Is Finance Parasitic?

We all know what a parasite is: an organism that attaches itself to another organism and derives nourishment from the host organism and in so doing weakens the host possibly making the host unviable and thereby undermining its own existence. Ayn Rand and her all too numerous acolytes were and remain obsessed with parasitism, considering every form of voluntary charity and especially government assistance to the poor and needy a form of parasitism whereby the undeserving weak live off of and sap the strength and the industry of their betters: the able, the productive, and the creative.

In earlier posts, I have observed that a lot of what the financial industry does is not really productive of net benefits to society, the gains of some coming at the expense of others. This insight was developed by Jack Hirshleifer in his classic 1971 paper “The Private and Social Value of Information and the Reward to Inventive Activity.” Financial trading to a large extent involves nothing but the exchange of existing assets, real or financial, and the profit made by one trader is largely at the expense of the other party to the trade. Because the potential gain to one side of the transaction exceeds the net gain to society, there is a substantial incentive to devote resources to gaining any small, and transient informational advantage that can help a trader buy or sell at the right time, making a profit at the expense of another. The social benefit from these valuable, but minimal and transitory, informational advantages is far less than the value of the resources devoted to obtaining those informational advantages. Thus, much of what the financial sector is doing just drains resources from the rest of society, resource that could be put to far better and more productive use in other sectors of the economy.

So I was really interested to see Timothy Taylor’s recent blog post about Luigi Zingales’s Presidential Address to the American Finance Association in which Zingales, professor of Finance at the University of Chicago Business School, lectured his colleagues about taking a detached and objective position about the financial industry rather than acting as cheer-leaders for the industry, as, he believes, they have been all too inclined to do. Rather than discussing the incentive of the financial industry to over-invest in research in search of transient informational advantages that can be exploited, or to invest in billions in high-frequency trading cables to make transient informational advantages more readily exploitable, Zingales mentions a number of other ways that the finance industry uses information advantages to profit at expense of the rest of society.

A couple of xamples from Zingales.

Financial innovations. Every new product introduced by the financial industry is better understood by the supplier than the customer or client. How many clients or customers have been warned about the latent defects or risks in the products or instruments that they are buying? The doctrine of caveat emptor almost always applies, especially because the customers and clients are often considered to be informed and sophisticated. Informed and sophisticated? Perhaps, but that still doesn’t mean that there is no information asymmetry between such customers and the financial institution that creates financial innovations with the specific intent of exploiting the resulting informational advantage it gains over its clients.

As Zingales points out, we understand that doctors often exploit the informational asymmetry that they enjoy over their patients by overtreating, overmedicating, and overtesting their patients. They do so, notwithstanding the ethical obligations that they have sworn to observe when they become doctors. Are we to assume that the bankers and investment bankers and their cohorts in the financial industry, who have not sworn to uphold even minimal ethical standards, are any less inclined than doctors to exploit informational asymmetries that are no less extreme than those that exist between doctors and patients?

Another example. Payday loans are a routine part of life for many low-income people who live from paycheck to paycheck, and are in constant danger of being drawn into a downward spiral of overindebtedness, rising interest costs and financial ruin. Zingales points out that the ruinous effects of payday loans might be mitigated if borrowers chose installment loans instead of loans due in full at maturity. Unsophisticated borrowers seems to prefer single-repayment loans even though such loans in practice are more likely to lead to disaster than installment loans. Because total interest paid is greater under single payment loans, the payday-loan industry resists legislation requiring that payday loans be installment loans. Such legislation has been enacted in Colorado with favorable results. Zingales sums up the results of recent research about payday loans.

Given such a drastic reduction in fees paid to lenders, it is entirely relevant to consider what happened to the payday lending supply In fact, supply of loans increased. The explanation relies upon the elimination of two inefficiencies. First, less bankruptcies. Second, the reduction of excessive entry in the sector. Half of Colorado’s stores closed in the three years following the reform, but each remaining stores served 80 percent more customers, with no evidence of a reduced access to funds. This result is consistent with Avery and Samolyk (2010), who find that states with no rate limits tend to have more payday loan stores per capita. In other words, when payday lenders can charge very high rates, too many lenders enter the sector, reducing the profitability of each one of them. Similar to the real estate brokers, in the presence of free entry, the possibility of charging abnormal profit margins lead to too many firms in the industry, each operating below the optimal scale (Flannery and Samolyk, 2007), and thus making only normal profits. Interestingly, the efficient outcome cannot be achieved without mandatory regulation. Customers who are charged the very high rates do not fully appreciate that the cost is higher than if they were in a loan product which does not induce the spiral of unnecessary loan float and thus higher default. In the presence of this distortion, lenders find the opportunity to charge very high fees to be irresistible, a form of catering products to profit from cognitive limitations of the customers (Campbell, 2006). Hence, the payday loan industry has excessive entry and firms operating below the efficient scale. Competition alone will not fix the problem, in fact it might make it worse, because payday lenders will compete in finding more sophisticated ways to charge very high fees to naïve customers, exacerbating both the over-borrowing and the excessive entry. Competition works only if we restrict the dimension in which competition takes place: if unsecured lending to lower income people can take place only in the form of installment loans, competition will lower the cost of these loans.

One more example of my own. A favorite tactic of the credit-card industry is to offer customers zero-interest rate loans on transferred balances. Now you might think that banks were competing hard to drive down the excessive cost of borrowing incurred by many credit card holders for whom borrowing via their credit card is their best way of obtaining unsecured credit. But you would be wrong. Credit-card issuers offer the zero-interest loans because, a) they typically charge a 3 or 4 percent service charge off the top, and b) then include a $35 penalty for a late payment, and then c), under the fine print of the loan agreement, terminate the promotional rate on the transferred balance, increasing the interest rate on the transferred balance to some exorbitant level in the range of 20 to 30 percent. Most customers, especially if they haven’t tried a balance-transfer before, will not even read the fine print to know that a single late payment will result in a penalty and loss of the promotional rate. But even if they are aware of the fine print, they will almost certainly underestimate the likelihood that they will sooner or later miss an installment-payment deadline. I don’t know whether any studies have looked into the profitability of promotional rates for credit card issuers, but I suspect, given how widespread such offers are, that they are very profitable for credit-card issuers. Information asymmetry strikes again.


15 Responses to “Is Finance Parasitic?”

  1. 1 maynardGkeynes May 23, 2015 at 7:37 am

    It looks to me like at least some of the examples of “information asymmetry” that you cite are actually problems of 3rd party payors (eg., doctors ordering too many tests; many finance industry abuses, eg., fees charged to company-run 401K plans).


  2. 2 Kevin Erdmann May 27, 2015 at 10:51 am

    Hm. Normally I strain to keep up with you, so I could be missing something, but here is my reaction, if you’ll oblige me:


  3. 3 Shahid May 29, 2015 at 11:32 am

    David i read your previous, very impressive column on this issue before and it made alot of sense. Then i got a dose of the medicine myself. I used a credit card which, as you astutely observed in your post, offered ‘zero’ percent rate (why would anybody add percentage with a zero? i would love to hear a mathemetician say something about this). Its only when i started using it that various forms of charges (service charges, financial charges, etc) started to appear in repayments. To cut the long story short, i think i have paid almost three times the amount of the principle, and still have a bit to repay. Thinking about all this, i just could not figure out what benefit to the society did this transaction bring? I see none. You cant argue with with the bank, because they tell you that everything is on that 5 to 6 page document, where you’d find writing that is ahrd to reas without a microscope,a nd one whcih requires super human effort in terms of concentration. I dont know of many people who have that much time or concentration.

    So why do people keep falling for this trap? The answer, of whcih there is a hint in your post, probably lies in cognition. It is just an overpowering sensation to have a 5K or 10K limit credit card in your hand. It empowers you to buy anything at a mere swipe of the card (no hard work required; just swipe it). And unless humanity is an ardent follower of Abinezer Scrooge (whcih they aren’t), the instinct is to have spending power one way or the other. Those who practice finance (like payday loans) have been well aware of this cogntive trait for long, even before there was a formal financial industry. Its only when its time to repay that the reality hits home hard.

    There is another interesting aspect to this story, one which involves voluntary transactions. Its a basic concept in economics that voluntary transactions are healthy for economic activity. But thinking about what you wrote, this represents an interesting case of where a voluntary transaction ends up as harmful for the society. I wonder if somebody has ever done a micro level analysis of this aspect?


  4. 4 Shahid May 29, 2015 at 11:34 am

    sorry for the typos in my post.


  5. 5 David Glasner June 1, 2015 at 12:30 pm

    maynardGkeynes, Third party payors are certainly a problem, but the information asymmetry between a doctor and a patient exists even there is no third party. How does the patient know if the doctor is diagnosing him accurately?

    Kevin, Thanks for devoting a post to me on your blog, But I think you misunderstand me to some extent. I don’t see the problem with finance as too much trading, but in devoting lots of resources to gaining information asymmetries that can be exploited by trading.

    Shahid, I think that a lot has been written about this in the behavioral economics literature, and the perceptual or cognitive biases that lead people to consistently make choices that they wind up regretting.


  6. 6 Jan Z June 2, 2015 at 10:33 am

    For the vacant properties, here’s a policy prescription (above and beyond the Georgist land tax): how about rebates for occupied property? I think this would work best in a zone where we’re seeking some stability/revitalization… but I see it as a better use of funds than TIF going to large projects as a gambit to revitalize an area where maybe demand is weak at a given price point


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  3. 3 Central bankers and free markets: a convenient hate story | Spontaneous Finance Trackback on May 28, 2015 at 2:33 pm
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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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