opinions-political-finance

How finance serves society

Many people seem to think that finance is merely some sort of legalized gambling which makes some of the players rich and may be fun for some people but is totally useless to society, in the same way that a casino is useless.

Finance is similar to gambling and it does make some people rich but it is extremely useful to society. It's as if we invented a type of casino where merely by playing, people are doing useful work that makes the world a better place.

What is finance good for?

First, let's look at what finance can do:

• Investment: moving money around in space. Say you want to start a business, but you need some money to get started, and you don't have the money to do it yourself. You need someone else with money to come along and fund you. This is already finance, but modern finance also creates a "social network" whereby money can flow to where it's needed over multiple hops (for example, individuals' pensions go in their pension funds, which invest in VCs, who invest in startups; so if you have a pension, you may be indirectly contributing to startups. Similarly, the money in your bank account goes to loans to businesses, allowing you to indirectly fund businesses.
• Borrowing: moving money around in time. Say you are 35 and you have a job and you are saving money. Say that you have calculated that by the time you are 60 you will be able to afford to buy a house. Finance allows you to buy the house now, and live in it for an extra 25 years.
• Diversification: removing risk. If you invested all of the money in your bank account and in your pension into one startup, you'd be taking a pretty big risk, because most startups fail. Your pension fund and your bank mix your money with everyone else's to allow you to capture the average return over many investments, rather than having to make a bet on one thing. Diversification is called "the only free lunch in economics". It's really just the same as an insurance co-op; by spreading risk around, it's better for everybody.
• Transferring risk to speculators. Most people would like to invest their money but they don't want a high chance of losing it. Some people are willing to risk a higher chance of losing it. It is best for society needs for risk to occasionally be taken, e.g. most startups fail, but a world without startups wouldn't be very innovative. Just like finance can move money around, it can also move risk around, allowing two people with the same amount of money each to invest that money while choosing to take on different amounts of risk.
• Predicting the future. Finance is a social practise that results in a collective prediction of the future profitablity of various investments. Some research shows this collective prediction to be the most accurate form of prediction that humanity has ever invented; in fact, the predictions of "the market" tend to be more accurate than the predictions of any expert (assuming that expert is tested without being able to see what 'the market' has predicted!). It is very important for society to have good predictions about which businesses will be most profitable because this allows society to allocate (via finance) more funding to those businesses. This means that less money will be wasted, and the economy will grow as fast as possible.

Now, what is that good for? I'll go from least important to most.

Borrowing in particular makes our lives more pleasant by purchases expensive things in the middle of our lives instead of waiting until near the end.

A number of these are crucial for innovation to occur. For example, if you did not have investment, or if you could not diversify, or if you could not transfer risk, tech startups would rarely be born. If we used a method that was less good at predicting the future to allocate funding (for example, if committees of voters or of politicans allocated funding), then frequently the best startups would never be funded, as everyone has heard stories of awesome startups that most experts thought were silly ideas that would never work (until they proved the experts wrong by taking off anyways).

Most importantly, all of these lead to reduction of poverty. All of these things contribute to economic growth and economic growth is needed to give society the means to stamp out poverty worldwide (other things are needed too, but economic growth is one thing that is needed).

This doesn't mean that our financial system is perfect or that no regulation is needed. But don't throw the baby out with the bathwater; finance is not a senseless game that makes people rich, it is useful work that is making the world a better place.

On Glass-Stegal

This is a good idea but not because it would prevent bad things in itself. it's a good idea because it makes the system simpler and easier to understand. However, the real solution is braeking up Too Big To Fail banks.

On Too Big Too Fail

There will always be financial institutions going broke. The best that we hope for is to attentuate the domino-like, indirect spread of the failure by making the system as loosely coupled as possible. An important part of keeping the system loosely coupled is not having single institutions that are "too big to fail". Such entities should be broken up -- not because they have done anything wrong, but because their size is suboptimal for society.

So, Glass-Stegal is not the answer. Breaking up Too Big To Fail is.

On market 'demands'

A pet peeve of mine: the media always says that 'the markets demand this or that'. Markets don't demand anything. Markets only predict.

This usage probably came about due to the technical economic term "demand" as in "supply and demand". But it is being misinterpreted as "demand" as in "I insist that you give this to me". These are not the same at all. For example, there is "demand" in the economic sense for Monty Python DVDs. But this does not mean that the consumers of those DVDs are "demanding" them in the sense that they will get angry and complain of injustice and perhaps sue or protest or riot if the DVDs become unavailable (well, some people would, but certainly not every consumer who is demanding the DVDs in the economic sense of the word).

This use of language where markets are said to 'demand' things causes various problems. First, it implies that maybe the 'demands' of 'the markets' could be taken into account when making decisions. What the market 'wants' is not a good way to determine which political decision should be made (because, again, markets don't 'want' anything. They only predict). Now, perhaps some market-like mechanism for decision-making could be imagined, but present-day financial markets are not it.

A second problem is that people get annoyed at 'the markets' for being so 'demanding'. Then they try to regulate the markets to make them less 'demanding'. You cannot make the markets less demanding, because they already aren't demanding anything at all (nor should they). The effect of most reforms intended to make markets less demanding is merely to make them less good at predicting things, which doesn't help anything.