Before the break, FT Alphaville took a look at abstraction and morality in modern finance. This prompted some rather interesting discussion, among which this post from Interfluidity:
Finance has always been complex. More precisely it has always been opaque, and complexity is a means of rationalizing opacity in societies that pretend to transparency. Opacity is absolutely essential to modern finance. It is a feature not a bug until we radically change the way we mobilize economic risk-bearing. The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear.
The reasoning goes that there is a natural tendency to invest only in low-risk endeavours, rather than take greater risk (assuming away entrepreneurs, we guess…).
The only way for progress to occur is if everyone goes for it together in terms of the riskier investments, instead of hoarding cash and only parting with it for low-risk, low-return projects.
With everyone going for it, this ensures that on average, over the many projects that got seed money a decent return will be earned. Most projects will bomb, but some will do brilliantly well and bring the world greater good, like being able to order cheap textbooks on Amazon. This, as Steve Randy Waldman of Interfluidity points out, was “a pretty iffy investment in 1997″.
Luckily for society (cough), banks have stepped into the breach to provide this aggregation tool, pooling all the high-risk projects and offering investors a return greater than that they’d have earned in low-risk investments but lower than the banks themselves earn from the riskier investments on average, i.e. the banks take a cut for their pooling services.
It turns out that pooling isn’t the only good that banks offer. Like the free toy in the cereal box, lies and deception also come in your investment:
Like so many good con-men, bankers make themselves believed by persuading each and every investor individually that, although someone might lose if stuff happens, it will be someone else. You’re in on the con.
That “stuff” is that the bank actually choose those high-risk projects badly and hence is unable to make good on the promise not to burn investors. And that “someone else” could be the bank’s shareholders, debt-holders, the government, etc.
The argument in the post is that investors in the bank are assured, i.e. lied to, that they will not be left holding the can, and furthermore, getting back to the point about complexity serving to create the opacity that is necessary for society:
Banks innovate and interconnect, swap and reinsure, guarantee and hedge, precisely so that it is not clear where losses will fall, so that each and every stakeholder of each and every entity can hold an image in their minds of some guarantor or affiliate or patsy who will take a hit before they do.
In conclusion, if one were to have regulations that got rid of opacity, there would be insufficient amounts of investment and the economy would be unable to grow. Hence, there is a choice (emphasis ours):
You can have opacity and an industrial economy, or you can have transparency and herd goats.
The unfortunate downside, however:
A lamentable side effect of opacity, of course, is that it enables a great deal of theft by those placed at the center of the shell game. But surely that is a small price to pay for civilization itself. No?
Overall the post outlines an interesting potential justification for opacity in finance, and we encourage you to go read it in full.
At the tail end, the author goes on to make the analogy of finance as a placebo — that is, we have to believe in it for it to work, otherwise we’d just sit on piles of cash terrified of risky investments that serve to advance our society. Let’s look closer at placebos for a moment. From the American Cancer Society’s description:
Even though placebos do not act on the disease, they seem to have an effect in about 1 out of 3 patients. A change in a person’s symptoms as a result of getting a placebo is called the placebo effect. Usually the term “placebo effect” speaks to the helpful effects of a placebo in relieving symptoms. This effect usually lasts only a short time, and is thought have something to do with the body’s own chemical ability to briefly relieve pain or certain other symptoms.
Well, that may be a good description of the placebo effect in finance (though it may be different to what Waldman had in mind), namely it seems unlikely that investors will be fooled forever. Financial illusions have a tendency to shatter, whether they are in real estate, tech stocks, or triple-A sovereign bonds.
It also seems unlikely that investors, in the face of inflation and trying to save for the future, are unwilling to take any risks, particularly when the time to retirement is long… and getting longer, and longer. And then there are entrepreneurs who take huge financial risks.
We do, however, agree that banks, absent suitable regulation, can be fantastically good at taking advantage of their position upstream in capital markets, as they narrowly pursue shareholder value at the expense of all else.
And will we be reduced to goat-herding if we are insufficiently fooled by the placebo/con that banks are offering? Will we inadvertently destroy progress and innovation by demanding disclosure?
Erm, no. The lack of disclosure is what has banks trading at a fraction of their book value. We know there are bodies, but we don’t know how many or where they are buried, hence it’s hard to value the healthier parts of the business. The mysterious web of complexity hampers more than it helps.
The idea that opacity is created deliberately by banks to disguise where the losses will ultimately be borne strikes us as a touch too conspiratorial.
FT Alphaville has serious doubts that the head of securitisation met with the head of the rates desk, and the credit desk, and so on, and then they collectively decided, “hey guys, here’s the thing: no one is going to give us their money unless we build up a gigantic web of transactions that even we don’t understand. So get crackin, and don’t come back until our 10-K reveals nothing!”
Far easier to believe is that they all individually managed their businesses, squeezing out every last drop of profit, to the benefit of bonuses and shareholders. If the way to do that was chucking assets off the balance sheet to a vehicle that was meant to be bankruptcy remote, then so be it. Or if the way to do that was a ever growing web of swaps, then that too. As FT Alphaville pointed out before, as a society we are getting better and better at abstraction and complexity — with a drop of greed, who knows where we could end up.
One especially thoughtful post by Kevin Drum on Mother Jones pointed out the role that increased computing power has had to play:
… we have humans of distinctly limited intelligence using digital computing power to create a financial system so complex that no one truly understands it. Like the blind man and the elephant, we get glimpses now and then of the whole, and certain individuals manage to understand small bits of the system in detail. But no one truly comprehends the entire thing.
Someone of distinctly more intelligence, of course, set up those computer systems. But once they were up and running, we were indeed off to the opacity races. There we shall stay, until the same technology is harnessed to increase transparency.
Will we, however, leave the last word to the wise goat-herders of Onion Creek Ranch, Tennessee:
Trying to breed for all markets generally results in failure in most markets. …
If making the almighty dollar is your driving force, you are doomed from the start.
Related links:
Abstractions and morality in modern finance – FT Alphaville
Why is finance so complex? – Interfluidity
Reply to Influidity - Trust Your Instincts
Discussion started by Philosopher’s Beard – MetaFilter
Our Digital Financial Overlords – Mother Jones