Trading in risk

The excellent essay aggregator The Browser linked this week to an essay by Steve Randy Waldman on the relationship between freedom and risk. It’s an interesting piece and well worth reading. I want to instead talk about the blurb that The Browser wrote to recommend it:

Learned essay on the contradictions between freedom and risk. We almost all want freedom, but few of us want to carry the risks that go with freedom. The history of finance is the history of attempts to lay off or mitigate risk: all of which are doomed to failure. The risk has to accumulate somewhere. And, as in 2008, it eventually blows up.

I know I shouldn’t take this too seriously—it is, after all, just a little hook to encourage readers to click on the link—but I think there are a couple of important things to mention.

I am extensively on record that economics is not the same thing as finance, but of course they are related. Let’s say for the moment that if we can think of economics as being about the allocation of scarce resources, we can think of finance as being about the allocation of scarce capital or money. At the core of economic theory is the idea of mutually beneficial trade: it is possible that we can trade resources and both be better off than before. More than that: a trade willingly entered into by two parties with good information on the things being traded seems almost tautologically mutually beneficial. If it doesn’t benefit both, why do it?

Now of course “good information” is important. For example, when you sell me a used car knowing that it is in fact a few miles away from becoming kaput, I may later be upset. Similarly, in finance, if my information on the riskiness of an asset is bad, I may be sad later, and not just in the sense of being unlucky. But the claim that “all [attempts to lay off or mitigate risk] are doomed to failure” is very peculiar. There are two problems here. The easy one first: clearly not all risks “eventually blow up”. This is the point of risk! If all risks eventually come to pass, then surely they are not risks but racing certainties.

The second problem is that where the risk goes matters. Naturally “the risk has to accumulate somewhere”; we cannot magic away risk by passing it around. But where does it end up? Can the trade of a risky asset be mutually beneficial? Yes: if you are more willing to bear the risk than I am, then you will be willing to part with more to buy that risk than I am willing to accept to sell it. You can buy that risk from me—assume it for your own—and we can both be happier. Think of unemployment insurance: for me to lose my job may be catastrophic. I will be destitute; this risk is very costly for me to bear. For an insurance company, the risk that I lose my job is trivial. The insurance company is happy to absolve me of (some of) this risk, and I am happy to pay them a premium to do so. We are both happy. Dare I even say that my freedom is enhanced when I can trade risk in this way?

So yes, the risk accumulates. But the idea behind all trade is that we might be able to send resources to the place where they are most valuable. And so it is with risk: if we can trade risk, perhaps we can have it accumulate in the hands of those to whom it will be the most bearable. While we do not eliminate the risk, we minimize the pain that is caused if the bad outcomes happen. Hey presto!

Of course there is fraud and lies and bad information, and of course some risks can aggregate into systemic kerfuffles, but let’s not throw the baby out with the bathwater. Trade in risk is not an inherently destructive activity.

Hey, look, it’s a financial crisis

Nothing like a good financial mess to underscore just how little anyone really understands the “economy”. By which I probably mean the financial system. I think. There’s also nothing like a good financial mess to slaughter in cold blood any chance I ever had of convincing anyone that economics is not the same as finance

Fortunately, the economics behind everything from risk trading to bailouts is very simple, even as the financial system manages to be opaque enough to make a lot of people look confused and silly. Even better, pretty much everyone understands that economics: for example, ‘moral hazard’ can mean something as simple as ‘if the government is willing to bail out a bank when it’s in trouble, risks for that bank are less risky so they might be willing to take more risks’. Of course, then you might well ask ‘more than what?’ or ‘how risky?’, but the idea is solid. Even the trading of risk is not especially difficult to grasp, because we’re all familiar with the concept of insurance, and it’s in exactly the same spirit, perhaps with a bit of hot potato thrown in as the risk gets chopped up and passed around. 
But the system? I think that’s pretty confusing. The BBC has valiantly compiled a little glossary of some of the jargon, but we’re already in very, very deep; too deep for that glossary to be helpful. Sure, it might turn some otherwise baffling sentences into plain English, but what if I don’t know, say, what the stock market is, what is does, what it means? What good is a passage like this one to me:
Not far behind was Royal Bank of Scotland, whose shares ended down 10.2% at 189.1p. Barclays fared better, its shares closed down 2.53% at 308p.

Hell, what good is that to anyone? What is it saying? For those of us who know what the stock market does, maybe because we’ve studied finance, were simply interested or just have that little piece of information in our heads, it means something, but how many people is that? It’s just as bad as using the word ‘economics’, which I’ve already argued is usually meaningless
It must be hell to try to write about a financial crisis for a lay audience. There’s a perfect parallel between the entanglement of the institutions themselves and the contortions of language needed to explain it. Of course, personally, and I realize this is a terrible thing to admit, I’m experiencing delightful schadenfreude over the whole affair, so I admit to being less sympathetic than curious. 

Economists talk weird

I was going to rant a bit about “Lessons in Love, by Way of Economics” by Ben Stein from the New York Times, but, and I didn’t even think this was possible, the whole thing is too ridiculous to justify it. Suffice to say it’s more bad PR for the poor econ set.

One of my least favorite things about economists is that we often seem more prone to talking about normal stuff in economics-speak. You’d like an example?

In every long-term romantic situation, returns are greater when there is a monopoly.

Good grief. I mean, who is reading a bunch of aphorisms about ‘love’ translated into economics jargon and thinking ‘awesome article’? Plus, as an added irritant, half the dodgy analogies are to finance, not economics, viz “[t]he returns on your investment should at least equal the cost of the investment” etc etc.

Who knows, maybe there could be something interesting under that title. What I hoped might crop up in an article with such a title might be something about the things people want, the monetizing of economics versus the rich motivations of life. From the tail end of the article:

Ben Franklin summed it up well. In times of stress, the three best things to have are an old dog, an old wife and ready money.

OK. It’s the old “no-one ever died wishing they’d spent more time at the office” bit. Shouldn’t that apply to economists too? Then why are economists so keen to spend all their time at the office by talking about normal stuff in economics jargon? That’s tiresome, not fun.

Economics or finance?

From a fun baseball story about a minor league player selling shares in his career:

“Newsom has decided to use that economics degree he got from Tufts, and along with two friends he’s started a new company called Real Sports Investments. It’s a company that allows baseball fans to invest in minor league baseball players by purchasing shares of the player.”

Being from Britain, it reminds me of those human interest stories you sometimes read about a father laying a bet that their son will one day play soccer for England (here’s merely the first example I got from Google). More to the point, how is Newsom’s economics degree helpful?

The short answer is not at all. The study of economics isn’t “business”, or management, or whatever you call the skills and knowledge that would be useful in setting up or running a company. It also isn’t finance, so it can’t help him understand how a stock market works.

What’s the difference between economics and finance? A good starting point might be this, from Brian Hollar:

“Finance typically focuses on maximization of wealth. Economics focuses on the optimization of subjectively valued goals. Conceived of in this way, finance is a specialized subset of economics.”

That gives the correct impression that finance is the one that’s interested in the study of the management of money and assets. I might go further and say that finance is arguably vocational; I don’t think economics courses hold a great deal of value for aspiring investment bankers (perhaps one of the commonest misconceptions held by undergraduate economics concentrators) – finance courses are the ones that will teach them how asset markets work. Economics, being more of a method than a body of knowledge, is not really vocational at all, even though students of economics will certainly develop other applicable skills like data analysis, applied math and writing. Economics probably uses optimization rather than “focusing” on it.

Just to complicate matters, the unfortunately named field of “financial economics” is, as the name might suggest, something of an intersection of the two. Financial economics is the application of the economic method to the particular case of the trade in money and assets like stocks and bonds: how do financial markets and the trade of assets affect the allocation of resources? How does the financial system affect the decisions made by people, companies, governments? Financial economics, being part of economics rather than finance, fits Hollar’s definition of “optimization of subjectively valued goals”; it’s again a descriptive tool rather than practical training or a recommendation of a course of action.

Finance and economics are terms often used interchangeably in the press. I think the best illustration is the word “socioeconomic”, which to my mind really means “sociofinancial” – what’s your social status, and how much money do you have? If we start using “economic” to mean the amount of resources a person has at their disposal, the nuance of the word as signifying the allocation of resources is obscured.

I always wondered why The Economist magazine has a composite section for “Finance & Economics”. It might be worth emphasizing the distinction between these two concepts a little more cleanly. In an ideal world we might even have a third word: economics for the economic method, finance for asset markets and a shiny new one to talk about the “world economy”. What does “America’s weakening economy” really mean?