IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
The latest Scorsese blockbuster is still making the headlines for its novel artistic work with timelines. Does the Wolf, however, have anything whatsoever to say about Wall Street? Very little, and it may actually work to strengthen and entrench any bad practices that remain in the financial world!
For the propaganda of East-European dictatorships, “Wallstreet” was a metonym for the evil capitalist order where the working class gets exploited as revanchist capitalists extract the surplus value from them and leave them only with scraps and bones fit for the wolves. Homo homini lupus. But that should not surprise us. Every ruler in history used “politically engaged art” to consolidate his (or, less frequently, her) power and wealth (though communists did especially excel in this, even where they didn’t rule). Today’s democracies are no exception. Only in a free society, however, is there also room for privately funded “politically engaged art” which has to survive on the market in a fair competition with other artistic expressions, politically engaged or otherwise. An example of such is the recent blockbuster “Wolf of Wall Street”. No taxpayers were harmed in the production of this movie. They may have been harmed indirectly, however: by misrepresenting the real Wall Street, the film draws our attention away from real problems on financial markets.
There are two main ways of understanding “Wall Street” in our everyday language. In the first, broadest sense it represents high finance. If you believe its portrayal in most media over the last several years, it is a place where investment banks and hedge funds work hard to weave simple IOUs into a complex web of financial instruments and derivatives which not even their designers (a.k.a. “Quants”) are supposed to understand, let alone traders or customers…
Meanwhile, on this planet, the complexity is necessitate by globalization where companies themselves are enormously complicated legal entities with hazily defined domiciles, so the bloodline the keeps them running as smoothly as possible has to be equally complicated. But it’s no bed of roses. It would be difficult to dispute, for example, that financiers have insured insufficiently against a downturn and this in turn turned against them. The only dispute remains over what caused this excessive risk. Was it the governments by never even attempting to dispel the assumption that any crash would be plastered over by tax money, using the “too big to fail” argument? Or had the governments caused the crash much earlier by actively encouraging risk-taking, be it through their Freddie Mac and Fannie Mae agencies, or by circulating the myth of “riskless sovereign debt” which Greece and others now boisterously dispelled? These are all fascinating questions about Wall Street which all have their credible roots and storylines, including “human stories” that could form a backbone of a film narrative. Yet these are precisely the themes that Wolf does not even touch.
Perhaps the closest that the Wolf gets to these systemic risk issues is in the scenes depicting testosterone-fuelled orgies of sex, drugs and (in the background, at least) rock-and-roll. A few years ago, University of Chicago’s professor Luigi Zingales published with his colleagues a famous research which showed that even women with a greater level of testosterone do take more risky career paths (at least within the sample of the UofC graduate business school) and are prepared to bear more risks in (simulated) financial decisions. Yet in the film the timing of the revelries implies to the viewer that they are a consequence of financial success, not a cause that would encourage risk-taking and its (potential) reward. During client work all employees seem to be always sober. The eponymous hero Jordan Belfort himself is portrayed as a rather shy and tame novice at the beginning of the film when he is actually working on Wall Street. Some drugs do with a colleague appear, but they are not portrayed in any way connected to work and work performance. Their brief role during a lunch is to provide a bridge to Belfort subsequent exploits which are, however, as we shall see below, off-Wall Street.
In the second understanding, the term Wall Street gets applied specifically to the stock market. The New York Stock Exchange (NYSE) to this day resides at 11 Wall Street, tracing its stock trading roots all the way to late 18th century. They were by no means uncontroversial. NYSE was formed by the famous Buttonwood agreement, a classic cartel contract aimed at preventing competition not only from outsiders, but also among insiders. But a stock exchange in principle is a useful instrument which allows those who have money but no ideas what to do with them find cheaply those who have those ideas but no money. In its absence, a lot of good ideas for the benefit of mankind would go unfulfilled, and those with money would “have to” spend them in particularly silly ways (since you cannot take it to the grave and passing it to your children is more difficult without financial instruments).
The modern stock market is not without its own problems, especially regarding to using privileged information in a world where general information is in principle is instantaneous and that which isn’t is that much more valuable. But especially the portrayed US Wall Street has very stringent rules and regulations regarding this, which can often serve as a role-model for the European stock markets where so called “insider trading” is still not a widely discussed topic. In the United States it is not uncommon to see even celebrities serving hard time in prison for such behaviour, something still probably unthinkable in Europe.
But these problems are also completely avoided by film. Belfort is swimming around these highly ordered and regulated waters only in the first minutes of the film, until he is made redundant from his company on Black Monday. The cocaine anecdote is more of a trick by the director Martin Scorsese to establish in this official Wall Street the roots for what will be heavily exploited in the remainder of the film. Cocaine users can be found in all social strata, but especially among the high-income groups: Based on UK data, of all the classes of drugs cocaine has the greatest positive association with income [bottom table] while cannabis, for example, has strong negative association. If drugs dominate Wall Street, it seems more likely to be not recreational but performance use. The long hours expected of workers are famous, so Adderall seems to be the drug-of choice among the financiers.
So what is there wallstreety about the Wolf? Not much. His company sells stock that has never been on the Wall Street stock market or has long since been excluded. However high the portrayed earnings are, he is not a wolf in the world of high finance. He does not trade on Wall Street but in the suburbs. He does not sell his get-rich-quick dream to investors but to ordinary, relatively poor citizens who know the aura of Wall Street only from the TV and believe that some of it will shine their way. Even in the biggest market economy there are still many people with miniscule financial literacy, the prime target of Belfort’s pump and dumpscheme: it is a form of a fraud where difficult-to-verify information is circulated about shares of micro-capitalised companies going currently for literally pennies, and once thus created artificial demand raises the price sufficiently, Belfort’s company dumps their share on the market, bursting the little bubble but making nice profit for the selling Wolf. The tiny prices can be deceiving here. If Apple shares were to rise from $500 to $750, we’d hear nothing else from all news outlets. Yet a penny stock going from $0.01 to $0.02 is an increase twice as big, and so is the profit of the seller. Such self-generated power to change price (and create a self-fulfilling prophecy) is realistic only on markets with low liquidity, away from Wall Street. These are usually referred to as “OTC” – over the counter. You are buying something in a shady back-alley, not on the general shop-floor of the exchange, so caveat emptor.
About the real world of high finance which has been making the headlines every day since the economic downturn – the film has nothing to say. In fact, it can be even counter-productive. One of the problems of modern financial world is its being dominated by a handful of huge firms. These are subsidized by national governments in at least two ways:
1) Fat cheques are received from the tax-payers for the financial companies’ numerous consulting capacities. Often, especially when privatization programmes are involved, they also benefit disproportionately to what would happen on a free market. (The most recent case in point is the case of Royal Mail privatisation in the UK which is still making the headlines for “behind the scenes” deals between the government and the financial houses).
2) Governments promise to the companies, implicitly or explicitly, that their taxpayers will foot the bill for the companies’ insurance against risk. Risk is an intrinsic part of our world, especially on the financial markets, and whoever does not have to bear the cost of such risk through proper insurance, will end up taking too much risk. And that cannot be good for the world.
Small financial firms, on the other hand, do not receive such subsidies and therefore face unfair competition from the large ones. Yet their existence and survival are crucial to provide the competitive fringe that checks on the behaviour of large firms.
It is not difficult to imagine that the film Wolf of Wall Street will leave the cinema goer with the feeling that small firms (such as the one depicted) are implicitly all “dodgy” and of nefarious intentions. That only security is with long established firms. If that happens, there will be no hope for any new company to start and try offering better terms to the customer than the current big firms. And so we will all lose out, incumbents will be protected from competition, may grow even bigger (through eating each other, for example) and therefore even closer to governments, who will then see them as even more too big to fail.
Small scale investors cannot naturally check the credibility of their money managers individually. That’s why there are financial oversight authorities. The mistrust invoked by the film should be directed at those operating outside of such oversight, not at those who are small and may be trying something new.