Thursday, December 16, 2010

The Wall Street Two-Step

I've long harbored the suspicion that our modern financial sector is something of a parasite, sucking wealth out of the American bloodstream. This suspicion intensified when I moved to New York, when I started meeting wealthy people who weren't obviously doing anything valuable to justify their wishes. (I know, a nervy statement coming from someone in advertising.)

But this article, from Tyler Cowen, brought these fuzzy thoughts into sharp relief. Cowen starts with the mission of explaining income inequality, but transitions to focusing on how Wall Street, in his words, "has learned how to game the American (and UK-based) system of state capitalism." How? By "going short on volatility," or by making financial bets that assume what is likely to happen will always happen. Cowen explains it well here:
To understand how this strategy works, consider an example from sports betting. The NBA’s Washington Wizards are a perennially hapless team that rarely gets beyond the first round of the playoffs, if they make the playoffs at all. This year the odds of the Wizards winning the NBA title will likely clock in at longer than a hundred to one. I could, as a gambling strategy, bet against the Wizards and other low-quality teams each year. Most years I would earn a decent profit, and it would feel like I was earning money for virtually nothing. The Los Angeles Lakers or Boston Celtics or some other quality team would win the title again and I would collect some surplus from my bets. For many years I would earn excess returns relative to the market as a whole.

Yet such bets are not wise over the long run. Every now and then a surprise team does win the title and in those years I would lose a huge amount of money. Even the Washington Wizards (under their previous name, the Capital Bullets) won the title in 1977–78 despite compiling a so-so 44–38 record during the regular season, by marching through the playoffs in spectacular fashion. So if you bet against unlikely events, most of the time you will look smart and have the money to validate the appearance. Periodically, however, you will look very bad.

This is essentially the same as Nassim Taleb's Black Swan argument, but Cowen explains why it in fact makes sense to ignore Black Swan possibilities. Taleb argues that there is opportunity betting against the herd (and also that the herd is too stupid to see these risks), but what if the Wall Street herd is actually smart enough to know that the government will have to step in when these unlikely events happen, to 'save the system'?

So far, Cowen is simplifying and clarifying arguments I have come across before, that essentially we are held hostage to Wall Street because it is the lynchpin of the economy. But one could still argue that it in best interests of individuals not to fail, because they will lose money, prestige, and opportunity. That is where Cowen makes his most devastating observation:

Another root cause of growing inequality is that the modern world, by so limiting our downside risk, makes extreme risk-taking all too comfortable and easy. More risk-taking will mean more inequality, sooner or later, because winners always emerge from risk-taking. Yet bankers who take bad risks (provided those risks are legal) simply do not end up with bad outcomes in any absolute sense. They still have millions in the bank, lots of human capital and plenty of social status. We’re not going to bring back torture, trial by ordeal or debtors’ prisons, nor should we. Yet the threat of impoverishment and disgrace no longer looms the way it once did, so we no longer can constrain excess financial risk-taking. It’s too soft and cushy a world.

If, to pick one example, Wall Street traders who lost billions of dollars lost every dollar they had, or spent years in prison, or were exiled to Zimbabwe, individuals would have incentive to resist following the investing herd. But they end up only slightly less rich and successful if they fail than if they succeed. This allure of big money without big risk, as Cowen and others observe, draws smart, driven people away from other fields (creative endeavors, entrepreneurialism, scientific exploration) where success is a prerequisite of financial reward.

The only problem is that this whole no-lose system depends on governments to be able to bail out the banks when the periodic crashes happen. But depending on this will encourage financial firms to take bigger and bigger risks until they overwhelm the government's ability to intervene. Whether what follows is another depression or societal collapse is unclear, but we can be sure it will be ugly.

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