more broadly, we need to think of capital as the commodity.
Finally, we get to the usual picture of high finance: forecasting company performance. As before, we’ll start with the grain market, but with a twist—now there’s barter.
Rather than buying grain with money, imagine that consumers barter for grain, paying with chickens. Different consumers presumably have chickens of varying quality, so their chickens will buy varying amounts of grain.
Now, suppose some middleman comes along and realizes that a new consumer—let’s call her Alice—raises chickens of higher quality than most people realize. Everyone will figure this out eventually, as people eat Alice’ chickens and word gets around, but for now the secret is still fresh. Accordingly, this middleman offers extra grain for Alice’ chickens. Does this create real economic value?
It all depends on the elasticity of Alice’ chicken supply.
If Alice only raises fifty chickens, no matter what, then fifty of Alice’ chickens will eventually be consumed, no matter what. There’s the usual gains from trade, but the middleman isn’t increasing those. The middleman’s gain comes entirely from other traders’ ignorance of the quality of Alice’ chickens; the middleman’s gain is exactly equal to the other traders’ missed opportunity.
But the story is different if Alice responds to the higher price by supplying more chickens. Then, real economic value clearly is created. By making prices better reflect the true value of Alice’ chickens, the middleman has enabled more chickens to be created.
Now let’s switch to capital markets.
When people imagine making money in stocks, the usual picture is:
Find a company whose stock is “under-valued”
Buy their stock
Does this create real economic value?
It all depends on the elasticity of the company’s outstanding shares.
If you buy the stock from an investor, then you’re simply gaining money which that investor would otherwise have gained. It’s zero sum: their missed opportunity is exactly equal to your gain. But if you buy the stock from the company (either directly or indirectly), then it’s a whole different story. You’re supplying a bit of extra capital to the company. That will create real economic value when the company can invest the capital better than the competition—i.e. this company can get more value out of an extra oven than some other company would get out of an equivalent investment.
Put differently, suppose a middleman buys some stock in Millisoft. How much additional capital does Millisoft receive, compared to a scenario where the middleman did not buy any stock? Then, how much additional value does that capital create, when it’s used by Millisoft rather than whoever might have used it otherwise? That’s where the real economic value comes from, when forecasting company earnings.
When you think about it like that… well, forecasting earnings (and other similar activity) probably creates some real economic value, but probably not much, especially at the margin. Most of the gains from this sort of activity really are zero-sum.
I don’t have numbers on this, but I would guess that most of the real economic value created by the high finance industry comes from warehousing. Ironically, it’s largely from the day traders and high-frequency algo traders who are so often vilified.
Institutions like investment banks also create real economic value, but they are rent-heavy. Looking for places where investors’ expectations are inaccurate can create value in principle, but it’s probably mostly zero-sum.
I don’t have a complete picture of my own of how everything works and fits together, but this part seems clearly wrong:
A typical case of a stock being undervalued is when there is some large shareholder trying to exit for liquidity reasons (think of a venture capitalist selling shares in an IPO’ed company so they can redeploy the capital into new startups, or a company founder selling stock to reap the rewards of their labor) and not enough people with enough capital have done enough work to be confident of the company’s true value. If you step in as an additional buyer, you raise the price they can sell at, so for example the VC now has more capital to redeploy into their next round of investments. In general it seems that if you do additional work to bring stock prices closer to fair value, society as a whole would be rewarding people in a more efficient way, with the rewards being closer to the actual value they created, which should be positive-sum.
It is still tempting to assume each exact transaction is zero sum (while the macro level invisible hand is yielding positive sum) but that would be a mistake. First, there may be a little bit of buyer and seller surplus (represented by a market maker facilitating a strike price between the bid/ask spread). Second, risk matters—could be that gain the seller missed out on was just not the right deployment of their capital for their risk profile, so they actually aren’t “missing out” on it at all. Third, you’re not observing opportunity costs in strike prices, so could be that gain the seller missed out on was a lower conviction bet they wanted to take off so they could get into a higher conviction bet, so they aren’t actually “missing out” on it at all. Fourth, add in a subjective value function and suddenly on a utility basis, it is extremely easy to see the potential for actors to view trading as offering gains (though as mentioned, you don’t even need this to begin chipping away at the zero sum notion).
Finance is easy to side-eye, but read Matt Levine, it’s just like any other market where people are trying to solve each other’s problems and make some margin.
I have a hard time picturing the end-to-end value-add of daytraders still.
Can’t people stake their money either to increase or to decrease volatility? Amplifying every minute’s price movement by a factor of two should still be expected value zero.
I expect more value from forecasting, hopefully not just because I’ve been spending time on prediction markets lately.
If we lived in a world where speculating on ventilators and medicine and masks were accepted, going long on those enterprises weeks or months before the politicians admit a need would be useful.
At the margin, every dollar by which the price goes up is a dollar for every share the company issues, and also might change the amount of shares it issues. (Right?) If all trading stops and all that the shares do is pay out dividends on earnings, every dollar shifted from a company that makes 1% on marginal capital per year to one that makes 5% on marginal capital per year is ~+4% of real value, right? And a lot of that (how much?) is captured by third parties anyway, so if the investor sees 5% returns that’s more real value generation.
Shouldn’t every dollar that goes long on the company (vice versa for short) necessarily go indirectly, perhaps acausally, to the company? Note that the initial valuation should take into account future buyers.
This post made me feel confusion about how money keeps its value over time. So, uh … thanks!
The retirement savings/oven example gave me a giddy moment of thinking that the value of money shouldn’t be stable. And, y’know, there is in fact inflation, deflation and stuff!
Now, money’s value does stay pretty stable, but now that feels like something that needs a mechanism to make it true rather than the default.
Not quite! If there were no central bank, money’s value would not jump around aggressively and discontinuously
I believe answering such questions needs empirical tools not speculations, unless one is an armchair economist. At the starting point must be reality, then we can sit and theorise that reality
Do financial markets drive real economy? We can approach it with causal discovery tools over two time-series. We almost surely know that there is no connection between these two, for instance from papers such as IMF paper of Igan et al. 2020. Also there is a body of evidence that gdp drives financial markets, not vice versa
However, I believed that to address this specific question we have to casually study the relation between fixed capital formation or real investment and financial market growth. The literature here is inconclusive, e.g. Muyambiri2018, to the best of my knowledge.
Overall, It seems that financial markets do not have any significant effect on the real economy (e.g. look at the booming market of Caracas, Venezuela) moreover, , if we think about the human resources engaged with the financial market instead if doing something real, we can conclude that the effect is adverse.
I like your instinct here, but bear in mind that “empirical tools” does not necessarily mean spreadsheets. Numerical time series are not a very rich data source, compared to the wealth of information we can get by e.g. directly watching the day-to-day activities of market participants, or doing some accounting to track down the physical capital in which money ends up invested.
Your could do with an explanation of why rent-seeking is bad.