Scott Sumner writes,

I define “finance” as the business of allocating capital, which is a bit different from how it shows up in the national accounts. For instance, I believe the CEOs of major non-financial companies are being paid (in part) for the decisions they make in allocating capital…If all you have to do is churn out iron and steel and washing machines and apartment buildings, it can be done passably well with central planning…[but not] when the decisions were about whether to allocate capital to Google or Genzyme, or whether to build that auto parts plant in Detroit or Mexico or China. It’s no longer about simply mobilizing capital to mass produce clearly defined output of stuff we all know consumers will want.

As the economy becomes more complex, the process of organizing production and distribution becomes more challenging. If that process consisted of central planning, the skill demands on the central planners would be much higher today than they were 50 years ago, or even 25 years ago. If that process consists of market mechanisms, then the rewards for key players in the market should be much higher today than they were 50 years ago. I think that this is an important point. To put it another way, if the task of organizing production were not a challenge, we would not have 10 percent unemployment today.

On the other hand, what is frustrating is that so many on Wall Street were rewarded handsomely for mis-allocating capital. For an explanation of how that can happen, I turn the microphone over to Eric Falkenstein.

In an expansion investors are constantly looking for better places to invest their capital, while entrepreneurs are always overconfident, hoping to get capital to fund their restless ambition. Sometimes, the investors (dupes) think a certain set of key characteristics are sufficient statistics of a quality investment because historically they were. Mimic entrepreneurs seize upon these key characteristics that will allow them to garner funds from the duped investors. The mimic entrepreneurs then have a classic option value, which however low in expected value to the investor, has positive value to the entrepreneur. The mimicry itself may involve conscious fraud, or it may be more benign, such as naïve hope that they will learn what works once they get their funding, or sincere delusion that the characteristics are the essence of the seemingly promising activity. The mimicking entrepreneurs are a consequence of investing based on insufficient information that is thought sufficient, but they make things worse because they misallocate resources that eventually, painfully, must be reallocated.

Remember, I think we live in a world in which people want to issue risky, long-term liabilities and hold low-risk, short-term assets. Finance consists of meeting those desires by taking on a balance sheet of the opposite shape–issuing assets that are less risky and of shorter term than the underlying projects.

The way I look at it, there are five ways to make money in finance, which, as Falkenstein points out, includes some of the decisions made by executives of non-financial firms.

1. Have superior ability to select projects in which to invest

2. Make use of diversification to improve the risk-return trade-off.

3. Be able to signal that you can provide people with the assets that they want.

4. Get lucky with bets. This can include the “picking up nickels” strategy that is equivalent to writing out-of-the-money options and having the good fortune not to suffer from a rare event, so that you collect insurance premiums without having to pay claims.

5. Exploit government subsidies, such as the too-big-to-fail subsidy.

Note that if you cannot do (3), that is signaling, you are not likely to get to deploy other people’s money, no matter how good you are at any of the other strategies. On the other hand, if you can do (3) really well, you might be able to deploy other people’s money without having other skills, at least until things go bad and you get exposed.

How did men in finance get especially rich in the last twenty years? I see Sumner as arguing that it is because of (1). I see Tyler Cowen as arguing that they exploited (4) and (5). I see Falkenstein as argung that many in finance exploited (3). He suggests that finance is inevitably opaque, and thus it will usually be possible for people who are not really creating value to learn to do a credible imitation of those who are creating value. As a result, there are going to be repeated episodes of capital misallocation, although each bubble will have its own unique characteristics.