The Dangerously Divergent Interests of Wall Street and Main Street

A century ago, Wall Street was seen as a den of fat-cat bankers who corrupted government, toyed with the investing public, and would lend money to pretty much anyone — even Communists — just to make a buck. Familiar and even evergreen as this description may sound, it’s only partially fair. The financial world does much to keep the global economy running, and practically everyone benefits. But today, as then, the interests of Wall Street and Main Street are dangerously divergent.

Financial markets are abstract constructions run by people — a relatively small group of very well paid people. The sector composes about 5 percent of employment in the United States, yet in the past decade it has contributed 25 percent of corporate profits. Because the highest earners make most of their money through performance-based bonuses, a hefty share of those profits goes straight into their pockets — a phenomenon that’s increasingly rare in the rest of the workforce.

Financial firms earn their money through fees for their services and returns on their portfolios, which can include anything from home mortgages to speculative derivative trades. Increasingly, the portfolios have supplied the bulk of financial firms’ profits, even for banks. In January, Bank of America reported a steep drop in profits, mostly because of a decline in revenue from trading. So did Citigroup, JPMorgan Chase, and Goldman Sachs, where trading accounts for the lion’s share of all revenue. When trading ticked up again, so did overall profits.

And trading is where the Wall Street and Main Street are most likely to clash. Consider, first, the flood of cheap money that has been sloshing around the economy for most of the past 15 years. Low interest rates have helped consumers, but they’ve also offered the financial sector a huge opportunity to borrow cheaply and invest abroad for higher and riskier returns. So far, so good — but wait until the Federal Reserve turns off the taps.

Whenever the Fed decides to raise interest rates — maybe June, maybe September, maybe even later — it will be a signal that demand for Americans goods and services is on a strong footing and prices are set to rise. It will be good news for American workers; even with their limited bargaining power, wages should rise as well. But it will be terrible news for firms that have earned millions from the carry trade.

The same divergence of fortunes will occur when the European Central Bank and the Bank of Japan, both of which have been pumping tens of billions of dollars worth of euros and yen into the global money supply every month, finally raise rates in their respective economies. Good news for people outside the financial sector will curtail profits for those on the inside. Of course, economic growth may help financial firms to earn more fees, making up for the lost profits from trading. But if the decline in trading profits comes suddenly, then firms will have to pay their debts by selling off assets, creating a selloff in the markets that could paralyze hiring and spending in the economy at large. Wall Street’s addiction to cheap money could kill an economic boom just as it was being born.

Another source of conflict is volatility. Main Street hates it — uncertainty causes people to save rather than spend, as they did following the global financial crisis, and hurts the job market as well. It’s not good for the economy’s productivity, either, since people with jobs tend to hang onto them rather than seeking better opportunities.

But Wall Street, thanks to the wonders of derivatives, has grown to love volatility. It offers the chance to sell insurance, either in the traditional form of policies or more complex forms like swap contracts. And it also opens up gaps in the market for arbitrageurs — the traders who make money by spotting differences in prices for essentially the same assets, then reacting by buying and selling more quickly, and with more leverage, than anyone else. By contrast, when markets are quiet, the hedge funds and other investors who exploit these trades have little to do.

Finally, Wall Street has always known how to play Main Street for chumps. As I’ve written before, it’s rare that a household investor will know more than a financial firm about the true value of a share. So when the two trade, it’s easy to predict who will get the short end of the stick. The more individuals trade, the more Wall Street’s portfolios gain value.

In this dissonant context, it’s hard to believe the credulous news headlines that follow the phlegmatic pronouncements of Wall Street’s titans. Though they may play the role of concerned uncles offering plainspoken advice, their greatest incentive is to say things that will help their firms’ traders. If the traders are betting the market will dip, the titans should predict disaster to accelerate and deepen the selloff. That way their firms can make money on the way down, then buy in at the bottom — an artificially low bottom of their own making. Main Streeters who take the titans at their word will be left holding the bag.

The reasons for mistrust between Main Street and Wall Street are myriad, and the aftermath of the global financial crisis has done little to mitigate them. Yet the two will never be free of each other. The challenge, in the United States and elsewhere, is to regulate Wall Street in a way that protects Main Street — without impeding the central role of finance in the economy. Even though the financial markets have changed enormously in the past century, progress on that front seems limited at best.

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