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Describe two examples of equity investments

Why are we so good at creating complexity in finance? But I don’t think it’s right at all. More precisely it has describe two examples of equity investments been opaque, and complexity is a means of rationalizing opacity in societies that pretend to transparency.

Opacity is absolutely essential to modern finance. It is a feature not a bug until we radically change the way we mobilize economic risk-bearing. The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear. Financial systems help us overcome a collective action problem. In a world of investment projects whose costs and risks are perfectly transparent, most individuals would be frightened. Further, the probability of success of any one project depends upon the degree to which other projects are simultaneously underway.

A budding industrialist in an agrarian society who tries to build a car factory will fail. One purpose of a financial system is to ensure that we are, in general, in a high-investment dynamic rather than a low-investment stasis. In the context of an investment boom, individuals can be persuaded to take direct stakes in transparently risky projects. But absent such a boom, risk-averse individuals will rationally abstain.

Each project in isolation will be deemed risky and unlikely to succeed. If only everyone would invest, there’s a pretty good chance that we’d all be better off, on average our investments would succeed. But if an individual invests while the rest of the world does not, the expected outcome is a loss. Colored values wearing tilde hats represent stochastic payoffs whose expected value is the number shown. This is a core problem that finance in general and banks in particular have evolved to solve.

A banking system is a superposition of fraud and genius that interposes itself between investors and entrepreneurs. It offers an alternative to risky direct investment and low return hoarding. Banks guarantee all investors a return better than hoarding, and they offer this return unconditionally, with certainty, without regard to whether other investors buy in or not. Under this new set of payoffs, there is only one equillibrium, the good one on the upper left. Basically, the bankers promise everyone a return of 2 if they invest, so everyone invests in the banks. Since everyone has invested, the bankers can invest in real projects at sufficient scale to generate the good expected payoff of 3. The bankers keep 1 for themselves, pay their investors the promised 2, and everyone is made better off than if the bad equilibrium had obtained.

Suppose we start out in the bad equillibrium. It’s easy to overpromise, but harder to make your promises believed. Investors know that bankers don’t have a magic wealth machine, that resources put in bankers’ care are ultimately invested in the same menu of projects that each of them individually would reject. Those risk-less returns cannot, in fact, be riskless, and that’s no secret.

So why is this little white fraud sometimes effective? Like so many good con-men, bankers make themselves believed by persuading each and every investor individually that, although someone might lose if stuff happens, it will be someone else. If something goes wrong, each and every investor is assured, there will be a bagholder, but it won’t be you. Bankers assure us of this in a bunch of different ways.

If the trail of tears were truly clear, if it were as obvious as it is in textbooks who takes what losses, banking systems would simply fail in their core task of attracting risk-averse investment to deploy in risky projects. Almost everyone who invests in a major bank believes themselves to be investing in a safe enterprise. Even the shareholders who are formally first-in-line for a loss view themselves as considerably protected. The government would never let it happen, right? Opacity and interconnectedness among major banks is nothing new. Banks and sovereigns have always mixed it up.

This is the business of banking. Opacity is not something that can be reformed away, because it is essential to banks’ economic function of mobilizing the risk-bearing capacity of people who, if fully informed, wouldn’t bear the risk. Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper. Insufficient economic risks are taken to sustain growth and development. You can have opacity and an industrial economy, or you can have transparency and herd goats. A lamentable side effect of opacity, of course, is that it enables a great deal of theft by those placed at the center of the shell game.

But surely that is a small price to pay for civilization itself. Nick Rowe memorably described finance as magic. The analogy I would choose is finance as placebo. Financial systems are sugar pills by which we collectively embolden ourselves to bear economic risk.

As with any good placebo, we must never understand that it is just a bit of sugar. Some notes: I do think there are alternatives to goat-herding and kleptocratically opaque semi-fraudulent banking. Sovereign finance should be viewed simply as a form of banking. Sovereigns raise funds for unspecified purposes and promise risk-free returns they may be unable to provide in real terms.