Progress: We Still Don’t Understand How The Automatic Garage Door Opener Works

Robert Shiller in Financial Times:

Modern behavioural economics shows that there are distinct limits to people’s ability to understand and deal with complex instruments. They are often inattentive to details and fail even to read or understand the implications of the contracts they sign. Recently, this failure led many homebuyers to take on mortgages that were unsuitable for them, which later contributed to massive defaults.

But any effort to deal with these problems has to recognise that increased complexity offers potential rewards as well as risks. New products must have an interface with consumers that is simple enough to make them comprehensible, so that they will want these products and use them correctly. But the products themselves do not have to be simple.

The advance of civilisation has brought immense new complexity to the devices we use every day. A century ago, homes were little more than roofs, walls and floors. Now they have a variety of complex electronic devices, including automatic on-off lighting, communications and data processing devices. People do not need to understand the complexity of these devices, which have been engineered to be simple to operate.

Financial markets have in some ways shared in this growth in complexity, with electronic databases and trading systems. But the actual financial products have not advanced as much. We are still mostly investing in plain vanilla products such as shares in corporations or ordinary nominal bonds, products that have not changed fundamentally in centuries.

Why have financial products remained mostly so simple? I believe the problem is trust. People are much more likely to buy some new elec­tronic device such as a laptop than a sophisticated new financial product. People are more worried about hazards of financial products or the integrity of those who offer them.

James Kwak at Baseline Scenario:

The point of this metaphor is to convince you that, since houses and consumer devices like laptops have become immensely more complex in the last hundred years, financial products should as well – and the fact that they have not is a problem.

This is a perfect example of a misleading metaphor. No one today would want to live in a house from 100 years ago (not the house itself, but all the stuff in it, is what Shiller means), nor do we want to give up our laptops. Because most of our financial products were around 100 years ago, we must be missing out on all sorts of potential improvements. But nowhere does Shiller show – or even argue – that there is some underlying feature of financial products that makes them like technological products in this respect. In technology, for example, we have Moore’s Law – the observation that every 18 months (originally two years) the achievable density of transistors doubles – which implies that products can get smaller and cheaper. Shiller makes no equivalent claim for financial products. The point of our Democracy article was to argue that there is in fact no equivalent for financial products, because financial innovation is fundamentally different from technological innovation. You may not agree with us, but at least we argued the case, instead of relying on a metaphor.

I think metaphors are a great way to illustrate abstract concepts, especially to beginner audiences. I use them all the time. But their value is solely illustrative; they don’t ever prove a point. If you say A is like B, and you want to show that A has some attribute that B also has, you have to prove it without reference to B. A good example is Paddy Hirsch’s video comparing a CDO to a pyramid of champagne glasses; there, he walks you through why a CDO has the properties of a pyramid of champagne glasses, instead of simply asserting it.

Free Exchange at The Economist:

However one feels about financial innovation, it should be clear that it is fundamentally different from technological innovation. Technological innovation generally results in something that either demonstrably improves the way we do things (or enjoy things), or it reduces the cost of things we’re already doing or enjoying. Some financial innovations are like this. Most of the ones that are—like ATMs or online banking—are actually technological innovations.

Many other financial innovations aren’t really like this at all. They allow market participants to do things that they couldn’t previously do, but it’s often far from clear that this leads to any net increase in utility, and it certainly doesn’t seem to reduce the cost of finance overall.

Just to focus on consumers, I think it’s interesting to see how consumer product innovations have been different from those in consumer finance. Consumer technologies have largely been about making it ever easier to manage an increasingly large range of options. Even as products, like computers, cameras, appliances, and so on, have grown increasingly sophisticated, user interfaces have gotten simpler. Sitting here at my Mac, I can handle a remarkably large range of tasks and manage massive amounts of data in various forms, using little more than a mouse and the dock full of application icons at screenside.

Finance doesn’t work like that. It might be one thing if innovations were like the increasingly boggling array of wires and circuitboards inside an iPod, all of which serve to make it very simple to craft the perfect playlist or easily move through photos and videos using only an index finger, and which seem to get better and cheaper all the time. Instead, innovation is like those same wires and circuitboards dumped in front of consumers, who are then asked by a loan officer where he should start soldering. And at the end of it all, consumers aren’t sure what they’re getting and what they’re paying for it. To make it plainer still, when a consumer pays $300 for a new iPod, Apple makes money and the buyer is happy. When a consumer takes out a confusing loan or signs up for an account with overdraft fees that are applied when the bank juggles the times at which deposits and purchases are cleared, well, the banks make money, but buyers often feel bewildered or angry, or are unsure exactly what they’ll wind up paying.

Vincent Fernando at Clusterstock

Neil Collins:

There are examples of useful financial innovation - the cash machine and the credit card come to mind – but products which appear to reduce risk are not among them. Plain die-to-win protection is useful, simple and easy to understand, but has a thin profit margin, which is why the life offices would rather sell you an endowment policy, precipice bond or pension plan, products which have little to do with insurance. They are driven by the fees which can be extracted while putting the savers’ money through the mincing machine to construct the “product.”

Saving and investment is tricky, and it’s in the interests of the financial services industry to make it harder by adding complexity. For the ordinary punter, one rule should apply above all else: never buy a structured product.

UPDATE: Felix Salmon:

James Kwak has a great response to Robert Shiller’s FT op-ed about financial innovation. But his line at the end about how “for the sake of argument, I am willing to concede that these are useful innovations that would make people better off” has been misconstrued, and it’s worth pointing out that in fact they’re not useful innovations that would make people better off.

Why not? Mainly because, at heart, they’re all variations on the theme of doing-clever-things-with-as-yet-uninvented-derivatives. But that’s a theme which really shouldn’t have survived the financial crisis.

In 2003, Alan Greenspan famously said that ““what we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so.” But, as it turned out, they weren’t. Lots of people wanted to transfer risk, and precious few were genuinely willing and able to take it on: even hedge funds generally prided themselves on being lower-risk than the stock market as a whole.

The result was a system where derivatives were used to hide risks, and shunt them off, unseen, into the tails. A system where hidden risks turned out to be much more dangerous than if they’d all been out in the open all along.

And Salmon again:

Comment of the day comes from Chris:

“The person most willing to take on risk is the one unaware he is doing so. He charges no risk premium…

The resulting market equilibrium is that the guy who is unaware of the risk ends up loaded with it. Then the music stops.”

This is possibly a very beautiful and elegant explanation for the extreme profitability of investment banks. They charge their clients a lot of money to take risk off their hands, and then they transformed that risk, using sophisticated financial engineering, into instruments which didn’t, on their face, look risky at all, and which could easily be sold to risk-averse investors. Bingo, massive profits.

Financial complexity and innovation, on this view, are essentially tools of obfuscation. And it’s easy to hide risks when risk-averse investors want debt-like products which retain their face value: such instruments tend to have very low volatility, and so look and feel as though they’re low-risk, even if they’re full to bursting with enormous amounts of tail risk. The answer, as I’ve said many times in the past, is for risk-averse investors to be willing to take a small amount of explicit market risk, and to move towards safe equities (utilities and the like) and away from debt. Because if they go to an investment bank asking for safety, they’re likely to just get hidden risk in return.

Matthew Yglesias:

Conclusion: “Financial complexity and innovation, on this view, are essentially tools of obfuscation.” I don’t think we should say that financial innovation is “essentially” one thing or another. A lot of the financial innovation of the past thirty years was aimed at regulatory arbitrage. A lot was basically aimed at hiding the ball so as to better be able to mislead people (and in some cases the financial institutions themselves) about where risk lay. And it’s also true that if you look at shifts in the global economy over the long run, innovation has led to more efficient financial markets. It’s much easier than it was 150 years ago to find reasonable ways to finance moderately risky projects in capital poor areas of the world.

But I think the upshot of this isn’t that we need to be “against” financial innovation but that we need to be skeptical of the claim that any measure to reduce the pace of innovation is likely to bring economic disaster. We should try to stifle innovation aimed at exploiting loopholes in regulations or ripping people off. It’s pretty basic to see that there are good business opportunities in those fields and thus we should expect a lot of innovative activity to be aimed at exploiting those opportunities.

Megan McArdle:

But aren’t a lot of the most risk averse investors funds or insurance companies with limits on the kinds of assets they can invest in? I’m not sure we can fix this problem without knowing the answer to the question we’ve been asking for a year now:  why did the ratings agencies underestimate the tail risk, and is that reason fixable?

Arnold Kling:

What Felix omits in his short post is the unwilling risk taker known as the taxpayer. A lot of the trick of investment banking is to figure out a way to transfer risks to taxpayers. And the investment bankers have gotten really good at it, particularly in the last thirty years. That is why there are those of us on the right (Russ Roberts and myself, to name two) and those on the left (Simon Johnson and James Kwak,, to name two) who are skeptical of the incumbent regulators when they say that they can control moral hazard. Our view is that the moral hazard problem is much more profound than the regulators acknowledge.

Another really profound issue, which Salmon raises, is why so many people prefer debt-like contracts to equity-like shares in enterprises. If he were to read This Time is Different, by Carment M. Reinhart and Kenneth S. Rogoff (and perhaps he already has), Salmon would have even more reason to raise this issue.

My theory is that people have the illusion (and again, government policy can foster this illusion and sometimes make it come true) that they will not be victims of default. Every individual thinks, “Of course, if I see trouble coming, I’ll be able to get out (or be bailed out) before I take a loss.” When a default occurs, somebody will be left holding the bag. However, as individuals, none of us believes that that we are going to be the bagholder.

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