Why Is Finance So Complex?

Lisa Pollack of the Financial Times poses a question and answers it herself: “Why are we so good at creating complexity in finance?” She offers the Flynn Effect as an explanation—the idea that human intelligence rises over time. From this perspective, finance keeps getting more complex because finance professionals keep getting smarter.

It’s a very interesting theory. But I don’t think that’s what’s going on at all.

Finance has always been complex—or, more precisely, it has always been opaque. And complexity is a tool for justifying opacity in a society that likes to pretend it is transparent. Opacity is a core feature of modern finance. It’s not a bug; it’s a feature, and it cannot go away unless we change the way we take on economic risk. The central objective of today’s financial system is to get people to bear risks that they would not have taken if they had understood those risks in detail.

Financial systems help solve problems that require collective action. If the costs and risks of every investment project in the world were perfectly transparent, most people would be too scared to invest. Business is genuinely risky. The odds of success for any given project are tied to whether other projects happening at the same time succeed. A capitalist who tries to build an auto plant in an agrarian economy will fail. Her peers won’t be able to supply the parts needed to build cars. Even if a miracle happens and the plant is built and cars roll off the line, low-capital, low-productivity farmers won’t have the money to buy them. Real-economy investment doesn’t succeed through isolated projects. It succeeds when optimists charge in like waves, most of them get burned to a crisp, and a few survivors do great things for the world and make their investors rich. But winners can only exist if there are losers. If Qwest, the now-bankrupt US telecom, hadn’t overbuilt fiber, companies like Amazon—losing a dime on every sale but making it up on volume—would never have existed. Even in the wild tech boom of 1997, Amazon was a very iffy investment. Without the growth and momentum of the thousands of other startups chasing the same space (many of which went under), investing in Amazon would probably have been insane.

One purpose of the financial system is to keep us in a generally pro-investment environment. When there’s an investment boom—like in 2020–21—ordinary people can invest directly in transparent, high-risk projects. But when that’s not the case, risk-averse individuals quite rationally won’t invest. Isolated projects will look risky and unlikely to succeed. Savers will prefer projects that offer relatively certain returns with low risk—warehouses, storage facilities, that sort of thing. Even diversified exposure to many risky projects won’t look attractive unless people are confident that others are doing the same.

We can think of this game in terms of a Nash equilibrium, like a prisoner’s dilemma, where ROW stands for “rest of world.”

If everyone invests, we all end up with better outcomes and a higher probability of success. But if a single individual invests while the rest of the world does not, that individual is likely to fail. There are two equilibria here: one at the upper left and one at the lower right. If everyone stays pessimistic and refrains from investing, we all end up stuck in the bad equilibrium. Keynes’s “animal spirits” are just game theory in disguise.

This is the problem that banking and finance evolved to solve. The banking system is an overlapping bundle of fraud and genius that sits between entrepreneurs and investors. Banks offer an alternative to either piling into very risky investments or just hoarding cash. They promise returns that are better than holding money, and they promise those returns unconditionally and with certainty—even if other investors don’t invest. That gives us a payoff matrix like this:

Under this matrix, there is only one equilibrium, at the upper left (2, 2). Banks guarantee everyone a payoff of 2, so everyone invests through banks. Because everyone invests, banks can put money into real projects at sufficient scale to generate a payoff of 3. The bank keeps 1 for itself and pays investors the promised 2, leaving everyone better off than in the bad equilibrium. In effect, banks make the world a better place by making promises they might not be able to keep. (If they fail to raise enough funds or the projects they back underperform expectations, they may not be able to honor those promises.)

Now suppose we start from the bad equilibrium. Making promises is easy; getting people to believe them is hard. Investors know banks don’t have some magical money machine. They know the pooled funds will be invested in projects that individuals would have turned down. They know that the supposedly risk-free returns banks promise can’t actually be risk-free—and that this isn’t a secret. So why does this well-intentioned fraud sometimes work? Why do investors believe unsecured promises and invest through banks?

Like most great con artists, banks win the trust of each individual investor by insisting that someone might get hurt, but it won’t be you. You’re not the mark; you’re a participant. If something goes wrong, someone will be left holding the bomb, but the bank promises that person won’t be you. Banks make this promise in many ways. First, they give you the right to withdraw your money anytime, anywhere. You can always get your money back when you want it. If anything looks even a little shaky, you can pull your funds immediately. They say exactly the same thing to everyone, without batting an eye. Then they point to the people standing in front of you in line and assure you those people will absorb the losses. The people ahead of you include bank shareholders, bondholders, the government, “stabilization funds,” and so on. Deep-pocketed players, you’re told, stand behind our bank. Someone will take the hit, but it won’t be you. And banks say this to everyone, again without batting an eye.

If it were perfectly transparent who would bear how much of the losses, the banking system could not channel risk-averse capital into risky projects—the very reason it exists. Most people who put money into major banks believe they are investing in very safe institutions. Even shareholders, who are first in line to take losses, assume they are protected to some degree. Would the government really let a big bank fail? Banks innovate, interconnect, swap, reinsure, hedge, and guarantee. The point of all this is to make it impossible to know exactly who will lose money. Everyone who invests can imagine someone else taking the hit in their place and convince themselves, “I won’t be the one who gets wiped out.”

The opacity and interconnectedness of banks are nothing new. Banks and sovereigns have always been intertwined. Long before federal deposit insurance, there were private deposit insurers—monolines—that were considered trustworthy. Shadow banking is not some novel invention; it’s just a new vocabulary for reclassifying entities and guarantees so that no one thinks they themselves are at risk of taking losses.

This is the banking business. Opacity is not something that can be eliminated through reform, because opacity itself is the tool that lets banks perform their economic function: getting people to bear risks they would not have taken if they had known all the information. Societies without opaque, mildly fraudulent financial systems do not develop and prosper. They simply do not take enough economic risk to sustain growth and development. You can have opacity and an advanced economy, or you can have transparency and herd sheep.

The downside of opacity is that it enables people at the center of the financial game to steal. But perhaps that’s a price we’re willing to pay for civilization itself. Or are we?

Nick Rowe compared finance to magic. My word of choice is placebo. The financial system is a sugar pill that lets us collectively endure greater economic risk. And like any effective placebo, it only works if we don’t realize it’s just sugar. We have to believe we’re swallowing a pill built on complex science and technology that our minds could never grasp. That’s exactly what the peddlers of financial placebos persuade us to believe.

Original article: Why is finance so complex? - interfluidity