Finance Followups

Cross-posted from Pu­tanu­

In Defense of Fi­nance gen­er­ated over 110 com­ments across WordPress, LessWrong and the Red­dits, as well as in per­sonal com­mu­ni­ca­tion. As pre­dicted, I learned a lot.

In this post I’ll ad­dress some of these com­ments and offer fol­low up thoughts that didn’t fit in the origi­nal es­say be­cause they’re more spec­u­la­tive. Also, be­case that post ran to 5,500 words already.

Peo­ple said: “I don’t buy this, fuck cap­i­tal­ism!” If you want to stick it to cap­i­tal­ism, you can gift a dona­tion to a cre­ator pub­lish­ing his work on­line for free.

Peo­ple said: “Fi­nally some­one gets it and does the math right!” If you think I get it and I do the math right, you can for­ward me job offers at lu­cra­tive hedge funds, PE firms, and star­tups.

Peo­ple said that it’s overly defeatist to claim that fi­nance won’t im­prove no mat­ter how we try to fix it, we just have to live with it. But that’s not quite what I think.

Fi­nance im­proves it­self, mostly af­ter crises. In 1929 we learned that es­tab­lished com­pany stocks are riskier than we thought, and in 2000 we learned the same about star­tups. Fi­nan­cial in­sti­tu­tions learned how to deal with 20% in­ter­est rates in 1980 and with 0.02% rates in 2010. After 2008 we learned that 6% is too low of an equity ra­tio for banks, that rat­ing agen­cies with no skin in the game are use­less, and that CDO-Squared are re­ally dumb. Hope­fully, we also learned some gen­er­al­iz­able math les­sons, such as the fact that lack of cor­re­la­tion in nor­mal times (e.g., in mort­gage de­fault rates) doesn’t im­ply lack of cor­re­la­tion when a crisis hits.

We’re on the cusp of the longest pe­riod ever be­tween re­ces­sions in the US. In the decade since 2008 the Mid­dle East has gone crazy, Europe has gone crazy, Venezuela has gone crazy, elec­tions have gone crazy, the weather has gone crazy, the Cubs have won the World Series, Le­ices­ter won the EPL, Bit­coin rose and fell and rose and fell and rose. Through­out all of this, the bankers and traders have kept their nose down and didn’t reck­lessly en­dan­ger the world.

One day af­ter this gen­er­a­tion of fi­nanciers will have been gath­ered to the Hamp­tons, a new one will arisethat does not know The Big Short and they’ll do some­thing re­ally dumb to cause the next fi­nan­cial crisis. But for now, fi­nance seems less of a global threat than Twit­ter.

Turkeys in the Jungle

Peo­ple said that I defended the parts of fi­nance that are easy to defend, such as banks mak­ing loans to busi­nesses, and didn’t ad­dress the whatabouts. What about high-fre­quency trad­ing firms? What about mu­tual funds that charge 2%/​20% to un­der­perform in­dices? Pay­day loans? Penny stocks?

I don’t have a knock­down ar­gu­ment for those and per­haps there isn’t one – per­haps the above are ac­tu­ally net harm­ful to hu­man­ity. But I have a use­ful and very stretchy metaphor: fi­nance is a jun­gle.

First, fi­nance is a jun­gle in the col­lo­quial sense of a hy­per­com­pet­i­tive en­vi­ron­ment. Fi­nan­cial firms com­pete with each other, and it’s hard for any of them to build moats or ac­quire mo­nop­o­lies. Chang­ing your bank or bro­ker­age is a lot eas­ier than chang­ing util­ity providers, so­cial net­works, or even fridges. So if a hedge fund makes money do­ing some­thing that seems in­effi­cient or bad for cus­tomers, you have to an­swer why it has not been com­peted away by some­one bet­ter.

Se­cond, fi­nance is a jun­gle in the sense of be­ing a com­plex, in­ter­con­nected ecosys­tem. Another les­son we should have learned from 2008 is that banks, hedge funds, in­surance com­pa­nies, and gov­ern­ment agen­cies de­pend on each other in crit­i­cal and opaque ways. Elimi­nat­ing a class of in­stu­tion from the fi­nan­cial sys­tem is like elimi­nat­ing some an­noy­ing in­sect from the jun­gle: it could make things a lit­tle bit bet­ter, or it could bring the en­tire thing crash­ing down un­ex­pect­edly.

But the more I thought about this metaphor, a new pic­ture came to mind. Fi­nance isn’t just a jun­gle of sharp-toothed jaguars, ven­omous frogs, and vi­cious par­a­sites. It’s a jun­gle sur­rounded by turkey farms that send fat, defense­less birds by the mil­lions run­ning into the deadly for­est. Th­ese turkeys are most of the peo­ple you know.

Peo­ple are breath­tak­ingly stupid about fi­nance. And by “peo­ple” I mean “av­er­age Amer­i­cans”. This isn’t be­cause Amer­i­cans are less fi­nan­cially liter­ate than the rest of the world, it’s just that the best data available about fi­nan­cial idiocy con­cerns the “av­er­age Amer­i­can”.

The av­er­age Amer­i­can has more than $5,000 in credit card debt, on which they pay more than 15% in­ter­est. The av­er­age Amer­i­can doesn’t know how much debt they have or how much it costs them.

Less than two in five Amer­i­cans have enough sav­ings to cover an un­ex­pected $1,000 ex­pense. The me­dian in­come in the US is $59,000, so all it would take to save up $1,000 for the av­er­age Amer­i­can is to only spend 98% of what they make for a sin­gle year. The av­er­age Amer­i­can can’t do that.

The smart Amer­i­can isn’t much smarter than the “av­er­age”. Mar­ried cou­ples with post­grad­u­ate de­grees fall into spirals of debt for no rea­son other than their own poor plan­ning. One of my smartest friends was pay­ing 9% on a loan while in­vest­ing in funds that wouldn’t re­turn that much in a good year. One of my smartest cowork­ers told me yes­ter­day that he won’t fund his 401k for the first six months of 2019 be­cause of a “hunch”, thus fore­go­ing six months of ex­pected pos­i­tive re­turns. Many smart peo­ple told me they like get­ting a tax re­fund, not re­al­iz­ing that it means that the gov­ern­ment earned in­ter­est on their money for a whole year in­stead of them.

I of­ten hear from peo­ple who tell me they loved Get Rich Slowly, but then ad­mit that their own money is in hand-picked stocks or sav­ings ac­counts.

And these same peo­ple ex­pect to be able to buy what­ever they want when­ever they want at the swipe of a card. They ex­pect their cash to be available at any ATM in the world, with no fees. They ex­pect their re­tire­ment to be pro­vided for, even if they do not provide for it them­selves.

The worst as­pects of fi­nance are a di­rect re­sult of the av­er­age per­son be­ing stupid about fi­nance. Peo­ple ex­pect to beat the mar­ket, so they pay bro­ker­ages and make their pen­sions in­vest in high-fee funds. Peo­ple don’t un­der­stand debt and in­ter­est, which fuels bub­bles and crises from MBS to stu­dent loans.

It is not clear that gov­ern­ment reg­u­la­tion will help. For one, out­law­ing stupid be­hav­ior (like day-trad­ing stocks) will of­ten just shift peo­ple to stupi­der be­hav­ior (like day-trad­ing movies). For an­other, if peo­ple aren’t smart enough to deal with per­sonal fi­nances, how could they vote in­tel­li­gently for fi­nan­cial poli­cies on a na­tional level?

The only solu­tion to this is fi­nan­cial liter­acy ed­u­ca­tion, and I’m do­ing what I can to help my read­ers with that. That’s one of the rea­sons I wrote In Defense of Fi­nance: when you stop hat­ing fi­nance you can start to un­der­stand how it works, and when you start to un­der­stand how it works you can make it start work­ing for you