My previous post on opacity in finance attracted a lot of discussion, both in an excellent comment thread and throughout the blogosphere. Thanks. As usual, your comments put my drivel to shame.

I thought I’d follow up (very belatedly, i’m sorry!) with some remarks on opacity in finance. This will be long and very poorly organized, a brain dump of responses I feel I owe people so I can move onto other things. If you actually read it, I am grateful. (I am always grateful that you read my words at all!)

Anyway here goes:

• I, personally, detest opaque finance. I would prefer we eliminate whole sectors of status quo finance, replacing the existing skein of deceptive institutions with very simple arrangements that make it absolutely clear who bears what risks. Banks, money market funds, and pension funds are the first institutions we’d reform out of existence. They wouldn’t be the last. I became interested in financial systems as a large scale information system. It is with great unhappiness and reluctance that, after devoting years of my life to thinking about finance, I’ve concluded that financial systems are better characterized as large-scale disinformation systems and that disinformation is at the core of how they function, not some tumor that can be excised to restore the patient to good health.

• I am still an idealist. I think we should try to develop financial systems that are honest and transparent, that do not combine kleptocracy and effectiveness into a bundle that’s both impossible to refuse and debilitating to accept. But that is a larger and very different project from, say, increasing capital and liquidity ratios at status quo banks.

• We must give the devil her due. It pissed a lot of readers off and pisses me off too, but the argument I offered in the previous post is true. Over the broad scope of history, societies with financial systems that mobilize capital opaquely and at very large scale have completely dominated those that have relied only upon consenting risk assumption by well-informed individuals. Industrialization occurs in societies with corrupt and fragile big banks, or else in societies where the state coerces and obscures risk-bearing and reward-shifting on a large-scale, or (more usually) both. China is a great present day example. That does not mean it would be impossible to develop a set of institutions that would be both effective and transparent. But it does mean developing such a system is an ambitious and ahistorical project, not a mere matter of “fixing what’s broken”. Under present arrangements, transparency and what we perceive as effectiveness stand in opposition to one another. It is incoherent to demand transparency and expect “more” macroeconomically stimulative intermediation from our current financial system.

• A lot of responses to the previous post were of the form, “You are wrong, and like, duh! Look around! Look at where opaque finance has gotten us! No one trusts anyone, we can’t mobilize risk capital at any scale, etc. etc.” That’s all true! But it’s the exception that proves the rule. The trouble with opaque finance is that the opaque and kleptocratic financial sector doesn’t con people into providing capital at scale only when it knows how to put it to good use (my first payoff matrix from the previous post), but tries to do so habitually, all the time. Financiers aren’t especially bright, and they are in the business of mobilizing capital, it’s what they get paid to do. As a group, they can’t distinguish periods with excellent real opportunities from periods in which they are shepherding capital into idiocy and waste. Financiers are first and foremost salesmen. Some of them do understand when they are selling poison. But many of them, like most good salesmen, persuade themselves of the amazingness of what they are selling in order to persuade the rest of us more effectively. So there are periods, as we’ve just seen, when financiers attract huge gobs of capital and confidently deploy it into an incinerator. They are then forced to break their promises to everyone. Since no one (most especially the financiers) believes themselves to have agreed to be the bagholder, we are left in an ocean of conflict over who must bear what costs. It’s awful! Where we are now is awful! So how can opaque finance possibly be good? Well, banking crises are not new. We’ve been at this for centuries. The US had depression-strength “banking panics” every decade or so during the 19th Century, with all the attendant conflict and recrimination when banks failed. Thailand had no banking panics. Which country developed? I’d wager that, over the course of history, the correlation between banking crises and long-term growth is strongly positive, not negative. Banking crises are evidence of banking, and banking is evidence of the recruitment of dispersed capital that enables industrialization and development. When disturbingly common crises destroy trust and render opaque finance ineffective, we don’t segue into prosperous periods of honest, transparent activity. As a general rule, our economies remain debilitated until con-men of both the private and public sector (a distinction without a difference) restore faith in some even more convoluted and cross-guaranteed variation on the same con.

• Lots of responses were of the form. “Bankers don’t think that way!” No, of course they don’t. Most bankers don’t understand themselves to be con artists. Remember how finance enthusiasts used to like to gush about the power of “emergent systems”? If there’s any conspiracy in this story, it’s an emergent conspiracy, not some some self-conscious attempt to serve the greater good by pulling the greater wool over everyone’s eyes. Bankers just think about making money. They work to attract cheap finance via suggestions of clever risk-management and cross guarantees. They try to cover themselves in case it all goes wrong. They persuade themselves in some big-picture way that the “system” in which they are participating in does some good, they rationalize away practices that might seem to be a bit sketchy. Every industry has its sausage factories, right?

  It might be better if bankers actually were self-conscious conspirators. If they understood themselves to be the masters of sneakily pilfered resources, they might feel some kind of noblesse oblige to deploy those resources with care, and they might coordinate in the service of communal aims. Compare modern financial elites to their old-style WASP-dominated predecessors. Part of what makes an FDR different from a Mitt Romney is that an FDR understood his power to be derived from more or less arbitrary privilege, while a Mitt Romney imagines himself to have “eaten what he killed” in brutally efficient markets. The neoliberal revolution in finance and economics was not pap invented merely to enslave the plebes. As the value system of the first world grew more “open” and “meritocratic”, it became hard for those who achieved outsize influence in finance both to accurately understand their own roles and to consider themselves good people. Self-regard being more important to all of us than truth, financiers eagerly followed and encouraged an academic movement that described the conflicted institutions which had elevated them as “efficient” and tending inevitably towards “optimality”. They persuaded themselves, long before they persuaded the rest of us, that any games they played for their own enrichment would necessarily lead to social gain over the long term. It was because they were true believers, rather than mere deceivers, that they could evolve such rapacious forms of finance without the slightest hint of conscience. Their belief in an invisible hand so perfect it would be unrecognizable to Adam Smith led them to make mistakes that their chummy predecessors never would have. (The old WASP establishment would have responded to East Asian mercantilism instinctively. The neoliberals rationalized obvious strategic dangers as presumptively optimal market outcomes. Instead of resisting, they sought opportunities for self-enrichment and forged increasingly transnational identities.)

• Many readers pointed out that, if the coordination problem I describe is real, there are lots of ways to overcome it, so opaque finance isn’t necessary. That’s absolutely true in theory, but questionable in practice. Governments could transparently tax resources away from citizens and, by some indeterminate intelligent means, directly invest those resources in order to maintain an efficient scale of activity. But as a matter if politics and practice, that doesn’t happen. Governments primarily contribute to the pace of investment in the most opaque manner possible, subsidizing a vast menagerie of not-at-all transparent financial intermediaries with a variety of often tacit guarantees. Sometimes a visible circumstance, like an immigration wave, can inspire a wave of direct investment by households, overcoming the coordination problem. Several readers pointed out that the 1990s tech boom I used as an example was itself financed rather transparently, by equity investors who dutifully accepted losses from risks they’d agreed to bear up front. That’s right, and a fair critique of my example. The tech boom was, to a very large degree, spontaneously coordinated by investor enthusiasm for a new technology. If animal spirits are a coordination problem, a game with multiple equilibria, lots of circumstances could put us into the good equilibrium. But then lots of circumstances could put us into the bad equilibrium too. Opaque finance isn’t needed to ensure that we occasionally find ourselves in a good equilibrium. Its function is to ensure that we reliably stay out of the bad equilibrium, or that if we fall into darkness, we don’t stay there for very long.

• Some idealists suggest that the United States’ various twitches towards an “equity society”, or the popularity of the “Stocks For The Long Run” mantra, imply that there is no need for opaque finance. Americans, under this theory, have been successfully persuaded to willingly and informedly bear the risk of industrial development. So there is no need for any kind of a con. I’m afraid that’s terribly wrong. First, it’s wrong empirically. Despite the United States’ near obsession with its stock market, households have never held the majority of their financial wealth as direct claims on firms. Even if one defines holdings of index and mutual funds as “transparent” finance, transparent vehicles have never comprised the majority of US household financial wealth. Most household wealth is held as a mix of bank deposits, bonds, and pension fund reserves. (Just browse through table L.100 of the Fed’s Flow of Funds, even at the height of the dot com euphoria for equities.) Stocks are disproportionately held by high income households, so I suspect the bias towards opaque finance of the median household (rather than the average “household and nonprofit” tracked by the Fed) is overwhelming. An “equity society” in which individuals voluntary hold the preponderance of their wealth as claims against real-economy projects whose risks they are willing to bear is an ahistorical pipe dream. And it’s worse than it looks. Many mutual funds are money market funds, an institutional form which is a contrived masterpiece of opacity, explicitly structured to mimic “guaranteed” bank accounts, perceived by customers to be reputationally and now politically protected against “breaking the buck”. Index funds, in my view, should increasingly be grouped as opaque rather than transparent finance. Conventional financial wisdom now suggests that younger people should pay no attention to the underlying investments, but treat stock indices as long-term savings accounts. Inevitably, the growing popularity of that practice has coincided with political pressure for stabilization of “the market”, stabilization which is now widely and justifiably perceived to exist. People who invest in “the market” as a long-term savings vehicle do not really consent to accepting whatever outcomes the industrial firms they blindly fund happen to deliver. They consent to vertiginous short-term fluctuations in value, sure. But they expect, well, something to deliver the long-term stable growth that’s been promised, stocks for the long run. If things don’t work out that way, the political system is supposed to make it so. Indexers do not blithely consent to take a long-term loss, if that’s the way the cookie crumbles, and the political system, from the Fed to the US Congress to the President are increasingly geared toward ratifying expectations of things working out in the end. Remember all those emergency Fed interventions? Remember the pathetic frantic do-over when a market crash was attributed to an initial rejection of TARP? Would there be no bailout if a 401(k) catastrophe meant that a generation of “responsible, successful” people would have to retire in penury, people who did what experts advised, the kind of people who have a high propensity to vote? (Probably the bailout would take the form of interventions that reinflate the market, of course, so those responsible, successful people can pretend to have hung tough rather than to have been bailed out.) Index funds have become another form of opaque finance, with promises and justifications of safety delivered up front and conflict stored up ex post should things look not to work out. “Stocks for the long run” boosters, however sincere, serve the role of classic finance con-men: convincing large groups of people to bear risks they do not themselves evaluate, understand or fully accept; persuading people that some indeterminate force will ensure that they are safe; contributing on the one hand to the mobilization of capital for useful purposes, but also to inconsistent expectations about who will bear what costs should macroeconomic outcomes fail to work out.

• Some readers misinterpreted the argument in the previous piece as being about bubbles. That’s my fault, since I used the 1990s tech boom as an example, but note that I dated those investments at 1997 rather than 1999 or 2000. Up until about 1997, there really was no tech bubble, just a boom. A long-term investor in a representative bundle of tech companies would have earned a decent, if not stratospheric, return, even though many of the companies in which they invested would eventually have failed. The success of the winners would have made up for the losers. 2000 was a bubble. An investor in a representative bundle of tech firms in that year would have been killed. In my story, the bubbles fanned by the financial sector are the price of the booms, a bug not a feature. One can make the case, à la Dan Gross, that the external benefits of (some) bubbles outweigh their costs to investors and others. But that is not the case I am making. I claim we would forego a lot of plain booms, the kind that ultimately enrich investors as well as society at large, if we didn’t have a financial sector skilled at getting people to assume risks they’d not directly consent to take. At its best, an opaque financial sector overcomes a coordination problem, makes bad risks (on average) good by getting everybody to jump at once, by ensuring a high baseline level of activity.

• It is important to distinguish between the idiosyncratic and systematic functions of finance. The argument I’ve outlined is about the role of finance in managing systematic or aggregate outcomes, and has little to do with idiosyncratic risk and reward. Status quo finance is quite capable of helping individuals manage idiosyncratic risks, and largely performs as advertised. If you purchase fire insurance and your house burns down, your guaranteed and regulated insurer will probably pay the claim. If banks occasionally and sporadically fail, you gain a real benefit by putting your money in an FDIC insured bank, foregoing some potential deposit income in exchange for genuine safety. However, if there are systematic shocks to the banking system, premia from solvent banks will fail to cover the losses from failures. Cross guarantees can never protect against systematic shocks. If they are made to appear to do so, if FDIC-insured depositors are all made whole following a serious system-wide shock, it is because someone is covering FDIC’s losses. In aggregate, the payouts to the public are taken from the public, what we gain from deposit insurance we lose from additional taxes or higher bank fees. In reality, we are not an aggregate, so systematic shocks engender social conflict about to whom losses should be allocated. If we had not entrusted our resources to banks in the first place, our stashes of canned food and ammo would have remained safe.

  The always excellent David Murphy objects to my characterization of finance as a placebo:

  Diversification, tranching, maturity transformation, and capital allocation are not sugar pills.

  Diversification and maturity transformation can protect us from idiosyncratic shocks, and Murphy is right to point that out. But they cannot protect us from systematic misfortunes. In aggregate we hold the aggregate portfolio, and the opportunity cost of transforming that portfolio into current consumption is whatever it is. Of the benefits Murphy lists, the only ones that could apply systematically are capital allocation and risk allocation (of which tranching is one technique). In aggregate, do we invest our resources is fruitful and beneficial projects? When things go wrong, are the costs allocated to those best able to bear them? It is always possible to imagine worse capital allocations than those we’ve experienced. We might have simply burned forests, rather than employing lumber to the construction of ghost suburbs in the desert. But I think it’s hard to make the case that our financial system as a whole, especially the largest and most opaque parts of it, does a very excellent job in allocating capital. Shifts in our aggregate portfolio seem to jerk around very faddishly, regulated by occasional crashes. It’s not obvious that Western quasiprivate capital allocation dominates equally opaque (and also terrible) “state capitalist” allocation.

  On capital allocation, status quo finance could do better and could do worse. Let’s call it a glass half full. But on systematic risk allocation, I think it unquestionable that status quo finance is completely terrible. When losses cease to be occasional, all that ex ante tranching turns out to be little more than prelude to continuing conflict, “tranche warfare”. In the recent crisis, the behavior of mortgage servicers — agents of banks working to avoid existentially threatening loss allocations — has been entirely perverse with respect to ex ante expectations that they would serve as agents of investors. Throughout the financial system, intermediaries and their erstwhile “clients” continue to struggle over who will bear costs. More broadly, the financial system, including its public and private elements, has by and large protected the nominal and real value of opaque “low risk” investments by shifting costs to the marginally employed (who relieve pressure on the price level by becoming unemployed) and to taxpayers (including people who hold few financial claims and those who are outright in debt). In other words, it is clear ex post that the risk of the aggregate portfolio has been borne by those who were least able to bear it (a circumstance that is unfortunately correlated with political weakness). In my view, there is no reasonable case that status quo finance did a remotely good job of allocating systemic risk to those best able to bear it in the recent crisis. And this shifting of costs to diffuse taxpayers and the marginally employed is hardly unusual. As allocators of systematic risk, opaque financial systems are very much worse than sugar pills. Opacity serves to delay and obscure conflicts, which are almost always resolved in favor of the powerful and at the expense of the weak.

  Status quo financial systems certainly do help us manage our idiosyncratic risks. And you can sum up the benefit of this insurance against idiosyncratic risks to argue they improve our aggregate welfare by some amount. But from a systematic perspective their main contribution is that they persuade us not to hold our wealth as canned goods and ammo. They embolden us to jump.

• Though I acknowledge the important function opaque finance has served, I very much look forward to the day when we can euthanize whole swathes of our miserable financial system. But that will require institutional work. We have to create alternative means of overcoming coordination problems associated with the pace and scale of investment activity, while hopefully expanding the menu of investment options and improving the quality of investment decisions. As utopian as it sounds, I think we can work around compromised banking systems and gradually render them obsolete with a combination of “crowdfunding”, social insurance, and a shift of government support away from opaque debt guarantees and towards undiversified equity. But that’s a project still before us. We won’t be rid of all our vampire squids until we invent what will replace them.

This entry was posted on Sunday, January 22nd, 2012 at 8:02 am PST.
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