Goldman Sachs’ income from trading and principal investment rose 90% in the third quarter, while allocated remuneration per employee soared 46% to $527,000 in the first nine months of 2009. Good luck to them, but it shows once again that they and to a lesser extent the rest of Wall Street, are currently playing a different game to the rest of us. The question is, how best to restore the operation of a competitive free market.

Investment banking has changed radically over the last 30 years, and it’s not clear that either regulators or the market fully understand the modern sources of its income. Trading, a fairly peripheral activity 30 years ago, has come to dominate the investment banking income statement, with income arising for investment banks both through acting as intermediary and through “proprietary trading” for their own account.

The immense and unstoppable proliferation of derivatives is the principal factor that has brought this about. After all, total outstanding derivatives contracts at the end of 2008 had a nominal principal amount of $514 trillion, more than ten times Gross World Product. You don’t need to skim very much off the top of a pot of cream that size to make your practitioners very rich indeed. A decade ago, defenders of the derivatives revolution could reasonably claim that the economic value and risk of those contracts was a tiny fraction of the total outstanding. Today, when we have seen multiple examples of credit default swaps paying close to 100% on billions of dollars of obligations, that claim has become laughable; the fraction of risk involved in that $514 trillion isn’t as tiny as all that.

The intellectually curious must wonder what purpose all this activity serves. Defenders of derivatives and trading in general mutter the magic words “hedging” and “liquidity” and expect their questioners to fall back abashed. However there aren’t $514 trillion of exposures to hedge; indeed in a $50 trillion world economy there aren’t even $50 trillion of exposures to hedge. Hence at a very conservative estimate 90% of all derivatives activity serves nobody beyond the dealer community.

The same applies to liquidity; the immense trading volumes daily in the foreign exchange or futures markets do indeed provide liquidity, indeed more liquidity than can possibly be necessary to run the system. Proponents of trading will again say that it is necessary for a large financial institution to make a $1 billion block trade, but why? Surely in a well-run economy institutions should invest on a long-term basis, not engaging in random short-term speculation.

If a senior institutional investor breaks up with his girlfriend who is CEO of a company, why should the entire resources of Wall Street be deployed to allow him to dump his institution’s $1 billion position with one keystroke, rather than making him do so gradually, over a period of time during which calmer and wiser thoughts may prevail. Likewise, there can be no significant systemic value, if a company reports an unexpected loss, in allowing the billion-dollar shareholder with the fastest trigger-finger to dump his position on the market, or on other shareholders who may have less immediate access to information.

If the economic value of hedging and liquidity are modest compared to the galactic amounts of contracts outstanding, or even to the enormous sums earned by trading, then it follows that some pretty large percentage of trading revenues represents nothing more nor less than rent seeking, the extraction of value from the economy without providing any economically valuable service in return. The explosion in derivatives and trading volume can then be seen as a gigantic smokescreen, which has enabled Wall Street to extract larger and larger rents from the remainder of the economy.

That is intuitively sensible. Investment bankers and traders are intelligent, capable people, but an average remuneration of $527,000 in nine months, or $703,000 per annum, for the entire staff of Goldman Sachs including janitors and interns suggests that some mysterious force is preventing those returns from being driven down to a level for which all but the most senior of Wall Street veterans would happily work. It’s not a question of the “social value” of trading, a dubious concept at the best of times. It’s a question of what barriers to entry prevent every corporation in America from setting up a derivatives trading department in order to extract some of these extraordinary returns.

The same applies to “proprietary trading” by which modern investment banks deploy large amounts of capital to achieve very high returns. The Efficient Market Hypothesis postulates such excess returns to be impossible, since capital would rush to the nexuses where they existed, and drive returns down to an equilibrium level. One need not be a believer in the EMH to agree with its conclusions in this respect; Warren Buffett, the greatest investor in America, has achieved returns only barely above 20% annually in his 50-year investment career. It is unreasonable to suppose that ever greater amounts of capital could be deployed into achieving returns considerably greater than that, year after year if some artificial barrier to competitor entry was not involved.

There are two barriers to entry that appear to prevent capital from arbitraging away investment banks’ trading returns. The first is insider information, not generally the illegal kind about corporate activities but the entirely legal kind about money flows, equally valuable in a trading environment. If you are one of a handful of major dealers in a particular type of derivative contract, or you have a computer set up at the New York Stock Exchange that sees the order flow before competitors, you have insider information that is not available to third parties, just as surely as if you knew the secrets of next quarter’s earnings.

The second kind of barrier to entry is that of crony capitalism. In the private sector, this is the way business has always been done; a company’s CEO is a close friend of one investment banker rather than another, so gives him preference when there is a transaction to be done. The position becomes much more doubtful when the public sector is involved, as it increasingly is the case in this less and less capitalist environment. If the Treasury Secretary is an alumnus of Goldman Sachs, as was Hank Paulson last year, there must be some suspicion at least when bailouts are arranged so that Goldman receives a $13 billion payoff at public expense on credit default swaps issued by AIG, as well as receiving a payoff on credit default swaps issued on AIG, payable only on an AIG default. To put it bluntly: such largesse had not been available to Lehman Brothers.

Similarly, large government-directed contracts that are awarded without full competitive bidding, or advisory work where the investment bank’s government contacts are themselves leveraged, or investment opportunities not available to the general public, are all examples where crony capitalism must at least be suspected even if it can never be proved. With the immensely greater amounts of capital now available to the major Wall Street houses and the death of the “it’s not cricket” gentlemanly prohibitions against naked rent seeking, it’s not surprising that such profits have multiplied.

The question now arises of how best to reverse this trend. If much of Wall Street’s extraordinary profitability is in fact rent, then eliminating it will make the rest of us richer and make the US economy as a whole more efficient, as capital is allocated more optimally. The rent seeking problem appears to be quite concentrated at the center of financial services; the losses reported by Bank of America and many regional banks suggest that old-fashioned banking is at best only normally profitable.

The first change that is desperately needed not only to reverse this rent-seeking but in general is a reversal of US monetary policy. US monetary policy has been far too accommodative now for over 14 years, with the last year being particularly egregious (however understandable the panic last September.) That has caused asset values to soar and made leverage altogether too attractive and profitable. Add to that problem the various bailouts and special favors which the Fed and the US Treasury have lavished on Wall Street in the last year, and you can see how rent seeking got out of hand. The fact that Bank of America cannot make money on home mortgages and credit card lending (having over-expanded in both areas) is no justification for showering benefits on traders at other houses who may have no involvement in those sorry businesses.

A second change that will reduce rent seeking is a tax on transactions, a “Tobin tax”. Set at a low percentage level this will push the market back towards longer-term investment. It will particularly penalize the high speed trading operations, which appear to have no significant economic justification beyond rent seeking. It is here and not in higher fees paid by deposit takers that the regulators need to impose a tax on Wall Street to pay for all the bailouts.

A third change needed is a regulation restricting credit default swaps to participants having an “insurable interest” in the credit concerned. There are many economic arguments for allowing lenders to lay off credit risk, thereby managing it more effectively. There are no good arguments for allowing short positions on unrelated entities. Just as the eighteenth century insurance market discovered that allowing insurance policies on strangers caused the rate of unexpected deaths to soar, so today’s economy does not need a bunch of Wall Street traders seeking to making speculative profits from others’ bankruptcies. Bankruptcy is a necessary economic mechanism, albeit with a heavy social and economic cost to creditors and employees; it should however be used only as a last resort and not as an additional source of chips for Wall Street’s casino.

Finally, government needs to get the hell out of the economy. Meddling in the housing market through the absurd Fannie Mae/Freddie Mac guarantees was among the most important causes of last year’s disaster. The government-sponsored bankruptcies of GM and Chrysler will almost certainly prove to have destroyed the US automobile industry, as the British Leyland fiasco did in Britain. Every time the government meddles in economic transactions, the chance for rent seeking is created, to the great detriment of the rest of us. Wall Street is supremely good at rent seeking; it should not be encouraged to pursue this avocation any more than necessary.

Both traders and Wall Street in general perform vital economic functions. That does not mean they should be allowed to multiply the rewards to themselves for doing so ad infinitum. The free market needs to be restored.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)