Inequality

[Admiral Yi]

A financial group understands where are risks involved with stocks and sovereign bonds and you can lose money.  But it is a well understood risk with centuries of history behind it and that is why you diversify your portfolio when fund managing.  The situation regarding the derivatives suggests for some reason they did not understand the risks they were taking on at all.

Are you actually telling me that only complex financial products lose money?  Because LOL

WFT?? No, I'm arguing the exact opposite.

[Valmy]

Obviously it is too complicated to even have a comprehensible argument about it.

[DGuller]

The problem in finance is that if you discount the possibility of a nuclear event, because you can't really protect yourself against it anyway, your consequent actions are skewing the probabilities in such a way that makes the nuclear event more likely.

Sounds like a macroeconomic problem. I don't see why an individual company would care (at least when contemplating its own actions).

Of course not, hence the need for regulation.

[grumbler]

CC--I don't know what you are trying to say.

He's trying to say that his reading about derivatives trumps your actual experience in them.

Maybe you have some concerns that mortgage backed securities were packaged in securities with derivatives embedded. In some cases these received solid ratings and were sold to institutionals who apparently were satisfied with the ratings. The issue here seems to be a problem with a lack of transparency in the securitization process combined with a lack of investigation on the part of consumers. I don't see a reason to think derivatives were the key to misleading the purchasers of the products.

The rating agencies had some serious accountability issues, for sure.  The lack of widespread understanding of the nature of the "bet" being made was also, as you note, a factor.

[grumbler]

Of course not, hence the need for regulation.

Good point. 

[The Minsky Moment]

Part V

Fiancialization doesn't create the speculative motive; the motive is always there.  It does make it easier and cheaper and provide more avenues and greater potential depth.  As actors hold financial assets for speculative purposes, potential investment funds can be diverted from the real economy.  Going back to our old example of the Farmer-Captalist and his wondrous machine, imagine instead of using his new profits to buy a new car, he plays the market in commodity options.  The link between sellers and buyers of real goods and services is broken and Say's Law falls by the wayside.

There are several caveats to this story though.  One is that the new financial infrastructure itself generates some level of additional employment, as people as needed to run IT systems and print up CDO prospectuses (although this is offset by trends to electonic trading).  Another is that financialization does provide some spin-off benefit to the real economy in terms of flexibility of financing, although the degree of benefit is relatively small is comparison to the vast increase in overall financial activity. 

In the US, since 1982, speculative financial activity drove three boom periods.  In each period, those directly involved in speculative activity made extraordinary, unprecedented gains.  It also brought benefits to a wider group of people in the form of increases in the value of commonly held assets like stocks, bonds, and most particularly, housing.  Wealth effects from the increases allowed for increased consumptions levels, thus offsetting the drain of funds in speculative activity - although as it came principally in the form of higher individual consumption down, some of that impact was lost in overseas via curret account deficits.  The net impact in the boom periods on the non-financial sector was ambiguous.  If one asks qui bono?  the answer is financial speculators, the much broader group of people who provide services to them and their counterparties, and asset holders who were lucky on timing.  The other are institutional players in the financial world who may not speculate in the conventional sense, but took advantage of opportnities to exploit leverage.

That brings us to the key feature of this time period - the assymetry of gains in the boom and losses in the bust.  The successful financial players in the 20s became the aprochryphal suicides of the 30s.  We learned the lessons of the Depression and after WW2 the government has been there to backstop the system.  But the original corollary to that protection was a system of regulation premised on a view of financial activity as a regulated utility.  Starting in the 80s, the government backsto stayed and indeeed grew beyond all anticipation but the cost of protection was removed from the direct users and beneficiaries and socialized.  What results is a massive subsidy paid to speculator, bankers and other institutional users of financial leverage, and paid by everyone else.  The subsidy is hidden from view in off-budget commitments, and abstruse Federal Reserve and Treasury operations but it is real and significant.

So as applied to facts of US experience since 1982, financialization has facilitated great returns to speculative holding of financial assets, diverted resources from th rest of the economy to limit losses to such activity, and possibly suppressing investment activity into other economic sectors.  At the same time, the government's spending on real good and services has actually declined, in favor of increased transfer payments primarily involving transferring resources from working people to retirees.  During the same period, the tax burden on wage earners has not lightened, but it has improved nicely for those with sufficient flexiblity to be able to recharacterize their income as dividends of capital gains.   

[Admiral Yi]

When talking about the three waves of speculation you're referring to commercial property (and the S&Ls), dot.coms, and the recent real estate bubble?

[Tamas]

That brings us to the key feature of this time period - the assymetry of gains in the boom and losses in the bust.  The successful financial players in the 20s became the aprochryphal suicides of the 30s.  We learned the lessons of the Depression and after WW2 the government has been there to backstop the system.  But the original corollary to that protection was a system of regulation premised on a view of financial activity as a regulated utility.  Starting in the 80s, the government backsto stayed and indeeed grew beyond all anticipation but the cost of protection was removed from the direct users and beneficiaries and socialized.  What results is a massive subsidy paid to speculator, bankers and other institutional users of financial leverage, and paid by everyone else.  The subsidy is hidden from view in off-budget commitments, and abstruse Federal Reserve and Treasury operations but it is real and significant.

That's what I wanted to drop in the discussion here but felt a bit ouf of place. "deregulation" of the 80s, as mentioned here and elsewhere may have been damaging, but it was because while it removed limits on speculative profits, the protection against grand scale speculative losses certainly remained in place. 2008 being the best example.

Very interesting thread by the way.