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.

Originally published at Economist’s View and reproduced here with the author’s permission.

2 Responses to "DeLong: The Hidden Purposes of High Finance"

  1. Ed Dolan
    Ed Dolan   June 7, 2009 at 9:44 am

    As a possible cause of the crisis, Thoma lists concentration of power in the hands of people who believed that markets could self-correct and self-regulate. I wonder if it is not something else. Perhaps the problem was a concentration of power in the hands of people who were close enough to what was going on to understand that markets were not self-regulating, but who were motivated to continue gambling, because skewed compensation schemes, based on bonuses with no clawbacks, allowed them to gamble with other peoples’ money. That would make the crisis not so much the result of self-delusion as the result of a massive agency problem

  2. Anonymous   June 8, 2009 at 10:55 pm

    Ed Dolan’s comment is right on. Making money loaning other people’s money, knowing full well that enormous collection risks were piling up towards an inevitable calamity, but living in daily denial of the obvious because others would end up holding the bag and one could cash out early without fear of personal consequences, this has been the Dark Side of high finance and the near ruination of our country. “Everybody’s doing it, and the money’s rolling in!” The truth is that markets are corrupt wherever possible – that big players seek monopoly advantage and legal loopholes wherever possible, and collusion between partners in the check & balance systems seeks to mislead & dissemble. When the regulators can be bought off, market makers will pay for all advantages with sufficient ROI to justify them. Human nature and the power of money & greed are not divine mysteries beyond the understanding of mere mortals. Market makers, politicians, regulators and their hired economists all together create a dangerous cabal with the power to topple nations. The coming consumer credit crunch will reveal just how much damage the financial sector has done over the last 25 years. Our Chinese creditors, however, are absolutely thrilled with their excellent works.