Finance as Magic

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.]

 

Comments

[Alex Plante]

I once heard a witch being interviewed on the radio, and she claimed that money was a very powerful form of magic.

[Andrew F]

Gold coins have the same problem. You can't eat gold. It's useful for precious little. It's another confidence trick, and people buy it on the expectation that someone else will buy it, hopefully at a higher price some time in the future.

It seems to me that the value in finance comes from portfolio optimization. Creating combinations of assets that have less risk (variability) in aggregate than each individual asset might offer, while offering superior returns to cash stuffed in a mattress. These portfolios can fairly closely resemble cash (approaching the so-called 'risk-free rate of return'), but of course are never quite the same thing. It's also interesting that portfolio optimization has applications outside of finance, such as creating portfolios of renewable energy sources that reduce variability in power output by selecting sites and technologies that are less correlated.

It might not all be a confidence game either. There is a plausible buyer of last resort for many securities. If a share prices falls too far, the corporation that issued the stock may like to buy it back. Same goes for bonds when yields rise farther than is justified.

[Patrick]

"It's just a confidence trick; it all depends on trust"

Ah, but I think deep down, we all know (or knew) that. So much of the machinery of our society is geared towards fostering and maintaining the trust that enables the magic. Take away the government, laws, the courts, the police, etc. and you'd probably be back to locked chests and stuffed mattresses pretty quickly.

"Life in a medieval economy ain't so bad."

Bring out your dead!!! Bring out your dead!!!

:)

[reason]

You should read Steve Waldmann http://www.interfluidity.com/ - that is just about all he talks about.

[Rogue]

Here's a story going around that illustrates how Wall Street does its magic: Once upon a time, in a village, a man appeared and announced to the villagers that he would buy monkeys for $10 each.

The villagers, seeing that there were many monkeys around, went out to the forest and started catching them. The man bought thousands at $10.

And, as supply started to diminish, the villagers stopped their effort. He further announced that he would now buy at $20 for a monkey.

This renewed the efforts of the villagers and they started catching monkeys again.

Soon the supply diminished even further and people started going back to their farms. The offer increased to $25 each, and the supply of monkeys became so small that it was an effort to even find a monkey, let alone catch it!

The man now announced that he would buy monkeys at $50! However, since he had to go to the city on some business, his assistant would now buy on behalf of him.

In the absence of the man, the assistant told the villagers. "Look at all these monkeys in the big cage that the man has collected. I will sell them to you at $35, and when the man returns from the City, you can sell them to him for $50 each."

The villagers rounded up all their savings and bought all the monkeys. They never saw the man nor his assistant again, only monkeys everywhere!

[Just visiting from macleans]

Finance: the transfer of wealth.

[Andrew F]

Rogue: finance is not a Ponzi scheme. The question asked is how does finance produce useful product, when it seems like it should not? You're claiming that finance offers nothing of use, which is pretty obviously incorrect.

[JP Koning]

“But then you still need to research the bank… Unless of course you just trust the researcher. But why should you do that? … It's just a confidence trick; it all depends on trust.”

But why do you trust that the company manufacturing your car will not create something that blows up on first drive? Why do you trust that the chef at your favorite restaurant isn't spitting in your food? Trust is earned over time through effort, passed on by word of mouth, and bolstered by performance and reputation. Such forces function in finance the same way they do in the real economy. To write off finance as a con game entirely dependent on trust is to write off the real economy as that same con game.

Nick, you're complaining about the difficulty of investing, but these sorts of difficulties are a fact of life. Investing isn't easy, it takes time & effort, just likes it takes time & effort to learn what kind of camera to buy, or what house to purchase.

“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… Life in a medieval economy ain't so bad.”

I don't know if you said this just to stimulate controversy, but I'll take the bait.

You want to stick to gold and real assets to avoid finance based con games dependent on trust. But do you trust that your wife or children won't make off with your gold coins while you're asleep? Did you do the research on them, or better yet, hire a private eye to do the work? Did you research the private eye to make sure he’s trustworthy, or better yet, hire a private eye to investigate the private eye? As for your real assets, do you trust that the government won't confiscate them, or put a special tax on them? Did you research that in the newspapers, or get such knowledge from a friend? How do you know you can trust your sources? In the end, your choice of gold and real assets comes down to the same trust based “con game” by which you have characterized finance.

If finance is a magical con game, so is everything else. More likely, while trust can be gamed from time to time, it is a real force that has been preceded by genuine effort, work, and time, and it operates in the financial economy just as it does in the real economy.

[Brandon]

Finance is not “like any other industry”.

Finance is a method to dynamically transfer risk to the party who can bare it at the lowest cost. “Shifting risk around” is the point. I may be willing to acquire a high risk asset today, but, when circumstances change tomorrow, would like to exchange that high risk for less risk. Of course, there are costs and benefits involved in this transaction and the underlying project hasn't changes. My preferences or personal circumstances may be different however.

If it is working properly, finance does effectively separate the risky and less risky elements of particular assets and then distributes the risk to those who are willing to bare it.

The key point is that it is dynamic, not magic. In a static world, your "magic" agrument may make sense, but when we consider changing circumstances over time, finance makes sense.

[Neil]

Patrick - without trust in "the government, laws, the courts, the police, etc." there is no money - nothing to stuff in mattresses or chests. The medium of exchange can only exist so long as we trust that we can buy goods or services with it. If society broke down, no amount money - whether gold or paper bills - would be able to buy a meal. You would have to directly exchange your own goods or services for what you need through barter. And even then, if you're providing or receiving a service that takes any amount of time to complete, there has to be trust that one party will pay up.

So yes, the institutions of civilisation exist in order to allow us to trust each other. And without trust there is at best an extremely inefficient economy.

[winterspeak]

LOL Nick!

I certainly agree that economists have decided to take the witch doctor approach to understanding finance!

The alternative is obviously too horrible to contemplate ; )

[Rogue]

Ok, here’s my serious take on finance. It exists because it knows who, in a given population, are willing to exchange their liquidity for yield. And it knows, on average, how much that yield should be, given how much everybody is willing to part with his liquidity.

It works because, in a given population, people have varying preferences for liquidity. They have different durations whereby they sacrifice liquidity. For as long as this preference for liquidity is the determinant of yield, everything is okay.

However, we occasionally see cases when people are chasing after yield, while maintaining the façade that liquidity is not being sacrificed. This usually builds up a bubble in yield that ultimately unravels when people realize that only the first person asking for his liquidity back will get it.

[Patrick]

Neil - I wasn't really thinking about total anarchy, though I didn't make that clear in what I wrote. Really I was thinking about the third world. Places where there is enough gov't to get by (e.g there is a currency and people mostly use it etc) but the machinery of private property and contracts etc doesn't really work very well.

[Michael Buckley]

All trades, but financial trades especially, can be thought of trading on two margins: real value, and information/trust. Economics is usually focused on the first because pricing is a pretty bright light. But the second margin is important, and blocks many advantageous trades. Long periods of stability cause market participants to shift their default calibration of trustworthiness (or recalibrate their willingness to deal with shady charactors). At the beginning, this increased presumption of trust sets off a spiral of wealth creation as all sorts of valuable, but information/trust challenged trades become possible. As this confidence boom grows, the shady actors start partying and the end is near.

Or just read http://d-squareddigest.blogspot.com/2004_05_23_d-squareddigest_archive.html.

[Nick Rowe]

I'm still trying to get my head around this, and respond to your comments.

There seem to be two questions:

1. Does the "industry" of Finance actually *create* short, safe, liquid, simple assets out of long, risky, illiquid, complex assets (in the same way that the steel industry creates steel out of iron ore). Or does it just redistribute those properties so that the people most/least willing to hold assets of a particular length, safety, liquidity, complextity get to hold most/least of what they want?

2. Is trust/confidence any more important, in principle, in Finance than in other industries?

Let's take the second question first. While I agree with Michael Buckley and JP Koning's point that trust is important in all industries ("Nick, you're complaining about the difficulty of investing, but these sorts of difficulties are a fact of life. Investing isn't easy, it takes time & effort, just likes it takes time & effort to learn what kind of camera to buy, or what house to purchase."), I think there's a difference not just in degree but in kind when it comes to Finance.

Suppose there were suddenly full free information about the qualities of cars and cameras. This would in no way harm the industry that produces cars and cameras. On the contrary, they would thrive (even though a few firms, the ones that produced crap cars and cameras would be harmed). But if there were suddenly full and free information on ultimate borrowers, why would we need Finance? Ultimate lenders would just lend directly to ultimate borrowers. In some sense, information is what finance produces.

On the first question, I still can't decide.

I wasn't serious, by the way, when I said we should go back to a Medieval economy. But without Finance, I don't think we ever would have escaped a Medieval economy.

[Rogue]

Nick, you're right in that if there were full and free information, finance can be dis-intermediated. It has been happening for some time, and this is why banks' reaction has been to grow bigger (to avoid dis-intermediation).

I guess it's not exactly comparable to the steel industry which creates steel out of iron ore because no one will actually demand to get back his iron ore, and no one is going to destroy steel just to return someone's iron ore. This kind of demand can happen in finance.

[Andrew F]

But you're looking at finance as producing a good, where it seems to be producing a service.

[ari]

Nick,

Risk and liquidity can always be transferred. I suggest that (some) risk can also be unconditionally eliminated, and liquidity can be conditionally created.

A simple example of how risk can be eliminated by pooling:
Mr A and Mr B hold sealed envelopes, one containing $10 and the other nothing. I agree to accept both envelopes and give A and B each $5 in return (or $4.50 if I'm a true financier). Voila! The risk no longer exists.

Liquidity can be created by pooling, but if the pool no longer behaves randomly (eg everybody wants to get out), the liquidity evaporates. If everybody in the pool was relying on liquidity, then new risk was just created! Finance can combine liquidity transfer with liquidity creation to create an overall more-stable liquidity (eg buyer of last resort).

[Patrick]

ari - I like your analogy. How about this extension:

Mr. A and Mr. B have sealed boxes containing 'quantum' $10 bills; the envelopes may contain as much as $10, but they might contain anywhere from $-10 (i.e. the holder owes money) to $10. Now even if you know the probability distribution of the quantum bills in the envelope, you still can't control what you get when you open them. You can come to perfectly rational arrangement likely to make you some money, but you can't completely eliminate the possibility of losing money.

And if it so happens that the probabilities of getting low or negative returns are somehow correlated and you didn't realize it, and you have a big pile of envelopes, and fate conspires against you .... well, you hope Mr. Geithner and Mr. Bernanke are in a generous mood.

[ari]

in that case, the extra risk was created by false confidence. There was some real risk reduction from the pooling -- otherwise a hell of a lot more Florida and Nevada banks would have gone under, and new york banks wouldn't have cared much -- but the big banks acted as if they were holding no risk at all. oops.