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Tuesday, June 02, 2009

DeLong: The Hidden Purposes of High Finance

Brad DeLong:

The hidden purposes of high finance, by J. Bradford Delong, Commentary, Project Syndicate: No one questions the usefulness of "low" finance. The ability to use checks, banknotes, and credit cards rather than having to cart around chests of silver, scales, and reagents to assay purity, and needing armed guards to protect the silver ... has obvious efficiencies. So does the ability of households to borrow and lend in order not to be forced to match income and expenditure every day, week, month, or year.

But what use is "high" finance? Economists’ conventional description depicts ... three types of utility. First, it allows for many savers to pool their wealth to finance large enterprises that can achieve the efficiencies of scale possible from capital-intensive modern industry.

Second, high finance provides an arena to curb the worst abuses by managers of large corporations. Managers’ fear that if the stock price drops too low they will be out on their ears...

Finally, high finance allows for portfolio diversification, so that individual investors can seek high expected returns without being forced to assume large, idiosyncratic risks of bankruptcy and poverty.

But these are the benefits of high finance as they apply to the ideal world of economists — that is, a world of rational utilitarian actors who are skilled calculators of expected utility under uncertainty, who are masters of dynamic programming. We do not live in such a world. ...

If we take the world as it really is, we see that high finance performs two further tasks that advance our collective welfare. It induces us to save, accumulate, and invest by promising us safe, liquid investments even in extraordinary times.

It is a fact that we are much happier saving and accumulating, and that we are much more likely to do so when we think that the resources we have saved ... are ... liquid... Of course,... financial wealth is not liquid in an emergency. And when we buy and sell, we are enriching not ourselves, but the specialists and market makers.

But we benefit from these delusions. Psychologically, we are naturally impatient, so it is good for us to believe that our wealth is safe and secure, and that we can add to it through skillful acts of investment, because that delusion makes us behave less impatiently. And, collectively, that delusion boosts our savings, and thus our capital stock, which in turn boosts all of our wages and salaries as well.

Seventy-three years ago, John Maynard Keynes thought about the reform and regulation of financial markets from the perspective of the first three purposes and found himself "moved toward... mak[ing] the purchase of an investment permanent and indissoluble, like marriage...." But he immediately drew back: the fact "that each individual investor flatters himself that his commitment is ’liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk...." ...

It is for these reasons that we have seemed frozen for the past generation or two whenever we have contemplated reforming our system of financial regulation. And it is why, even in the face of a severe financial crisis, we remain frozen today.

Perhaps this played a role, but I would cite the belief in the ability of markets to self-correct and regulate the accumulation of risk - the belief that a meltdown like we've just witnessed was not possible - coupled with a concentration of power into the hands of people who held these beliefs as more important factors in explaining the lack of regulation in these markets presently, and the difficulty we'll have changing that.

    Posted by on Tuesday, June 2, 2009 at 11:03 AM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (13)

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