Why is finance so complex? (2011)
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* Allows you to get a mortgage
* Allows you to protect yourself with health/car/life/home/title/etc insurance
* Pays for your highways/stadiums/schools and other public works
* Protects your deposits
* Pays for your retirement
* Funds the college fund that paid for your school
* ... Or the student loans that allowed you to attend school
* Supports the global supply chain that brings you your iPhone, stocks the grocery store/your favorite restaurants with food, and puts the clothes on your back.
* Funds the growth of corporations large and small, giving you the job that allows you to buy an iPhone
* Funds the massive philanthropy expenditures that help those in need everyday
* Pays the pensions of the elderly
Financial innovation make our lives more predictable and less sensitive to chance. One could argue a huge amount of human progress is owed to modern-day financial institutions.
Like a software system, it's extremely naive to think that complexity is a sign that a system is rotten. Finance is an art, not a science. Sometimes we make products that we don't always completely understand until later. But the vast majority of financial innovations are deeply ingrained in the good life that you get to enjoy every day.
Education prices are also a function of available credit that tops out at expected total salary less food/rent expenses.
It's enslaving you. Unless you ride it and enslave others.
Your list reads like a wide-eyed econ grad. This is not the real world.
Also note the "we" in the statement. Vested interest.
I need some serious convincing that the effects securitization of everything has been a net win.
The markets for most of this stuff are made or directly supported by the Federal government.
http://www.tradingeconomics.com/embed/?s=unitedstamonsupm0&d...
Look at that innovation! How is your life doing recently? I feel like mine is four times better. Oh no wait land is way more expensive and I'm working to pay my landlord every month. Should I go to my bank and make a huge bet on record low rates or wait for them to print some more whilst wages are static?
One natural experiment in the effects of speculation is home prices in Texas ( which taxes land rents more than most states ) vs. Florida ( which taxes them less ).
It would also help address some examples of misallocation of land. Since the tax base is now largely market driven, it's all but impossible to game.
http://inflationdata.com/Inflation/Inflation/Money_Supply_an...
Because we are in a big "liquidity trap": http://krugman.blogs.nytimes.com/2013/04/11/monetary-policy-...
The fed printed money can only be loaned, not just given away. This limits its direct impact on inflation. On the other hand, it certainly would cause inflation if it made it out of the banks. But banks will only loan if they think they can make money: only if there is economic growth to take advantage of, otherwise it just sits.
At this point we should not limit growth based on lack of liquidity, so it's probably not a bad thing that the fed is pumping money into the banks.
I read that some in the fed suggest that interest rates should be raised. The expectation of future higher rates might encourage people to borrow and spend now: https://www.stlouisfed.org/publications/regional-economist/a...
The reality is, the derivatives market is larger than the actual market. More capital is invested in calls guessing if Google is going up than is actually invested in Google. This is a sign something is rotten.
This article from 2008 has a lot of interesting data from after the subprime crash ( http://monthlyreview.org/2008/12/01/financial-implosion-and-... ). It then has an analysis of that data. Whether or not you agree with the analysis, the data it points to is interesting.
90,000,000,000,000 GWP
1,500,000,000,000,000 global derivatives
No. No it is not. No 1,000,000,000 times. NOTIONAL DOES NOT EQUAL MARKET VALUE.
It's also completely meaningless as most trades offset. Trades are rarely torn up, you just do a new one to offset your risk. E.g GS vs JPM: they probably have 100bn of notional with each other. Actual risk? very little as the vast majority of trades just offset.
Current outstanding derivative notional is more like a measure of all notional that's historically traded.
Anyhow that aside, notional is STILL a meaningless number. It tells you nothing about the risk or market value of the trade.
Having read up on the topic, the problem appears to be that this probability cannot be accurately determined, due to useless models being used (e.g. Normal distribution to model complex phenomena).
So the probability is often not so low as the financial experts think. Besides that, it does happen that the liability becomes due, as in the 2007/2008 GFC. People were shocked because their models indicated that such an event should practically never happen (due to it being of such low probability).
When the liability is due, the whole system collapses (as it did in 2007/2008) because the collateral that is held is often not worth what it's is marked up to be.
So the whole system is fragile and prone to systematic collapse. Sounds pretty rotten to me.
> Allows you to get a mortgage
Wonder if that was always so? Didn't people manage somehow to have a house without something which name suggests it will be paid for the whole life?
> Allows you to protect yourself with health/car/life/home/title/etc insurance
A casino, right? On average you lose, but for a price you buy a hedge against unforeseen? At least unforeseen for you?
> Pays for your highways/stadiums/schools and other public works
I thought my taxes pay for that :) . Do you mean "finances" as "machinery which helps moving money"? I think there are several definitions there.
> Protects your deposits
That's great and helpful
> Pays for your retirement
Nah, that's those same deposits. I largely pay myself for retirement, by saving the whole life. There is also an element of "societal insurance", when I pay a little extra to help myself in case I suddenly become disabled. Or dead. Or, well, not so little; that depends.
> Funds the college fund that paid for your school
Again, it's either another example of "moving money", or an oddity - as people managed to get educated even without banks.
> ... Or the student loans that allowed you to attend school
Same thing.
> Supports the global supply chain that brings you your iPhone, stocks the grocery store/your favorite restaurants with food, and puts the clothes on your back.
Yes, that's another important role - bringing together lenders and borrowers, for a fee. One ought to assume the fee in the computerized XXI century should be small?
> Funds the growth of corporations large and small, giving you the job that allows you to buy an iPhone
Same thing. Banks don't "fund" - they "serve". Money aren't theirs, but theirs', banks', depositors.
> Funds the massive philanthropy expenditures that help those in need everyday
Talked about that already.
> Pays the pensions of the elderly
We already talked about that.
So, to boil down - banks provide money-related services, like "guarding" deposits (you pay for the privilege) or "investing" deposit money (you ought to share risks and benefits). Other than that...
Plus regarding "funding" education etc they do no such thing, this is funded by the state. The post you reply to is littered with incorrect statements. Well done for calling some out.
>Didn't people manage somehow to have a house without something which name suggests it will be paid for the whole life?
Well, for a while people were indentured farmers, then you got people renting tenements and apartments in cities, with some land-grant family farms/homsteads being passed down through inheritance. Mass suburban home ownership is mostly a post-WWII phenomenon, and mostly funded through credit. Though for a time, most people got their mortgages from community credit unions (or similar), those were still financial institutions, just in decentralized cooperative form. Big banks ended up being able to provide better rates through sheer scale.
>A casino, right? On average you lose, but for a price you buy a hedge against unforeseen?
My mother had a brain hemorrhage last week, we paid about $1000 for $500k+ of medical care. The insurance industry works only because insurance companies can invest their giant pool of money and see large enough gains to both cover all their costs and make it worth their while. Insurance premiums aren't sitting around as cash.
Your point?
>that's those same deposits
Nope, it's the interest on those deposits, the core service of the financial services industry. Retirement is entirely predicated on compound interest.
> Same thing. Banks don't "fund" - they "serve". Money aren't theirs, but theirs', banks', depositors.
It's hard to imagine how you could possibly be more wrong. We're not talking about business checking accounts here, we're talking about banks investing in businesses. Banks absolutely do fund businesses, and own (shares in) those businesses in return.
An investment bank owns a business and, in turn, its checking accounts in retail banks.
I don't think you understand banks' roles in philanthropy and education - successful nonprofit institutions like universities draw their operating budgets from interest on their endowments. Were it not possible to park $x billion in account and draw $y million a year in interest for literally forever, many such institutions could not exist.
I do assume there are two kinds of banks. One is "retail", or financial services, as I understand it. Gets its money as fees. Another is investment - this one takes risks and reaps rewards, but it's a different kind of organization - somewhat similar to a group of people, who pooled their money and work on a kind of gambling, often reaping rewards, but also taking risks.
Talking about this second group, it's entirely different - for many people who are not members of that group of investors (risk-takers) it's outside of what they deal with. So I'm mostly talking about first group.
For example, my point regarding insurance is that I'm dealing with professionals having different amount of information than I do, and benefiting from that. Theoretically market should bring insurance premiums to some average profit margin. Also theoretically I should be able to earn on average more than I spend on average on insurance, so examples with big expenses are supposed to be exceptions, and on average I'd have more money paying for cases myself. In that sense, insurance premiums are spent (supposed to be, mostly) on cases where insurance events happen.
Next, "those same deposits" - I think the word "principal" is meaningful :) as there won't be interest without principal. So I still think we talk about deposits - together with added relatively modern service of investing, getting some averaged interest and paying some fees to the service which does the investing. Yes, that's the core service. Of retail banks... may be we actually agreeing here?
Next, of course banks invest, that's how they pay that interest. The principal money still aren't theirs - so banks don't "fund" - as in "fund with their own money" - since retail banks by definition don't deal with their own money; instead banks pass those money as credits - or, yes, even to buy shares. The fact that, say, universities takes their budgets from interest shows that service works - but it's not the banks, who "pay" - don't assign the source to them - it's principal, combined with the service (for which banks don't pay, but receive fees), which generates interest. Bank is a sort of an engine which you feed with fuel to get desired outcome (bad analogy, I know), but I think fuel here is more principal (sic), more fundamental than the service.
They used to own land (and peasants!) themselves or they were funded by someone who did (Church/King/Prince). The former was preferred due to the larger independence and stability it gave them.
Copenhagen University used to own lots of land, for example. So did (do) Oxford and Cambridge.
You are correct in that the money used to build highways etc. does start as your tax dollars. However, I would imagine that it is then held (and allowed to appreciate) in the form of a reasonably liquid portfolio of cash, bonds, and equities. I suppose you could technically reduce finance to "moving money around", but that is such a gross simplification that it would be like saying programmers just type for a living.
> Nah, that's those same deposits. I largely pay myself for retirement, by saving the whole life.
If your entire retirement savings are in simple savings accounts (i.e. in a bank instead of a brokerage account), I am afraid you are losing out on quite a substantial return that could allow you to either retire earlier or enjoy a higher annual income during retirement (or both).
> > Funds the college fund that paid for your school > Again, it's either another example of "moving money", or an oddity - as people managed to get educated even without banks.
The statement that college funds, loan programs, and scholarship endowments (all powered by "finance") pay for the education of practically every student in the country is true, unless you save for college in a piggy bank.
> you ought to share risks and benefits
If you want to share the risks and benefits, there's an easy way to do that: get a brokerage account. If you have deposited your money, the basic assumption is that you are willing to accept a lower rate of return in exchange for a (practically) risk-free place to store your money.
depends on how much you want to rely on the FDIC
Taxes are not the only way that governments get money. Sales of government bonds are likely to generate a large portion of capital behind infrastructure projects.
If your local municipality can go to Big Investment Bank Inc to arrange a bond issue, they can time-shift their tax receipts in order to build that new school/library/highway overpass now rather than 10 years from now.
You are talking about money. Not modern wall-street finance.
> huge amount of human progress is owed to modern-day financial institutions.
Like synthetic credit default swaps?
> Like a software system, it's extremely naive to think that complexity is a sign that a system is rotten.
Complexity that can't be coped with is rotten! The Linux kernel is quite complex but each part of it is well understood and there are a lot mechanisms in software to reduce complexity.
> But the vast majority of financial innovations are deeply ingrained in the good life that you get to enjoy every day.
Tell that to Greece people that got into the Euro because of clever CDS from Goldman Sachs or the masses of people that are stuck in debt from their education or credit cards.
> Sometimes we make products that we don't always completely understand until later.
That does not stop you from selling them and acting like you do. However recent financial crises have shown that banks offering these products for the most part understand them... the persons buying them don't.
> Funds the massive philanthropy expenditures that help those in need everyday
That shouldn't be needed in the first place if there wouldn't be such a huge inequality. Philanthropy is not a good idea for a good-working society. There are laws and a justice system that is more fair than a few far too rich persons with a selectively good cause.
> Finance is an art, not a science.
And it should be a tool not an art. A means to an end.
> I'd say this used to be true, but now ZIRP (Zero Interest Rate Policy) hurts any class of savers first world et al
If you're against CDS, you should explain why.
Like any financial product, CDS is not perfect, but it's also intellectually dishonest to argue that it doesn't offer any benefit to society. For example, CDS is used widely by the insurers that the parent noted help individuals protect themselves and their property.
> Complexity that can't be coped with is rotten! The Linux kernel is quite complex but each part of it is well understood and there are a lot mechanisms in software to reduce complexity.
You apparently assume that the financial markets are too complex to be managed but poll people on a busy street in any major city and many will probably tell you they feel computer software is unmanageably complex too. Should we call software rotten because some people who used it have suffered some loss as a result?
> Tell that to Greece people that got into the Euro because of clever CDS from Goldman Sachs or the masses of people that are stuck in debt from their education or credit cards.
It takes two to tango. It would be unfair to pretend that some of the near countless individuals and companies active in providing financial services have not acted immorally or even illegally, but it's intellectually dishonest to pretend that every person who has taken on more debt than he or she can manage is a victim who was coerced into making financially imprudent decisions.
This applies to countries too.
> However recent financial crises have shown that banks offering these products for the most part understand them... the persons buying them don't.
Save for Lehman, which was allowed to fail, the large banks were bailed out. If they were as savvy as you seem to think, why did they need bailouts?
I respectfully disagree.
I don't think the 2008 crisis was caused by complexity. Most actors on these structured credit markets understood well the products. It was rather caused by over leverage and complacency toward credit risk.
And it will happen again. Hopefully the banking system is much stronger now, and the legal mechanisms are in place to limit the cost of a failing bank to tax payers. But the excess of liquidity as a result of money printing has starved investors for yield, and I believe that they are investing in places where they would rather not, like in 2005. Then it was subprime and commercial real estate. Now most likely emerging markets.
1. http://www.theguardian.com/commentisfree/joris-luyendijk-ban...
>Tell that to Greece people that got into the Euro because of clever CDS from Goldman Sachs The people of Greece (and their political leaders) wanted to get into the Euro. They spun their own fiction.
Well understood by experts, as is the appropriate section of the financial system. You chose to learn about the kernel, someone else chose to learn about asset backed securities. The guy who learned about Bach probably considers both to be very complex.
</sarcasm>
Like a software system, it's extremely naive to think that complexity is a sign that a system is rotten.
Why would such an assumption be naive?
It doesn't seem naive to me at all. I was reading a 1994 paper that I posted recently called "A Uniform Name Service for Spring's UNIX Environment" which made me think how simplified a modern Unix could be if it adopted the name service primacy described therein from its onset.
It is just as naive to assume that all complexity is intrinsic and not incidental or the result of inadequate abstractions.
While not hundred percent sure, it is highly possible that finance complexity will magically disappear once we get a proper model for money transactions. I certainly hope so, because a better model means more means to solve economic issues.
Right now economists are like the physicians in the time of Molière, they understand nothing and have only two cures: bloodletting and lavement (change interest rate and remove taxes)
Can someone smarter than me tackle this argument?
His system still used circular orbits and epicycles. The only real difference was that he put the sun in the middle instead of the Earth. In fact, it required more epicycles / gave more imprecise results.
The real improvement came when circles were replaced with ellipses by Kepler.
That wasn't entirely accurate, either, but replacing the ideal circles with the law of Gravitation (Newton) fixed that.
Economists have many more than just two cures -- which is why some of them keep harping on regulations and overly protective labour laws in Greece (and the rest of the Mediterranean swamp), their very expensive pension system, and the huge size of their public sector. Krugman doesn't, which is why I have absolutely no respect for him.
Simply the base artifact of modern finance. Why do I need a mortgage? (hint: to supply interest payments to banks AKA the institutors of the world of modern finance)
>* Allows you to protect yourself with health/car/life/home/title/etc insurance
See above.
>* Pays for your highways/stadiums/schools and other public works
"Pays". A meaningless word.
>* Protects your deposits
Only through magic. If deposits are lost, they are merely re-created as modern finance is an arbitrary mathematical construct.
>* Pays for your retirement
"Pays for your retirement"
>* Funds the college fund that paid for your school
"Funds the fund" that "paid". Again, meaningless except insofar as your school depends on magic numbers being circulated.
>* ... Or the student loans that allowed you to attend school
Ah, yes, the loans; again, the foundational unit of modern finance, without which the "world of finance" would be radically different.
>* Supports the global supply chain that brings you your iPhone, stocks the grocery store/your favorite restaurants with food, and puts the clothes on your back.
Supports in name, but is curiously not actually involved in any physical aspect of realizing any of those things.
>* Funds the growth of corporations large and small, giving you the job that allows you to buy an iPhone
"Funds" ... "giving [me] the job"
>* Funds the massive philanthropy expenditures that help those in need everyday
"Funds", because the actual work is done by real people.
>* Pays the pensions of the elderly
I guess the system isn't complete evil.
You need insurance because you don't have the personal finances to adequately cover the risk of "life"
Giving out mortgages is not difficult. You just have to be a bank. Not only that but 2007 showed that profit-making banks are even worse than a reasonable person, or precocious five year old, would be at deciding who should be given a mortgage.
Mortgages are a necessary part of society. Profit-making banks are not.
The only reason you spend your life slaving away paying extra interest to the shareholders of banks, is because banks have manoeuvred themselves into a privileged position. Inequality is not an accident of the system, it is the point of the system.
You could have a default on a loan if you were paying for your house with NukaCola bottle-caps, or engraved-crab-shells.
As you noted, the concept of a "loan" entails the possibility of default.
If most currency is created through loans and loans must be repaid in that currency, the system-wide probability of defaults is significant. The likelihood of defaults increases as loans require payors to also include tribute payments (interest), for which no currency was ever created (necessitating that the payor obtain the requisite currency from someone else before the default day occurs).
The bank that is the closest to this model (that I know of) is Mondo (due to be launching soon). Along with it's other innovations, it plans to allow you to invest money via Funding Circle for a potential return:
http://www.thememo.com/2015/06/25/meet-mondo-the-app-thats-g...
This is a smart idea on a couple of levels, it mitigates against the risk of bank runs and it provides a better return than many high street banks offer (the current average return rate from Funding Circle is 6.6%):
Mortgages are secured loans, so an individual default is no problem. The primary risk is of mass default (a housing crash).
If you agree with the pseudo-MMT view of the world, then the mortgage is created out of thin air in the first place, so if everybody defaults all that happens is that the money supply increases permanently instead of temporarily.
It wasn't just banks making poor decisions in 2007 about who should have a mortgage.
That is true only if you are not concerned about being repaid at a reasonable rate of interest. Lenders need to assess credit and interest rate risk.
And a large part of why housing costs $400,000 in the first place is due to the availability of mortgages. Mortgages gave themselves a reason to exist.
A 500 sq ft monolithic dome house costs around $30k. It fulfills all the roles of a normal house, but better, safer, and cheaper.
Now tell me how I'm wrong because "furniture doesn't fit in curved walls" and how that justifies the $370k discretionary increase in how much you want to help banks prey on homeowners and earn more interest.
Well, yeah, if you are going to have a house that small -- 500 sq. ft. -- optimal shape is a pretty big concern.
> and how that justifies the $370k discretionary increase
Well, much of the increase is going to be land price. Even a 500 sq. ft. dome home anywhere more typical home prices for reasonably moderately sized homes are around $400,000 is going to be a lot more than $30k just of the land it sits on.
There were fourteen of these domes, run as a cooperative, on three acres of land. The loans on building them were paid off in full by the early eighties, and I believe there was about a decade where no one paid rent. But eventually it was decided that a nest egg should be built up for upkeep and so on; by the time I was there, it was running about a third of market rent, and these days (due to some additional pressure to modernize) the rents are up to about 2/3 market.
Cooperative ownership is fantastic, and a great cure for the ails of capitalism. But they tend to not get a lot of investment for exactly the same reason: capital isn't interested in investing in non-capitalist spaces.
But it's certainly possible to band together with some friends to get an initial down-payment+loan. Then you incorporate the cooperative, and essentially 'sell' the house to the new cooperative, so that the 'rent' you pay to your new co-op pays off the bank loans. Once the loans are paid off, the cooperative becomes an autonomous creature, self-sustaining as long as there are people happy to live with other people and decide how the place will be run, rather than dealing with a landlord...
> Cooperative ownership is fantastic, and a great cure
> for the ails of capitalism.
I agree capital tends to avoid housing co-ops because they smell funny and act differently and the laws around them are a mess. As a result, it's harder to assess the risk for a co-op than other businesses and more complicated to borrow, contract, etc.
Diamond/water paradox
Also, there's no paradox.
Also, high diamond costs are due to marketing.
For a space smaller than a typical studio apartment. The Monolithic Dome Institute[1] quotes domes at $125/sf (including walls) for a "regular" finish. Your $30,000 dome would have a footprint of 250 sf. My house would cost at least $287,500 to replace with a dome; in contrast, it would cost about $150,000 to replace it with another wood-framed house. Concrete block costs would depend heavily on how complex the floor plan is, but would still be cheaper than a monolithic dome.
[1] http://www.monolithic.org/forms/the-residential-evaluator
If mortgages never existed then people would value housing much less because it's no longer $x monthly, it's the whole thing up front.
You're right that a portion comes from material cost but the cost inflates to fit the budget of the expected buyer. Without mortgages the typical suburban house would be built so that a middle-class person could afford it.
From this you can argue that mortgages are a good thing because they allow a person with less wealth to get more/better houses by leveraging future income, but the trade-off is that buyer takes on more risk, there are no low cost homes in good neighborhoods which could be reasonably bought outright, and people are more dependent on their credit rating.
No, most of the value in a home comes from the land underneath it. The point being made above is that the availability of credit leads to asset inflation, as more people are able to compete for the same scarce things (desirable living locations).
Mind you, credit does have a purpose - if your income and your house's value appreciate faster than the interest rate being charged to you, then you were able to gather the resources for it.
If you want to see what life is like without access to modern financial tools, got visit an Indian Reserve in Canada. Housing is cheap there.
Lack of access to modern financial instruments--municipal bonds in particular--is a major block in the way of First Nation's prosperity. Last year a new kind of "aboriginal bond" was floated for the first time to get around this, and hopefully more will come.
So you have an example of what life looks like in your dream world. It isn't pretty. And like everyone else who is pro-finance here, I'm not saying there aren't issues with what we've got. We can fix them. What we can't fix is the massive poverty that comes without access to financial tools, however morally repugnant those tools seem to naive outsiders.
So the wealth which flows in resource-abundant places is due to banking, and subsequently the lack of wealth in some desolated lands is due to the lack of credit availability, and both have nothing to do with the natural conditions of those regions?
lol.
No banks means no jobs, bad housing, no tools, no pc's, no security, no stores - but that dosnt matter, cause you dont have any money either, bad food, no mass production++
Most people commenting in this tread has no concept about what finance is and does, so it must be inherently evil.
Well, the world is more complex than that. Without finance your standard of living would probably be below one tenth of what it is now -unless you already live on the street of course. But then you wouldn't care because you'd probably be a alcholic or druggie. You won't get hold of any drugs or boose either so your fucked as well.
Tldr; The world runs on debt & oil. Get used to it, it isn't going to change anytime soon.
I say financial innovation should treated by govt. with greater caution and suspicion especially when the effects of such innovation has consequences on the wider economy or when it involve other people's money.(Who's bright idea was it anyway, to allow banks and funds to gamble with people's pensions and deposits?)
If you can provide a counter-example to this, that would be much welcome.
edit: And no, I don't think a world without debt securitization would be such a bad thing.
Not necessarily. It may also make our lives a game of chance or a house of cards. You didn't say what kind of innovation.
"Finance" gives us 2% down payment mortgages which are than packaged and sold to Japanese pension funds with currency and interest rate hedges mixed in... which then go on to screw everyone involved since NO ONE reads or understands the terms of the investment vehicle besides the financial engineers who wrote & sold them.
The same holds true for all the points you listed.
Fortunately, Capitalism has a fail safe. All this financial nonsense would have been fixed if the banks were allowed to fail in 2008. The US federal government is largely to blame for the continued parasitical rent seeking of the high finance class.
This vague phrase is very misleading. It is certainly not true that all "Financial Innovation" makes our lives more predictable and less sensitive to chance. Please see 2008 for reference.
Sure, there are some benefits to basic finance and lending, but "basic finance and lending" are not really "Financial Innovation" at this point either. I think we would all benefit if you defined your terms better.
1. If a transaction is complex, it's easy to sucker people into buying. Why would anyone buy a structured product?
2. If a transaction is complex, both sides can claim an immediate profit based on their idea of how it should be valued.
3. A lot of complexity in finance is driven by the fact that big banks can borrow at 0% while true inflation is higher. Via various derivatives, this government interest rate subsidy is packaged and sold. For example, I can't borrow at 0% to buy stock, but if I buy a call option, the bank can borrow at 0% to finance their hedge.
4. Because different people have different interest rates (banks borrow at 0%, large corporations borrow at 5%), banks can price a derivative at 3%, and both sides can LEGITIMATELY claim an immediate profit on the trade. (Bank borrows at 0% and lends at 3% to finance the derivative hedge. The corporation is borrowing at 3% instead of the 5% they normally would pay.)
Of course, real interest rates have gotten close to zero, but in general real interest rates of 0% are nonsensical in stable, developed economies. Economically speaking, if rates were 0%, it would in the long run make sense to bulldoze the rocky mountains to save money on gas, because there is no marginal cost to consider.
Wait, run that by me again more slowly.
In general, it does make sense to make large infrastructure investments in order to increase long term productivity, especially when interest rates are low, but in general, it's always the case. Hell, bits of the Rockies WERE bulldozed (And dynamited) to save money on railroad or freeway construction that would pay off on a fifty to a hundred year timescale. What does zero percent interest have to do with that? Presumably there are even some positive interest rate values for which the eventual gas savings outweigh the cost of hiring the guys with the bulldozers, if those are the only costs you care about.
If there's a quadrillion dollars worth of hydrocarbons on Titan, and it'll cost me a trillion dollars and fifty years to bring them to earth, it makes economic sense for me to do it, even if interest rates are 5%. I don't think it's the interest rate that makes these projects make sense or not make sense.
What's the magic that happens at zero that causes otherwise nonsensical projects to make economic sense?
> What's the magic that happens at zero that causes otherwise nonsensical projects to make economic sense?
The bulldozing-mountains example is purposefully over-the-top (I believe I first heard it in an article by Bernanke[0]). The point that I am trying to illustrate is that at a 0% interest rate, the traditional marginal cost/marginal utility analysis breaks down, since as long as the marginal utility of the last investment dollar spent outweighs the marginal cost of spending that dollar (the interest rate), traditional economic thinking would have you spend that dollar.
> Exactly. I think he's assuming he'll never have to pay back the principle.
The rocky-mountain example does assume this, but it doesn't make a 0% interest rate any more ludicrous. Imagine that you could take out a loan for $x at 0%. Simply because of the fact that time gives assets the opportunity to grow, the future value of that loan when it is to be repaid is greater than the value when you received the loan [1]. Of course, the 0% rate would remove some traditional investment options (savings account, Treasury bonds, etc.), I think it is reasonable to assume that investments will still be able to appreciate to some degree.
However, this appreciation would be constrained in reality by inflation if the real interest rate is 0%. If, on the other hand, the nominal interest rate is 0%, then the loan effectively counteracts the headwind of inflation, and any return, no matter how small, winds up in your pocket.
[0 (7th paragraph)] http://www.brookings.edu/blogs/ben-bernanke/posts/2015/03/31... [1] https://en.wikipedia.org/wiki/Time_value_of_money
Suppose you spend $1M to produce something worth $100k. You lost $900k.
But suppose you borrowed at 0% while inflation was (to use round numbers) 10%. After about 50 years of borrowing at 0%, your $100k is now worth more than $1M. (I'm too lazy to use logs to figure out the exact breakeven point right now.) You made a profit.
With 0% interest rates, your investment that destroyed $900k of value was (eventually) profitable. If you can avoid mark-to-market accounting, you can just borrow, wait for inflation, and eventually sell for a profit.
When interest rates are less than inflation, a capital-destroying investment can seem profitable.
But I've tried again and again to understand how our basic Federal Reserve System functions - Gov't debt, banks, reserve margins, mortgage loans, etc. etc.
I've NEVER gotten a basic "THIS IS HOW IT WORKS in 21 DAYS", Stack Exchange-type-answer. Lots of opinions...
This itself leads me to believe that Finance is corrupt.
I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.
T. Jefferson
Sounds like all the people that think the same about IT. It's "magic".
Buy and read some books, it's laid out pretty clearly. If you're not sure what to read, email some of the professors in finance at the University you went to.
I got out of the field because I thought IT would be more rewarding. If I had it to do over again, I'd be one of those finance assholes ripping everyone off and laughing all the way to the bank.
I don't understand it, and I have seen countless interviews and articles from respected economists who say there are financial products they don't totally understand either.
To "understand" something in finance is not quite the same as other disciplines. You can understand all the pieces and all the rules of something, but not truly "understand" it entirely. Economics involves a lot of sociology/psychology and difficult-to-predict human behavior. It is likely that no one is completely aware of all of these factors when it comes to any given financial instrument.
So, I don't think you should be laughing at someone and telling them to read books as if this is algebra or something.
I have degrees in Finance and Economics, I'm a software engineer and my first job was as an Auditor for Andersen, so yeah, I've got a bit of a back ground in the "complex parts" of finance.
All it is for the most part is a fucking shell game FYI with different entities jumping through different nonsensical made up loopholes in tax law, financial regulations and anything else they can do to game the system.
Lots of people understood the "innovative finance" in 2008 and prior. For every stupid bet, there's someone on the other side. In fact, the reason we saw almost no finance people go to prison while the government gave billions, shows they know it far better than you give them credit.
You're right, reading a book about it is beyond most people. You have to actually pay attention as well.
I think the answer for why is it so complex is that it is a human domain that rewards complexity.
First, humans that turn their full brain power on something inevitably make complicated structures. If you think about it, this becomes clear that it's true, even if there's absolutely nothing there. For instance, it's almost worth picking up a practitioner's book on numerology or astrology, a really "good" book that goes deep into the details and history, not just a superficial "intro" jobber, to witness the incredible complexity humans bring into a field that 90%+ of the readers of this comment will agree there is virtually no reason for it to possess, because there's no "there" there.
How much more complexity and richness we can bring to an already complex field!
And as others are pointing out already, finance also rewards complexity, both because people can hide things in the complexity and because people can fool themselves into thinking they understand the complex things, and because the interaction of all these complex things is even more complex.
You want another domain that works much like that? Consider any ol' pile of code that a software company runs on. It's bad enough that all software companies of any size are trying to solve a non-trivial problem, but throw a few hundred random developers at it and before you know it the "simple billing system" has 100-line buggy sorting functions sitting next to the double-booking accounting algorithms and all the other endless monstrosities we sometimes swap stories about on HN or various reddits. And then one day a trivial quirk in that sorting algorithm accidentally erases all the data in your customer database when it accidentally decided everybody had failed to pay their balances for over a thousand years or something. Computing is complicated even before humans start humaning the place up, but then it gets even worse.
That is a pretty loaded statement. That would be like saying the core purpose of the software industry is to destroy jobs and in turn collect part of the salary that those jobs previously paid. It might technically be true, but it is twisting things to make them sound intentionally evil.
I could at least comfort myself by the fact that what I was doing was actually useful (and creating efficiencies that destroyed jobs), whereas concealing risk is actively deceitful and destructive.
Well done, good luck.
To call finance intentionally opaque is a perhaps true, but it shouldn't be vilified much more than other goods and services, the providers which all maintain some level of "opacity" towards their customers. In a sense, it's a fundamental part of any capitalistic transaction. A farmer sells an apple for more than it costs for her to make it, but you're willing to pay her for it because you aren't that good at growing apples. To her, it might be worth what it cost her to grow it, but to you, it is clearly worth what you are willing to pay for it, because you have the added benefit (or requirement) of being able to eat it and survive. So it is worth more to you, less to her, and she profits.
One could see similarities in insurance (much closer to finance than apple-growing, if not finance itself). An insurer charges you (or maybe an aggregated group of "yous") more than it costs to provide a certain protection (or hedge against a certain risk). You are willing to pay the premium because clearly the risk protection matters more than getting some "theoretically optimal" price.
With increased availability in technology and information, certain kinds of finance are becoming easy to do "on your own" - the most salient example is perhaps index investing. Many people are realizing that financiers cannot add value and they need less of a middleman.
I thought I'd share my contrasting thoughts, but I very much enjoyed the read.
Human behavior is a large part of the complexity because we try to use things like game theory to predict how someone will act based on a confined set of conditions which totally ignore the very long game which has been playing from long in the past and will continue long in the future. There are too many factors to account for which can make an actor appear irrational given the posited conditions, however the truth is there can never be a rational actor until we map every input and interaction in someones life. This is why the idea of a rational actor is horseshit.
Nick Szabo did a recent post that covers this:
A small-game fallacy occurs when game theorists, economists, or others trying to apply game-theoretic or microeconomic techniques to real-world problems, posit a simple, and thus cognizable, interaction, under a very limited and precise set of rules, whereas real-world analogous situations take place within longer-term and vastly more complicated games with many more players: "the games of life".
http://unenumerated.blogspot.com.au/2015/05/small-game-falla...
The very foundations of Finance are built on sand
What do I mean by that? Finance is built on the concept of value, or worth. "How much is this gold worth?", "how much is the client willing to pay for this service?"
The concept of value and worth are subjective. They are in the eye of the beholder:
If you ask a thirsty backpacker stranded in the middle of the Sahara: How much are you willing to pay for a 2 litre bottle of water? The answer, most likely is many monies & possible limbs.
Now trying flogging the same water to city trader in a champagne bar.
I can hear you scoffing, "Oh but that's a silly example, the backpacker was practically dead" Correct, worth is subjective. Its based on your circumstances. There are many other examples, the Turner painting in a jumble sale, the sale of a sports car when the wife becomes pregnant, etc, etc.
Complex derivatives are really not complex. They are normally a "RAID" of different types of contracts. What then happens is the end user is deliberately bamboozled into not asking questions.
In that way bankers are just like lawyers and accountants. You pay someone to do things you don't have the time to do (or even learn how to do) so you can focus on your job. Its division of labour at the macroeconomic level and everyone benefits from specialisation.
Now, I agree that contemporary finance is bloated with opacity and that banks do benefit from this via corruption (tax code and compliance reform are needed ASAP). But its disingenuous to say that the value of finance is entirely "placebo".
More on topic, this article is full of red herrings and poor analogies such as the above. Why on earth would you use game theory's payoff matrices as an analogy to what could perfectly be put into words? The authors thoughts on "financial institutions buffering fear" really don't require invocation of another complex framework unless he somehow wants to derive credibility from this, which would of course be poor form.
Fischer Black and Myron Scholes weren't sitting in front of their white board thinking about all the people they could rip off. They were genuinely trying to find a way to price options as a tool to mitigate risk.
I can use a hammer to build a house or sink the hammer into my enemies head. Either way, it's still a hammer.
To say that all things in finance are complex because they are opaque is pretty wrong. Maybe the author is talking about a different dimension of finance (e.g. the unpredictability of human behavior, I mean sure, that's opaque, but that's not finance).
This. If you have money, and let it be known that you have money, you will be offered a large number of stupid deals. There is a huge range of financial products out there which underperform the market. Amazingly, people buy them. Wealthy people.
The deals offered poor people, such as payday loans, and crap auto loans, suck even worse. Most Americans were better off when we had regulated savings and loans, tightly regulated banks, and a much narrower range of financial products.
Also, there's an inherent information asymmetry favoring the inventor.
However, there are only really two things that we can use to create these products: debt and risk. Thus, when we try to create financial products, we create structures composed entirely of debt and risk, which become very complex. The reason why they become so complex is similar to any other case in which you try to make highly sophisticated structures from only very simple/basic components: there ends up being a great number of details.
John Kenneth Galbraith, Money: Whence It Came, Where It Went (1975), p. 5