I understand risk-aversion. The assumption of diminishing marginal utility of consumption makes sense. And if you have diminishing marginal utility of consumption, you will prefer an investment with a certain return over an investment with the same expected return but a positive variance.
Loss-aversion is harder to understand. You need to assume the utility function is kinked, so even small losses lower your utility a lot more than small gains raise your utility. Plus, the kink seems to move, to wherever you are right now.
Nominal-loss-aversion is even harder to understand. Why would people care more about losing 2% of the dollar value of their investments than 2% of the real value of their investments (due to inflation)? They must suffer from money illusion.
Anyway. Let's just assume an economy where lots of people suffer from nominal-loss-aversion.
Suppose some promoter comes along with a new financial asset. The promoter promises that you will never lose money if you invest your savings in this new financial asset. Even better, he promises that he will buy back that financial asset at the issue price any time you ask him to. And suppose all the people who suffer from nominal-loss-aversion take him up on his offer, and buy the new financial asset.
But it is obvious to everyone that the promoter might not be able to keep his promise under some circumstances. Because he has invested the proceeds in various risky and illiquid loans.
That is very hard to understand.
Now suppose those circumstances happen, and the promoter cannot keep his promise. So the promoter goes to the government and says: "Very bad things will happen to the whole economy, and not just to me and the people who invested with me, unless you help me keep my promise". And the government believes he is right.
So the government helps the promoter keep his promise.
Sometimes, helping the promoter keep his promise is very costly for the government, and for the country. But the government does it, because it believes that the consequences of not doing it are even worse.
But the government takes no action to ban the promotion of those financial assets in future. All it does is impose regulations that reduce, but do not eliminate, the chances that the promoters will be unable to keep their promises.
That is even harder to understand.
Meanwhile, the government itself produces a financial asset that people can buy. And the government promises that the people who buy that financial asset will never lose money by doing so. And the government can keep its promise. Because that financial asset is money. It is the perfect asset for people who suffer from nominal-loss-aversion.
But instead of promoting its own financial asset, the government helps the promoters of competing financial assets to keep their false promises, even when it is costly for the country for the government to do this.
That is incredibly hard to understand.
Now, it is true that sometimes it is easier for muggers to steal the government's financial asset than the promoter's financial asset. And sometimes the promoter's financial asset is easier to buy and sell than the government's financial asset. But that problem is easily solved, if the promoter simply invested all the proceeds from selling his financial asset into the government's financial asset. Because then he could always keep his promise.
But this is not what happens.
Instead, whole countries get into very bad trouble because of people who suffer from nominal-loss-aversion, the promoters who make promises to those people that everybody knows they cannot always keep, and the governments who enable them to do this and keep those promises for them.
It must be some sort of really weird co-dependency thing.
I do not understand banks at all.
[Update: conflict of interest declaration: I own bank shares, and so have a vested interest in writing a post like this supportive of.....never mind.]