The Economics of Social Destruction

| Mon Aug. 3, 2009 12:56 AM EDT

As he so often does, Paul Krugman gets to the heart of what's wrong with the financial industry these days:

Even before the crisis and the bailouts, many financial-industry high-fliers made fortunes through activities that were worthless if not destructive from a social point of view.

[Recent examples include high-frequency trading and Andrew Hall's multi-billion dollar oil speculation.]

Just to be clear: financial speculation can serve a useful purpose. It’s good, for example, that futures markets provide an incentive to stockpile heating oil before the weather gets cold and stockpile gasoline ahead of the summer driving season.

But speculation based on information not available to the public at large is a very different matter. As the U.C.L.A. economist Jack Hirshleifer showed back in 1971, such speculation often combines “private profitability” with “social uselessness.”....As the great Stanford economist Kenneth Arrow put it in 1973, speculation based on private information imposes a “double social loss”: it uses up resources and undermines markets.

Now, you might be tempted to dismiss destructive speculation as a minor issue — and 30 years ago you would have been right. Since then, however, high finance — securities and commodity trading, as opposed to run-of-the-mill banking — has become a vastly more important part of our economy, increasing its share of G.D.P. by a factor of six. And soaring incomes in the financial industry have played a large role in sharply rising income inequality.

So what's to be done?  Krugman ran out of room before he could make any suggestions other than taxing high incomes, and I'm not sure that's really all that useful anyway.  There's a more basic problem here that has to do with financial transparency, the rise of derivatives, widespread abuse of leverage, and the basic profitability of the financial sector.  It's getting late and I don't feel like speculating on that right now, but one way or another, that's where we ought to apply our energies.

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