The Profit Motive Behind Financial Complexity
bloomberg.com
bloomberg.com
Economists fell for the myth of Black–Scholes. This is a neat way of quantifying risk, but it assumes that risk has a Gaussian distribution. Sometimes it doesn't.
Maybe you're being loose with your terminology, but there is no such assumption. The simplest versions of Black-Scholes does assume that stock price is a lognormal process with constant variance/volatility, which empirically it isn't.
The point of Black-Scholes is to price derivatives not quantify risk, but the price also has an empirical market price. Just as you can use the 'assumed' variance/volatility to try to compute the derivative price (according to B-S), you can use the market price of the derivative to compute the 'implied' variance/volatility.
If you look at the options page for AAPL on yahoo finance[0], you'll see a column for implied volatility, the above method is precisely how it is calculated.
But as you add more and more riders, variants, bells, and whistles the products become less comoditized and more profitable for companies that issue them. Their profit is your cost.
Genuinely curious, could you give examples of these? Maybe it's time to start a country for tax reasons :)
Now of course there’s the argument that the US government borrows too much: totally true. Someone has to jump on the grenade and cut military spending (the greatest discretionary income spend) and raise taxes (they’re at the lowest levels in US history, and must go up), but that’s a bitter pill to swallow.
As for reliability, consider the gold bonds the government used to issue. They guaranteed repayment in gold, and hence sold at a premium. In the 1930s, Roosevelt repudiated them, paid them off in dollars, and pocketed the difference.
The government can, and has, simply printed money and forced people to accept that as payment of debt.
This is an extremely mild accounting practice compared to what private companies routinely engage in. Not all of Google's IP actually originates from an Irish-owned company headquartered in Bermuda.
"Reliable" gold with its 30% annual price swings - well, enough said on that.
> The government can, and has, simply printed money and forced people to accept that as payment of debt.
Forced who - investors who willingly buy Treasuries, understanding full well how the dollar works?
Or did you mean 1930s investors who got fiat instead of gold-backed dollars? There were rather more significant victims of the Depression.
And when you spend the money (the asset), you're left with just debt.
> This is an extremely mild accounting practice
Spending trillions, and then still calling it an asset?
> Forced who - investors who willingly buy Treasuries, understanding full well how the dollar works?
The US government gold bonds promised to pay in gold. That's why they sold at a premium. Are you arguing that the bondholders shouldn't have trusted the government to keep its word?
> There were rather more significant victims of the Depression.
The topic is how government bonds are "the safest, most reliable investment product in the world", not who is the bigger victim.
Instead, consider a 3-node chain, where the US government discretionary budget has debts coming due to the SS budget, and the SS budget has obligations to the public.
When demagogues claim the SS fund is empty, they are actually trying to trick the public into writing off that debt, instead of going after the upstream debtors... Which is basically Congress.
After all, every dollar that isn't being spent servicing the debt to SS is a dollar that can be used in tax cuts for the wealthy...
There wasn't even an income tax until 1913.
http://blog.jparsons.net/2009/03/us-government-spending-as-p...
The current holdings are 2.8T with an avg interest rate of 2.9% [2]. I find the current system far better than simply putting dollars into a bag.
How would you design such a system with the same risk profile while not losing ~$150B a year that the current system maintains?
I'd argue that 1) there are more opportunities for graft in more complex products because a cut can be taken at every layer of indirection, so therefore amongst salespeople confusing multiply layered products will crowd out simpler products with fewer levels of commission and kickback, and
2) Making uncommon choices is a sign of expertise, because one has to be somewhat more knowledgeable about a domain to know of the existence of uncommon choices. This makes those choices easier to sell through flattery and/or the appeal of being an insider and getting a special deal. An example of where looking like an expert is an appeal that allows people to be suckered is the fact that the best odds at a craps table are on pass/don't pass, and every other bet is far worse, going from doubling the house edge to nearly multiplying it 10x.
That's a very insightful observation. Thanks!
If I need to take an old long bond off my books that has 10 years left until maturity then it might better to just sell it instead of going short the on the run 10 year even though the on the run has better pricing.
Dealers are just better equipped to handle the complexity so the higher profit margin on more complex products doesn't necessarily lead to a worse result for the customer.
The article was complaining about how complexity can impede sussing out how much risk a sufficiently informed investor might be exposed to from owning a complex security, this is a different kind of risk from not being sufficiently informed while actively using a complex product (like your car example).
That seems to be a story about corrupt hiring practices at municipalities. Maybe they should look into hiring the kid with the foreign name and funny accent instead of their high school buddy's kid.
I'm sure they got screwed on all sorts of construction contracts too.
Second, we all buy financial products that we don't understand and we generally benefit from them. Many people use fixed rate mortgages to buy homes and index funds to invest. I'd argue that they probably don't understand those products as they're relatively complex underneath the surface. This isn't financial advice, but I'd argue that they do benefit from using them.
The idea behind an index fund is that it invests in the components of an index. Generally, that is a specific basket of stocks or bonds. Stocks are perhaps the most straightforward financial instrument: pieces of ownership of a company. Bonds are a bit more complex, but they're just the right to repayment of a loan (principal plus interest). Complexity arises if the fund can't directly invest in the components of the index and most replicate it with other things instead but that's an implementation detail and an individual is perfectly capable of buying the individual components themselves if they're worried about that.
A fixed rate mortgage is a loan with a fixed, compounding interest rate and a fixed term. The mortgage payment is determined based on an amortization schedule but that's an implementation detail - it could just as easily be monthly interest plus a fixed portion of the principal or something else.
How much is the pre-payment option on your fixed rate mortgage worth? How much is the embedded interest rate swap that differentiates a fixed rate mortgage from a floating rate mortgage worth?
this is the achille's heal of libertarianism. it simply leans too heavily on the rationality assumption, while also ignoring many things of value in our lives like love, empathy, conversations, the future (unknowable) value of natural resources, homemaking activities, etc. it's political use (in the mano a mano sense, not in the government sense) is as a rationalization to be a jerk to your neighbor.
complex financial instruments are simply a manifestation of that mindset.
Not only I disagree completely with the notion that it is a weakness of the libertarian-economic model, but contrary to it, it offers the strongest protection against the misuse of paternalistic ideas. As Milton Friedman put it, "every man should have the ability to be stupid with his own money".
Behavioral economics are fun and interesting, but they are not the kind of ideas that will have an effect on policy the way that it disproves or makes the neo-liberal economic framework inapplicable.
The reality is that even presented with some predictably irrational behavior, we still prefer it. Even if you know the crossed-off price tag is economically irrelevant to the decision to buy or not, we react to it, we change our decision. And although there are circumstances worth exploring, trying to nuke out those solutions tend to have really worse results.
If you would describe most of the populace as imperfectly rational (I would, and I acknowledge my own contribution to that) then it seems irrational to support policy that depends on a perfectly rational populace; like a policy that depends on a nationwide constant temperature of 72 degrees.
I wonder how many unfair taxes have been repealed by the capacity to bear arms in response to them in the US. Examples of taxes that would be deemed extremely unfair by the recipients include soda, alcohol and tobacco taxes.
> If you would describe most of the populace as imperfectly rational (I would, and I acknowledge my own contribution to that) then it seems irrational to support policy that depends on a perfectly rational populace; like a policy that depends on a nationwide constant temperature of 72 degrees.
I'd like some more concrete examples of what you are pointing at. Classic economic models accept entirely that people are not perfectly rational, its just they tend to be for the majority of circumstances in aggregate. This is no secret, not even to Adam Smith, and that was centuries ago.
So what policies are you talking about? The state deciding what your diet should be, how your savings should be, how your work time should be, etc?
I don't see any justification for that assessment. How does libertarianism overlook empathy, for example?
> it's political use (in the mano a mano sense, not in the government sense) is as a rationalization to be a jerk to your neighbor.
That's not remotely true.
I've witnessed self-described libertarians doing exactly that. It usually goes along with a lack of understanding of the power they have over someone far less economically fortunate.
I'm met plenty of republicans who lack understanding of the power they have over the less fortunate. I've also met many liberals who can't comprehend why someone would want to own a gun, or who constantly look for any excuse to peg someone as racist/sexist/classist/etc. (Obviously these are all United States-centric examples since I've spent most of my life here)
To me it seems far more productive to examine the "best form" of each philosophy rather than the worst
I only meant to point out an example of ugliness that sometimes falls out of libertarianism.
This can boil down to something like the big boy principal, which does seem to advocate acting like a jerk, or acting in bad faith and then blaming your victim with a "He should have known better, so it's his fault I took advantage of him."
That said, the part about not forcing others to do your will is sometimes used to argue against levying taxes to be used for social programs (or almost anything else), and I think that is a mistake. I don't think I'm straw-manning here, as I have come across that argument fairly regularly, but I understand this does not represent the perspective of every person who identifies as libertarian.
Some think that zero coercion is tolerable, so fall under the umbrella of anarcho-capitalism.
Others think that because zero is unobtainable, there out to be a certain concession in order to achieve minimization. By centralization and legitimizing one coercive institution (the state), a lower amount of total coercion can be attained.
I think that we should minimize the size of the state as much as possible, and that given time the social support which the state provides will be irrelevant (nobody will need it). I also think the current social support structure (among other things) of the state is wildly destructive to the poor, and that many things could be done to improve that which don't involve higher taxation.
Thats the point of the libertarian moral tenets. You might disagree with them, but that does not imply 'jerkness' nor it is a 'nice thing' to do great things to some people by harming others.
That is not the only way to view social programs. Or taxes.
Its their intention by definition. Even by the coldest utilitarian model, a tax is about harming someone.
> That is not the only way to view social programs. Or taxes.
What is the other way? because I truly dont know any view that holds paying taxes as a benefit and receiving benefits as a harm.
The view I outlined is probably extreme by mainstream standards, but I think yours is, too.
I don't recognize this "debt", let alone if you do "owe" society something, the state is not society the same way that the church is not God.
> social programs provide some minimal compensation to people who are systematically screwed by the society they live in.
Nobody stops you personally from helping the people that you considered harmed by the system.
Ultimately, the people that believe in giving their resources to other people in need, dont require any help or force from the state. They can do it whenever and however they want.
Taxes however, are compulsory. They don't care about what you think or why you do it.
As for the God/church thing, I've heard that church helps some people connect with God. Similarly, government is an instrument that individuals can use as an interface of society. Both church and government may be severely flawed, but they both serve a purpose for many people.
There is one fundamental difference between the (modern)church and the state. You can choose to not go to church. You cannot choose to not pay taxes.
The fact that the state has the power to imprison you unless you pay is a powerful medium. And some would say you cannot get good results through bad means.
The State is not society. It's a social construct and organization like any other, and society predates a functioning State. It is definitely not owed anything because its not a person. Its like saying you owe the earth, or the stars. The taxes however, are levied by people. How do people get the benefit to dispose of your income, against your consent, in the name of society?
This may sound like copping out of the argument, but I don't think that's it. This is accepting that my political opinions are not the only valid positions, and I welcome disagreement and discussion.
I have two answers to the idea that taxes are what help other people. The first is that the government budget spends a fraction of its spending in progressive benefits. First, many of the things it does do not help society, or even help the people that need that help the most, and it does it while taking a big cut.
The U.S. government accounts for 36% of gdp spending every year. One out of 3 dollars is spent by the state. If you replaced the government with a machine that just cuts out an equal check to every single person in the U.S., it would be a universal basic income of 20.000U$S a year.
The above is to give an intuition on what the actual government actually is. It gets that amount of money, but there is nowhere nearly that level of redistribution.
I like equating the state with the church because again, when a believer puts money in the church box, he thinks he is helping God's cause, but he is helping the priest first.
The other answer is that the government often spends the money in regressive benefits. That is the benefit helps the upper half more than the lower half. That is a classic issue with Social Security for example. You can google Milton Friedman's social security talk for a great explanation of why SS is regressive.
So not only it spends an enormous amount of what it collects, but sometimes even redistributes it against reasonable economic principles.
If libertarians generally advocated for much broader liability for e.g. selling opaque financial instruments I’d be impressed. But I haven’t seen that.
the socioeconomic theorists like marx saw that the profit motive led to perverse incentives and exploitation as a fundamental property of capitalism.
modern economists fail to connect the... hand waving that they do regarding deception with the inability to predict economic events or the widespread social destruction that occurs when their (hand waved) mathematical theories are allowed to govern social outcomes "because otherwise, why would people work?"
let's face it, free market ideology isn't even a valid or self consistent and complete theory. it's a cover story for feudalism that layers on as many extra mathematical abstractions as it can manage purely to increase the cognitive cost of unraveling it... just as the OP suggests in a much smaller context within the same realm.
Incompleteness and wrongness are properties of every social and economic theory, and you seem to be attacking some pretty well established theory on the grounds that it is incomplete and/or wrong. No theory involving humans can be simultaneously complete, consistent, and interesting. The more important question is how bad are the consequences of letting a given theory guide policy, and while the status quo may be far from ideal, it is far from the worst humans have done.
Also, it's pretty bold to label your own comment insightful.
Enjoyment from successfully navigating complex constraint sets is natural, but turning the mechanisms by which human beings get fed and clothed into a game like that feels less productive than many alternatives.