Thanks to Jesse for his great comments on my previous post.
>> I think it is useful to separate profits by their source: value added vs rent seeking.
I completely agree. This is an idea I've thought about for a while. In the simple competitive equilibrium model, there's no distinction between the sources of profit. All agents are acting rationally, so they are all made better off by participating in the market.
But economics does not do a great job of addressing two key distortions: deception and manipulation. Even behavioral economics models focus on behavioral biases like time inconsistency, prospect theory, overconfidence, etc. But we almost completely overlook the possibility that wide swaths of the economy make money through deception and manipulation.
Preferences are malleable - this fact is at the heart of consumerism. How do we compute the welfare implications of a market system if it creates needs in order to fulfill them? Are people better or worse off if they would have been perfectly happy without a smart phone, but felt compelled to buy one because everyone else had one? Sometimes marketing is innocuous - simply informing us that a useful product is available. Most marketing, however, contains elements of deception and manipulation, creating subconscious and emotional associations that gin up sales but ultimately leave us empty.
Once we confront the mercurial nature of human preferences, separating "true" value-creation from profiteering becomes philosophically, psychologically, and especially economically confounding. Because economists don't know how to deal with it, we just ignore it. Thus, even the idea of "value added" profits quickly fall apart when we consider the impact of deception and manipulation.
Finance has taken deception and manipulation to an extreme through multifarious versions of fraud, shrouding risk in complexity, and subverting the government. Willful deception was at the heart of every piece of the mortgage crisis - appraisal fraud, liar's loans, deceptive selling of toxic CDOs, deceptive AAA ratings. Financial firms and markets compel the government to intervene aggressively by holding the economy hostage, making campaign contributions, and exerting ideological influence. In finance, the "freer" the market has become, the further it's moved from fair competition.
Deception undermines markets. Manipulation undermines markets. Both lead to economic inefficiency. Yet deception and manipulation are also incredibly lucrative investment opportunities. Because economists have no uniform framework to address these distortions, we focus on attacking government as a source of inefficiency. This in turn breaks down the rules that limit deception and manipulation.
Competition works when there are rules. Rule-governed competition in sports promotes the development of extraordinary physical ability. If we eliminated rules in sports, people wouldn't get faster or stronger. Sports stars would just be the psychopaths willing to go the furthest to undermine their opponents. This is what has happened in finance and other industries where we've embraced the ideology of unfettered self-interest.
While sweeping (e.g. government) reform is crucial, I think that moral and cultural reform are essential as well. Given the gridlock in our political system, I think that moral clarity is necessary to build the political will to pass meaningful regulatory reform in any case. In the financial industry, I'm convinced that no regulation can be effective without changing the moral framework. Bankers will always be wilier and more voracious than the regulators, so unless they themselves change, they'll always find ways to subvert the rules (not to mention rule-making!). True reform has to come from within.
We as a society seem to have given up the fight on moral grounds - we've accepted the ugliness of finance and consumerism as necessary for America to function. I argue that we can't give up. Unfettered greed (with emphasis on unfettered) is the cause of our problems, not a necessary evil. From a scientific standpoint, simplistic, Randian notions about the efficiency of the free market are simply wrong.