I can't get over the feeling that Finance is magic. We shouldn't be surprised if sometimes the rabbit doesn't come out of the hat, or comes out missing an ear or two. We should be surprised that the rabbit ever comes out of the hat at all.
By "Finance" I mean the whole industry that intermediates between ultimate borrowers and ultimate lenders. And that means not just banks, insurance companies and mutual funds, but also financial markets for stocks and bonds.
Like any other industry, Finance converts inputs into outputs.
The steel industry converts iron ore into steel. I don't understand the process myself, but I'm sure the engineers do. And I could probably figure it out if I read a bit about it. It's not magic. But Finance converts a sow's ear into a silk purse; it can't be done. Finance is magic.
Ultimate borrowers want to borrow to finance assets that are: long, illiquid, risky, and complicated. Ultimate lenders want to hold assets that are: short, liquid, safe, and simple. Finance is an industry that coverts the raw materials of the former into the finished output of the latter. And it just can't be done. It's an illusion, a confidence trick; it's magic.
Take converting risky into safe assets, for example. Sure, if Finance can divide and bundle assets, then diversification is your friend. Holding a tenth share of ten assets is safer on average than holding a full share of one asset. But ten assets are ten times more complicated than one asset. You need to do ten times the research to see if those assets are worth what you pay for them. You trade-off simplicity for safety.
You could contract out the research to a stock-broker or mutual fund manager, of course. Since information is a non-rival good, it makes sense for one person to do the research on behalf of many ultimate lenders. But then you still need to research the researcher. Is he any good at picking stocks? Past performance is no guarantee of future returns, and it may even be a contra-indicator if there is herd behaviour in financial markets.
Or, you could lend your savings to a bank, in exchange for a simple guaranteed return, and let the bank take the risk, as residual claimant. The bank then has the incentive to do the research properly, since it takes full responsibility for any gains and losses. But then you still need to research the bank; are the bank's assets valuable enough that its guarantee is worth counting on? And, who is going to hold the bank's shares? If the bank has leverage of ten, then one bank shareholder must be willing to accept ten times the risk of the underlying assets in order to guarantee the safety of nine bank depositors. And that one bank shareholder must do his research into the bank's assets very carefully.
How much can Finance really create safety and simplicity, and how much does it just shift around the risk and the need to do research into that risk?
Unless of course you just trust the researcher. But why should you do that?
And how can Finance convert assets that are long and illiquid into assets that are short and liquid? A thirty year long investment project can be financed by rolling over thirty successive one-year short loans. But this only works if the first lender trusts that the loan can be rolled over, which will only happen if he trusts that a second lender can be found who will trust that a third lender can be found...and so on. If anyone breaks the chain, or expects anyone in future will break the chain, it all unravels.
Converting illiquid assets into liquid assets is much the same as converting long assets into short. Each bulldozer is unique. But if you issue 100 paper shares representing a 1% ownership of a fleet of 100 bulldozers, then each of those paper shares is exactly the same as the other 99. Nowadays it's called "securitisation", but corporations have been doing it for centuries. Because the 100 paper shares are identical, and the 100 bulldozers they represent are not, there are lower transactions costs of trading the shares than trading the bulldozers.
If I want to hold a liquid asset I can sell in a hurry, if ever I need to, I will be more likely to buy shares in bulldozers than a bulldozer itself. Provided I trust that I can find a second buyer, who will only buy if he in turn trusts he can find a third buyer, and so on. We can't all rush to the exits and exercise our options to sell at the same time. If we tried to, we would soon discover that liquidity is an illusion. The magic only works if we believe in it.
Bank deposits can even be the most liquid of all assets -- money, the medium of exchange. But again that only works if people trust that other people will not all rush to withdraw their deposits at the same time.
An ideal Finance would take all the real assets that are long, illiquid, risky, and complicated, and convert them all into money. Money is the most liquid of all assets. It's the shortest of all assets. It's the simplest of all assets. And it's usually the safest too (provided inflation is controlled of course). The job of Finance is to take bulldozers, houses, cars, brand names, furniture, computer software, business organisations, farmland, oil wells, university educations, and convert them all into money. Ideally, all our savings should be held as money, except for the real assets that we ourselves want to use. We shouldn't need to hold stocks, bonds, or anything else.
An ideal Finance is impossible, of course. But what surprises me is how far it has come along that road. It's surprising that Finance exists at all. Theoretically, Finance doesn't seem possible. It's just too far-fetched to expect it to work in practice. It's just a confidence trick; it all depends on trust. Let's just stick to locked chests full of gold coins for our retirement, and real assets that we have financed with our own savings. And it's just too bad if the people who can best work those assets, and the people who have the savings to own them, aren't the same people. Life in a medieval economy ain't so bad.
[I started to write this post after reading Brad deLong. I was going to stick more closely to Brad's topic (and I may well come back to it in a subsequent post), but I wandered off into these musings. Then, coincidentally, while halfway through this post, I saw similar musings from Arnold Kling.]