Finance Followups

In Defense of Finance generated over 110 comments across WordPress, LessWrong and the Reddits, as well as in personal communication. As predicted, I learned a lot.

In this post I’ll address some of these comments and offer follow up thoughts that didn’t fit in the original essay because they’re more speculative. Also, becase that post ran to 5,500 words already.

People said: “I don’t buy this, fuck capitalism!” If you want to stick it to capitalism, you can gift a donation to a creator publishing his work online for free.

People said: “Finally someone gets it and does the math right!” If you think I get it and I do the math right, you can forward me job offers at lucrative hedge funds, PE firms, and startups.

People said that it’s overly defeatist to claim that finance won’t improve no matter how we try to fix it, we just have to live with it. But that’s not quite what I think.

Finance improves itself, mostly after crises. In 1929 we learned that established company stocks are riskier than we thought, and in 2000 we learned the same about startups. Financial institutions learned how to deal with 20% interest rates in 1980 and with 0.02% rates in 2010. After 2008 we learned that 6% is too low of an equity ratio for banks, that rating agencies with no skin in the game are useless, and that CDO-Squared are really dumb. Hopefully, we also learned some generalizable math lessons, such as the fact that lack of correlation in normal times (e.g., in mortgage default rates) doesn’t imply lack of correlation when a crisis hits.

We’re on the cusp of the longest period ever between recessions in the US. In the decade since 2008 the Middle East has gone crazy, Europe has gone crazy, Venezuela has gone crazy, elections have gone crazy, the weather has gone crazy, the Cubs have won the World Series, Leicester won the EPL, Bitcoin rose and fell and rose and fell and rose. Throughout all of this, the bankers and traders have kept their nose down and didn’t recklessly endanger the world.

One day after this generation of financiers will have been gathered to the Hamptons, a new one will arise that does not know The Big Short and they’ll do something really dumb to cause the next financial crisis. But for now, finance seems less of a global threat than Twitter.

Turkeys in the Jungle

People said that I defended the parts of finance that are easy to defend, such as banks making loans to businesses, and didn’t address the whatabouts. What about high-frequency trading firms? What about mutual funds that charge 2%/20% to underperform indices? Payday loans? Penny stocks?

I don’t have a knockdown argument for those and perhaps there isn’t one – perhaps the above are actually net harmful to humanity. But I have a useful and very stretchy metaphor: finance is a jungle.

First, finance is a jungle in the colloquial sense of a hypercompetitive environment. Financial firms compete with each other, and it’s hard for any of them to build moats or acquire monopolies. Changing your bank or brokerage is a lot easier than changing utility providers, social networks, or even fridges. So if a hedge fund makes money doing something that seems inefficient or bad for customers, you have to answer why it has not been competed away by someone better.

Second, finance is a jungle in the sense of being a complex, interconnected ecosystem. Another lesson we should have learned from 2008 is that banks, hedge funds, insurance companies, and government agencies depend on each other in critical and opaque ways. Eliminating a class of instution from the financial system is like eliminating some annoying insect from the jungle: it could make things a little bit better, or it could bring the entire thing crashing down unexpectedly.

But the more I thought about this metaphor, a new picture came to mind. Finance isn’t just a jungle of sharp-toothed jaguars, venomous frogs, and vicious parasites. It’s a jungle surrounded by turkey farms that send fat, defenseless birds by the millions running into the deadly forest. These turkeys are most of the people you know.

People are breathtakingly stupid about finance. And by “people” I mean “average Americans”. This isn’t because Americans are less financially literate than the rest of the world, it’s just that the best data available about financial idiocy concerns the “average American”.

The average American has more than $5,000 in credit card debt, on which they pay more than 15% interest. The average American doesn’t know how much debt they have or how much it costs them.

Less than two in five Americans have enough savings to cover an unexpected $1,000 expense. The median income in the US is $59,000, so all it would take to save up $1,000 for the average American is to only spend 98% of what they make for a single year. The average American can’t do that.

The smart American isn’t much smarter than the “average”. Married couples with postgraduate degrees fall into spirals of debt for no reason other than their own poor planning. One of my smartest friends was paying 9% on a loan while investing in funds that wouldn’t return that much in a good year. One of my smartest coworkers told me yesterday that he won’t fund his 401k for the first six months of 2019 because of a “hunch”, thus foregoing six months of expected positive returns. Many smart people told me they like getting a tax refund, not realizing that it means that the government earned interest on their money for a whole year instead of them.

I often hear from people who tell me they loved Get Rich Slowly, but then admit that their own money is in hand-picked stocks or savings accounts.

And these same people expect to be able to buy whatever they want whenever they want at the swipe of a card. They expect their cash to be available at any ATM in the world, with no fees. They expect their retirement to be provided for, even if they do not provide for it themselves.

The worst aspects of finance are a direct result of the average person being stupid about finance. People expect to beat the market, so they pay brokerages and make their pensions invest in high-fee funds. People don’t understand debt and interest, which fuels bubbles and crises from MBS to student loans.

It is not clear that government regulation will help. For one, outlawing stupid behavior (like day-trading stocks) will often just shift people to stupider behavior (like day-trading movies). For another, if people aren’t smart enough to deal with personal finances, how could they vote intelligently for financial policies on a national level?

The only solution to this is financial literacy education, and I’m doing what I can to help my readers with that. That’s one of the reasons I wrote In Defense of Finance: when you stop hating finance you can start to understand how it works, and when you start to understand how it works you can make it start working for you.

15 thoughts on “Finance Followups

  1. This is a really funny analogy: ‘Finance isn’t just a jungle of sharp-toothed jaguars, venomous frogs, and vicious parasites. It’s a jungle surrounded by turkey farms that send fat, defenseless birds by the millions running into the deadly forest. These turkeys are most of the people you know.’


    1. I think that M-M is irrelevant for most industries, and triply so for banking. M-M relies on a whole page of explicit and implicit assumptions, it’s an exercise in pure arithmetic. There are precisely zero companies in the real world that don’t care about their equity/debt ratio, and not just because of taxes.


  2. Let me try:
    M-M says that a 100% equity mortgage-lending company would be equally as valuable as a bank performing the same operations based on 10% equity and 90% debt, but it tells you nothing about which one is easier to bring into being. So invoking M-M to justify banning the latter arrangement doesn’t really hold up.

    In the big picture debt vs. equity arrangements are basically schemes for distributing future gains and losses, so it’s not that relevant that they don’t (to a first-order approximation) change the total value of the underlying operation.


    1. To pile on to my own comment, a company will have the same return on equity whether it is owned by one person or many. Does that imply that banning all joint-stock companies wouldn’t hurt the economy?


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