July 17, 2015 at 12:08Why finance is so hard
- Transfer
Translator's note: In our blog on Habré , Giktayms and Megamind we explain how the world of finance is arranged from different points of view, our educational programs serve the same purpose . Today we present to your attention an interesting material explaining why finance seems to most people to be a very complicated topic.
Lisa Pollack of FT Alphaville is trying to answer the following question : “Why are we so easily able to complicate the sphere of finance?” In her opinion, the “ Flynn effect can be the answer", Which consists in gradually increasing the level of human intelligence. The field of finance, therefore, becomes more complex over time due to the fact that financiers become smart enough to complicate it.
Pretty interesting hypothesis. But I do not think she is true.
The field of finance has never been simple. To be more precise, it was always opaque, and its complexity served only as an excuse in a society that claims to be open. Opacity is essential in the modern world of finance. It is more a characteristic of it than a disadvantage. It is possible to reduce complexity and increase transparency in this area only by radically changing the approach to accepting economic risks. The main goal of the modern financial system is to convince citizens that they have to take risks that they would never agree to accept, being fully informed.
Financial systems help us solve collective action problems. If the risks and cost of investment projects were publicly available, most of us would be scared by the details that have come to light. Entrepreneurship is a rather risky business. Moreover, the probability of success of a project depends on the direction of development of other projects. If an industrialist living in an agrarian society is trying to build a car factory, he is unlikely to succeed. Suppliers simply cannot provide the resources necessary to achieve their goals. Even if, by a lucky chance, he manages to start production, there will be no one to buy the goods: farmers with low labor productivity simply will not have money for a car. Truly successful investments are made not in individual projects, but in a stream of enterprises organized by groups of enthusiasts, most of which fail completely and only a few do something useful and increase the state of their investors. In addition, without losers, there are no winners: in a world where Qwest would not overproduce fiber, Amazon would not appear, which loses a few cents on each order, but compensates its expenses due to the large volume of sales. Even considering the incredible technological boom, in 1997, investing in Amazon was considered far from the most reliable. It would be foolish to invest this in a company if there were no growth and dynamics achieved at the expense of thousands of partner companies, only a part of which subsequently succeeded in business. most of which fail completely and only a few do something useful and increase the fortune of their investors. In addition, without losers, there are no winners: in a world where Qwest would not overproduce fiber, Amazon would not appear, which loses a few cents on each order, but compensates its expenses due to the large volume of sales. Even considering the incredible technological boom, in 1997, investing in Amazon was considered far from the most reliable. It would be foolish to invest this in a company if there were no growth and dynamics achieved at the expense of thousands of partner companies, only a part of which subsequently succeeded in business. most of which fail completely and only a few do something useful and increase the fortune of their investors. In addition, without losers, there are no winners: in a world where Qwest would not overproduce fiber, Amazon would not appear, which loses a few cents on each order, but compensates its expenses due to the large volume of sales. Even considering the incredible technological boom, in 1997, investing in Amazon was considered far from the most reliable. It would be foolish to invest this in a company if there were no growth and dynamics achieved at the expense of thousands of partner companies, only a part of which subsequently succeeded in business. where Qwest would not overproduce fiber, Amazon would not appear, which loses a few cents on each order, but reimburses its costs due to the large volume of sales. Even considering the incredible technological boom, in 1997, investing in Amazon was considered far from the most reliable. It would be foolish to invest this in a company if there were no growth and dynamics achieved at the expense of thousands of partner companies, only a part of which subsequently succeeded in business. where Qwest would not overproduce fiber, Amazon would not appear, which loses a few cents on each order, but reimburses its costs due to the large volume of sales. Even considering the incredible technological boom, in 1997, investing in Amazon was considered far from the most reliable. It would be foolish to invest this in a company if there were no growth and dynamics achieved at the expense of thousands of partner companies, only a part of which subsequently succeeded in business.
One of the tasks of financial systems is to ensure dynamics with a high level of investment activity, in contrast to a static state with a low level of investment activity. In a situation of a sharp increase in capital investment, people can be convinced of taking direct part in a clearly risky project. However, in the absence of such growth, a cautious person will most likely refuse this.
Each project individually will be considered risky and has little chance of success. Lean people will prefer to participate in projects with a lower level of risk and a small, but guaranteed refund, as, for example, in the case of storage of goods. Even the diversification of risks through participation in diverse enterprises will be unattractive, unless the investor considers that many other investors will participate in the project.
This situation can be described as a game with two Nash equilibria (here “ROW” means “everyone else” [English rest of the world]):
In the case when everyone else invests, it is likely that we are also better off making an investment, since, most likely, our investments will be successful. However, if only we invest, while everyone else prefers to refrain, most likely, we will lose. (The highlighted values with a dash are stochastic with the corresponding values of the expected outcomes). We see two cases of equilibrium: in a favorable situation (the upper left corner of the payment matrix) everyone invests and, as a rule, wins, and in unfavorable (the lower right corner) everyone cautious, and as a result no one wins. When everyone is pessimistic, everyone can be in an unfavorable situation. Studying herd instincts is precisely what the game theory is all about.
This is the main problem that the entire financial sector as a whole and banks in particular have tried to solve. Any banking system is a combination of fraud and cunning, and it invades the relationship between investors and entrepreneurs. It offers an alternative to risky direct investment and low-margin cash accumulation. Banks guarantee all their depositors a refund on more favorable terms compared to conventional accumulation and offer an unconditional return on these funds with a sufficient degree of certainty, regardless of whether other investors participate in the transaction. The payment matrix in this case has the following form:
In this matrix there is only one equilibrium favorable for all, which is in the upper left corner. In fact, banks guarantee everyone a refund of 2 units in the event of an investment. That is why everyone invests their money in the bank. After each invested a certain amount of money, banks can invest large sums in existing projects in order to get a good expected gain of 3 units. Banks keep 1 unit for themselves, pay 2 units to their depositors, and thus each one wins more than in the case of a “less favorable” balance. Banks allow the world to grow, making promises that they may not keep. (They will not be able to fulfill their promises,
Suppose we are in a situation of “unfavorable” equilibrium. Promising more is easy, it’s more difficult to keep these promises. Investors understand that banks do not have a magic machine to increase their investments and that, ultimately, funds are invested in one of the projects in which no one would invest on their own. Such a guaranteed refund is actually not so guaranteed, and this is not a secret. So why is such a petty deception sometimes effective? Why do investors believe empty promises and invest in banks, without which they could do without saving their money?
Like many other scammers, bankers convince every investor that, although in case of failure, someone may lose their funds, this someone will be different. And then you get into their network. Each investor is convinced that in an unfavorable situation some holder of a block of stocks falling in price will lose, but not him. Bankers convince us of this in a variety of ways. First of all, they offer a one hundred percent money back guarantee. You can take back your savings at any time at your request. At the first sign of impending problems, you can take your money. They say that to everyone without any hesitation. In addition, they point to other people standing next to you and ready to solve any of your problems. They can be shareholders of the bank, government, bondholders, “bank holding company” or “stabilization fund”, and anyone else. Our bank guarantees that you will become a millionaire! Someone else will still be at a trough. We don’t know who it will be, but definitely not you! And they say that to everyone, not even blushing.
If everyone was aware of this and it was clear who suffers what losses, banking systems simply could not cope with their key task - attracting investments with a low level of risk, so that later they could take part in risky projects. Almost everyone who invests in a large bank believes that his money is stored in a safe place. Even the shareholders - the first in line of those who may lose their savings - believe that their money is safe. After all, the government will not allow this, will it? Banks develop and interact with each other, exchange currency and reinsure themselves, guarantee the issuance of funds and eliminate risks. And they do it in such a way that it is not clear who will be the loser.
The opacity and interconnection of large banks is not new. Banks and government agencies have always interacted with each other. If bank deposits could not be insured by the state, private insurance companies appeared that were no less reliable than today's highly specialized insurance companies (“monoliners”). Shadow banking systems are also not something completely new: this is just a new way of reorganizing assets and liabilities in such a way that virtually no one is held accountable.
This is how banking systems work. Opacity is not something that can be eliminated, since it is inherent in the economic activity of banks aimed at lowering the risk threshold for those who, under other circumstances (fully informed), would never have done so. In a society free of nebula and deception, financial systems cannot flourish and develop. Acceptance of unreasonable economic risks contributes to maintaining the growth and development of society. We can live either in a society with incomprehensible economic phenomena and an industrial type economy, or in an open society with shepherds and herds of sheep.
Unfortunately, one of the side effects of having non-transparent economic activity is the obvious fact that a certain group of people has a great opportunity to deceive ordinary citizens. But to be honest, this is not such a high price that we pay for civilization, is not it?
Nick Roe, as you know, believed that finance is akin to magic. I would say that finance is more like a placebo. Financial systems are an artificial medicine that we all endorse in order to be able to take economic risks. As is the case with any effective placebo, we will never understand that in fact this is the most common piece of sugar. We need to believe in a fairy tale written by brilliant researchers, and the secret of which we will never know. So decided the merchants of these financial "drugs."
Remarks: I believe there are alternatives to herd behavior and kleptocratically opaque, semi-fraudulent banking systems. However, their implementation would require not just reforms, but a complete rethinking of the current state of financial systems.
The state financial system should be considered as one of the forms of the banking system. The Heads of State request financial resources for vague purposes and promise a 100% return of these funds, which in reality they may not return. When something goes wrong, bondholders think that taxpayers should pay a fee, and they, in turn, think the opposite. As always, everyone is looking for a scapegoat and believes that someone else must pay. Everyone thinks he has nothing to fear.
The state of things outlined in this article is somewhat embellished. (Real!) The benefits of demonstrated opacity need to be compared with the complex and even tragic social consequences that may arise if the placebo fails; especially considering the likelihood that traders with this placebo will continue their fraudulent activities after the good opportunities to attract large investments disappear. By hiding real economic risks from those who take them, modern financial systems impede the pursuit of a fair distribution of capital. We have enough of it, only its distribution is carried out inappropriately.
Lisa Pollack of FT Alphaville is trying to answer the following question : “Why are we so easily able to complicate the sphere of finance?” In her opinion, the “ Flynn effect can be the answer", Which consists in gradually increasing the level of human intelligence. The field of finance, therefore, becomes more complex over time due to the fact that financiers become smart enough to complicate it.
Pretty interesting hypothesis. But I do not think she is true.
The field of finance has never been simple. To be more precise, it was always opaque, and its complexity served only as an excuse in a society that claims to be open. Opacity is essential in the modern world of finance. It is more a characteristic of it than a disadvantage. It is possible to reduce complexity and increase transparency in this area only by radically changing the approach to accepting economic risks. The main goal of the modern financial system is to convince citizens that they have to take risks that they would never agree to accept, being fully informed.
Financial systems help us solve collective action problems. If the risks and cost of investment projects were publicly available, most of us would be scared by the details that have come to light. Entrepreneurship is a rather risky business. Moreover, the probability of success of a project depends on the direction of development of other projects. If an industrialist living in an agrarian society is trying to build a car factory, he is unlikely to succeed. Suppliers simply cannot provide the resources necessary to achieve their goals. Even if, by a lucky chance, he manages to start production, there will be no one to buy the goods: farmers with low labor productivity simply will not have money for a car. Truly successful investments are made not in individual projects, but in a stream of enterprises organized by groups of enthusiasts, most of which fail completely and only a few do something useful and increase the state of their investors. In addition, without losers, there are no winners: in a world where Qwest would not overproduce fiber, Amazon would not appear, which loses a few cents on each order, but compensates its expenses due to the large volume of sales. Even considering the incredible technological boom, in 1997, investing in Amazon was considered far from the most reliable. It would be foolish to invest this in a company if there were no growth and dynamics achieved at the expense of thousands of partner companies, only a part of which subsequently succeeded in business. most of which fail completely and only a few do something useful and increase the fortune of their investors. In addition, without losers, there are no winners: in a world where Qwest would not overproduce fiber, Amazon would not appear, which loses a few cents on each order, but compensates its expenses due to the large volume of sales. Even considering the incredible technological boom, in 1997, investing in Amazon was considered far from the most reliable. It would be foolish to invest this in a company if there were no growth and dynamics achieved at the expense of thousands of partner companies, only a part of which subsequently succeeded in business. most of which fail completely and only a few do something useful and increase the fortune of their investors. In addition, without losers, there are no winners: in a world where Qwest would not overproduce fiber, Amazon would not appear, which loses a few cents on each order, but compensates its expenses due to the large volume of sales. Even considering the incredible technological boom, in 1997, investing in Amazon was considered far from the most reliable. It would be foolish to invest this in a company if there were no growth and dynamics achieved at the expense of thousands of partner companies, only a part of which subsequently succeeded in business. where Qwest would not overproduce fiber, Amazon would not appear, which loses a few cents on each order, but reimburses its costs due to the large volume of sales. Even considering the incredible technological boom, in 1997, investing in Amazon was considered far from the most reliable. It would be foolish to invest this in a company if there were no growth and dynamics achieved at the expense of thousands of partner companies, only a part of which subsequently succeeded in business. where Qwest would not overproduce fiber, Amazon would not appear, which loses a few cents on each order, but reimburses its costs due to the large volume of sales. Even considering the incredible technological boom, in 1997, investing in Amazon was considered far from the most reliable. It would be foolish to invest this in a company if there were no growth and dynamics achieved at the expense of thousands of partner companies, only a part of which subsequently succeeded in business.
One of the tasks of financial systems is to ensure dynamics with a high level of investment activity, in contrast to a static state with a low level of investment activity. In a situation of a sharp increase in capital investment, people can be convinced of taking direct part in a clearly risky project. However, in the absence of such growth, a cautious person will most likely refuse this.
Each project individually will be considered risky and has little chance of success. Lean people will prefer to participate in projects with a lower level of risk and a small, but guaranteed refund, as, for example, in the case of storage of goods. Even the diversification of risks through participation in diverse enterprises will be unattractive, unless the investor considers that many other investors will participate in the project.
This situation can be described as a game with two Nash equilibria (here “ROW” means “everyone else” [English rest of the world]):
In the case when everyone else invests, it is likely that we are also better off making an investment, since, most likely, our investments will be successful. However, if only we invest, while everyone else prefers to refrain, most likely, we will lose. (The highlighted values with a dash are stochastic with the corresponding values of the expected outcomes). We see two cases of equilibrium: in a favorable situation (the upper left corner of the payment matrix) everyone invests and, as a rule, wins, and in unfavorable (the lower right corner) everyone cautious, and as a result no one wins. When everyone is pessimistic, everyone can be in an unfavorable situation. Studying herd instincts is precisely what the game theory is all about.
This is the main problem that the entire financial sector as a whole and banks in particular have tried to solve. Any banking system is a combination of fraud and cunning, and it invades the relationship between investors and entrepreneurs. It offers an alternative to risky direct investment and low-margin cash accumulation. Banks guarantee all their depositors a refund on more favorable terms compared to conventional accumulation and offer an unconditional return on these funds with a sufficient degree of certainty, regardless of whether other investors participate in the transaction. The payment matrix in this case has the following form:
In this matrix there is only one equilibrium favorable for all, which is in the upper left corner. In fact, banks guarantee everyone a refund of 2 units in the event of an investment. That is why everyone invests their money in the bank. After each invested a certain amount of money, banks can invest large sums in existing projects in order to get a good expected gain of 3 units. Banks keep 1 unit for themselves, pay 2 units to their depositors, and thus each one wins more than in the case of a “less favorable” balance. Banks allow the world to grow, making promises that they may not keep. (They will not be able to fulfill their promises,
Suppose we are in a situation of “unfavorable” equilibrium. Promising more is easy, it’s more difficult to keep these promises. Investors understand that banks do not have a magic machine to increase their investments and that, ultimately, funds are invested in one of the projects in which no one would invest on their own. Such a guaranteed refund is actually not so guaranteed, and this is not a secret. So why is such a petty deception sometimes effective? Why do investors believe empty promises and invest in banks, without which they could do without saving their money?
Like many other scammers, bankers convince every investor that, although in case of failure, someone may lose their funds, this someone will be different. And then you get into their network. Each investor is convinced that in an unfavorable situation some holder of a block of stocks falling in price will lose, but not him. Bankers convince us of this in a variety of ways. First of all, they offer a one hundred percent money back guarantee. You can take back your savings at any time at your request. At the first sign of impending problems, you can take your money. They say that to everyone without any hesitation. In addition, they point to other people standing next to you and ready to solve any of your problems. They can be shareholders of the bank, government, bondholders, “bank holding company” or “stabilization fund”, and anyone else. Our bank guarantees that you will become a millionaire! Someone else will still be at a trough. We don’t know who it will be, but definitely not you! And they say that to everyone, not even blushing.
If everyone was aware of this and it was clear who suffers what losses, banking systems simply could not cope with their key task - attracting investments with a low level of risk, so that later they could take part in risky projects. Almost everyone who invests in a large bank believes that his money is stored in a safe place. Even the shareholders - the first in line of those who may lose their savings - believe that their money is safe. After all, the government will not allow this, will it? Banks develop and interact with each other, exchange currency and reinsure themselves, guarantee the issuance of funds and eliminate risks. And they do it in such a way that it is not clear who will be the loser.
The opacity and interconnection of large banks is not new. Banks and government agencies have always interacted with each other. If bank deposits could not be insured by the state, private insurance companies appeared that were no less reliable than today's highly specialized insurance companies (“monoliners”). Shadow banking systems are also not something completely new: this is just a new way of reorganizing assets and liabilities in such a way that virtually no one is held accountable.
This is how banking systems work. Opacity is not something that can be eliminated, since it is inherent in the economic activity of banks aimed at lowering the risk threshold for those who, under other circumstances (fully informed), would never have done so. In a society free of nebula and deception, financial systems cannot flourish and develop. Acceptance of unreasonable economic risks contributes to maintaining the growth and development of society. We can live either in a society with incomprehensible economic phenomena and an industrial type economy, or in an open society with shepherds and herds of sheep.
Unfortunately, one of the side effects of having non-transparent economic activity is the obvious fact that a certain group of people has a great opportunity to deceive ordinary citizens. But to be honest, this is not such a high price that we pay for civilization, is not it?
Nick Roe, as you know, believed that finance is akin to magic. I would say that finance is more like a placebo. Financial systems are an artificial medicine that we all endorse in order to be able to take economic risks. As is the case with any effective placebo, we will never understand that in fact this is the most common piece of sugar. We need to believe in a fairy tale written by brilliant researchers, and the secret of which we will never know. So decided the merchants of these financial "drugs."
Remarks: I believe there are alternatives to herd behavior and kleptocratically opaque, semi-fraudulent banking systems. However, their implementation would require not just reforms, but a complete rethinking of the current state of financial systems.
The state financial system should be considered as one of the forms of the banking system. The Heads of State request financial resources for vague purposes and promise a 100% return of these funds, which in reality they may not return. When something goes wrong, bondholders think that taxpayers should pay a fee, and they, in turn, think the opposite. As always, everyone is looking for a scapegoat and believes that someone else must pay. Everyone thinks he has nothing to fear.
The state of things outlined in this article is somewhat embellished. (Real!) The benefits of demonstrated opacity need to be compared with the complex and even tragic social consequences that may arise if the placebo fails; especially considering the likelihood that traders with this placebo will continue their fraudulent activities after the good opportunities to attract large investments disappear. By hiding real economic risks from those who take them, modern financial systems impede the pursuit of a fair distribution of capital. We have enough of it, only its distribution is carried out inappropriately.