What I really mean to suggest is not that somebody should take more risk or less risk, but different people should be taking more or less risk. I absolutely don’t want intermediaries to be taking greater financial risks. On the contrary (and mostly in agreement I think with Yves), I think loan originators and securitizers and SIV managers etc took “too much” risk on behalf of investors, while representing their products as safe. Looking only at these actors, sure the problem was “too much” risk (adroitly foisted onto third parties). But intermediaries generated these problems because there was incredible demand for a category of assets that investors should be smart enough to know can’t really exist: safe, “high yield” assets. There was not a continuum of demand, accepting higher risk for higher potential returns. There were large clienteles who demanded only assets that were deemed “safe” by standards presumed authoritative, but then chased yield within that category. Intermediaries bent rules and invented false magic, sure, but they did so in the service of investors who demanded what could not be delivered.

Investors can demand all the safety that they like, but they cannot have it. Wealth does not magically go forward through time, and therefore claims on wealth must be perishable unless we succeed at regenerating it. Investors can have a sort of safety, default-free debt, but in any given currency they can have no more than the currency-printing government offers, and they can have it at only one price (yield). Even these assets are not safe, currency/purchasing-power risk is real. Investor expectations that they could “shop around” for “enhanced yield” “safe” assets were entirely unreasonable, and that our financial system encouraged those expectations to the point where we feel compelled to ratify them ex-post with taxpayer dollars and/or inflation is an error we should never repeat.

The general public should keep small amounts of money in FDIC insured bank accounts. But wealthy people cannot shirk their responsibility to help direct the use of the resources they control and expect to carry their wealth into the future, let alone multiply it. The job of the financial system is to facilitate the matching of owners of capital with wealth-generating projects. I’m sure owners of capital would prefer to multiply their wealth without doing that work, and intermediaries can earn fees by pretending to offer safe, zero-work, zero-risk returns. Pretenses eventually fail, and it is not only the gullible who are harmed.

There was much waste and awfulness about the dot com bubble, but one of its redeeming features was that everyone always knew it might all come apart. During the credit boom there was lots of cynicism and carping on the outside, but professionals treated magically high-yielding safe assets as though their failure was unthinkable, which really set up the hurting.

There’s a tension, when discussing the financial system, between positive and normative aspects. You are right, as a positive matter, that what I ask of the financial system is more than what the professional class standing beneath the banner “Finance” would consider part of their job description. As a normative matter, I think that’s a bad thing. I’m too familiar with what “financial analysts” do, as a profession. Generally speaking, they develop independent opinions tightly constrained by professional norms, in terms of what are reasonable asset classes and assets within classes, that severely limits the possibility that professionally manged capital — that is, most capital — will be deployed outside of what are deemed safe harbors. The “physical and intellectual separation of the real economic system from the financial system, and a separation of real economic investment from financial asset investment” is a bad thing, from my perspective.

“[T]he counterfactual would seem to involve at lot more central planning in the economy. Otherwise, how can we say that business was responding to anything other than the invisible hand that was dealt to it?”

I don’t think that’s reasonable. That an outcome occurred in an environment largely free of central planning does not imply that the same outcome would always have occured in similar circumstances absent central planning. The fact that demand for safety translated to a housing boom had everything to do with an institutional environment, with both public and private aspects, that is by no means predetermined. The existence of Fannie and Freddie, and the infrastructure and expertise devoted to generating and securitizing conforming mortgages, served as the seed and template for much of the innovation in the sub-prime, alt-A, and jumbo sector. Housing seemed a good candidate for “instasafety” because it was the only asset conventionally securitized, and had a pseudohistory of “never” having declined on a national basis. It would be quite possible to define tranched paper secured by pooled sector-specific inventories, plant, intellectual property, or subsidiary securities that would have allowed moderate-risk fixed-income investors to make qualitative choices about where their capital would generate the highest margin of safety. Of course none of those would have had the quantitative characteristics to simulate out as AAA paper in rating agency models. But those models were foundationally wrong, and surely not a necessary outcome absent central planning. The scenario we observed was a collaboration between the invisible hand and a set of institutions, habits, conventional assumptions and shortcuts. It was not what “the” invisible hand foreordained.

That said, the relationship between central planning and free markets in a “good” economy is a challenging one, and I don’t want to accept an implicit assumption that more central planning is always worse. I’m very biased towards market solutions to informationally challenging problems. But there is a “superstructure” (I know! That’s a Marx-word!) that generated constraints and biases under which the “invisible hand” operates, and there’s little evidence to suggest that relying on a meta-invisible hand to get those biases right is better than even very flawed state actors. Of course, I’d be very glad to improve upon flawed state actors, but one must make a case for how, not just hurl epithets about socialism and central planning, to do that.

When savers finance the current consumption of negative-savers, absent agency costs, they do so only contingent upon assurance that the negative savers will generate suplus future production a portion of which they can skim. That is to say that you are right that current savers are happy to transfer dis-savers future production to current consumption, for a price. And that’s fine, so long as they can discriminate wannabe current consumers with surplus future production from wannabe current consumers without. Rational savers absolutely do not finance the latter party’s consumption, but a lot of savings did in fact go to dissavers without expected surplus production. That was not a matter of volunatry allocation by invisible hands, but uninformed investors and malfunctioning agencies. Depositors would not have made the same loans their banks did. I’m glad to question those outcomes, and againwon’t concede that what flawed institutions have wrought was the only possible outcome absent central planning.

I agree that there was lots of intrafinancial risk, in terms of leverage and the structure of a variety of assets and derivatives. I framed this piece as “too little risk?” to be provocative. I’d suggest that there was too little risk taken along certain dimensions, and too much risk taken along others. However, even synthetic assets impact the real allocation of capital. If I buy a synthetic bond built out of Treasuries and GM CDS contracts, the teentsy little firm I’m funding is selling protection on GM bonds, driving down the cost of that protection, which affects the credit spreads demanded on “real” bonds, which affects GM’s cost of capital. I won’t make the strong claim that purchasing such a bond is equivalent to actually lending GM money. But broadly and in general, derivative transactions are “passed through” to the real economy by arbitrage and equilibrium, they are not a cul-de-sac unto themselves.

I’m mostly with the Austrians, by the way, on commercial banks and deposits. There’s this myth that there’d be no investment without highly leverage commercial banks and “maturity transformation” (which is the ultimate juvenile demand for safety that should not in general be accommodated). If all the funds deposited in checking accounts, savings accounts, and CDS were kept as cash in mattresses, that wouldn’t affect the quantity of real capital available for investment. It would undermine the system that we currently have for allocating capital, and the system that we currently use to mediate current exchange. I won’t quarrel that it would be disruptive. But the usual justification for leveraged, fractional reserve banking is that they are necessary to persuade the masses to invest society’s resources, which otherwise would sit unused. That’s BS. As long as wealth is stored as money or future claims, savings does not deplete the capital available for investing. the current banking system has more to do with who decides how capital is allocated than with making capital available.

I’m not sure if we’re disagreeing at all about the “global savings glut”. Contingent upon certain policy choices, China and the Gulf states have no choice but to invest in USD assets, and they prefer safety to risk with the vast majority. That was my point, it seems to be yours too. They drove up the price of safety, which created a great demand for cheaper (that is higher yielding) safe assets from the private sector, which also largely wanted safety.

Again, I do agree that the financial system took all sorts of “intrafinancial” risk, and that had much to do with the crisis. That’s why I used the formulation “equally accurate to suggest that the financial system took on too little risk.”

If you suggest that financial intermediaries should then I would disagree strongly. They are proscribed in the type of risk they can assume for good reason. If you mean that private capital has been AWOL then I might agree. They probably would serve their clients better over the long term by taking some reasonable venture risk rather than playing with paper.

I will grant the premise, I think you make, that too much capital was diverted to the housing market. However, this is both a political and economic problem. Unless you attack the forces promoting housing you can’t expect the intermediaries to do much else but continue to invest in the sector.

You say this in your last paragraph:

Investors’ childlike demand for safety has made the financial world terribly risky. As we rebuild our broken financial system, we must not pretend that risk can be regulated or innovated away. We must demand that investors choose risks and bear consequences. We need more, and more creative, risk-taking, not false promises of safety that taxpayers will inevitably be called upon to keep.

I would respond that:

1. Investors have every right to demand whatever level of safety they like. It’s their money. How society decides to give them that measure of safety is both a political and business decision.

2. Who is the royal “we” that will demand that investors accept some designated level of risk and who is going to divine that level of risk?

3.We always need more risk taking by the appropriate risk takers. Those are few and far between. The general public is ill equiped for that job. The banks and the investment banks should not be using the capital that they possess to direct the funds of risk averse investors into investments they have no ability to analyze.

To the extent that I may have misinterpreted the points you were trying to make, I apologize in advance.

It seems I drew something different out of it than others.

My take was that the current financial system is unwilling to take a risk on an actual physical product. There is a love affair with investing based on financial models, not products. The financing then drives the products.

The housing bubble didn’t arise because lots of builders had marketing plan to build the burbs. It arose because financers felt home mortgages were a safe bet. This gave the builder the money to build the safe product.

No one risked money trying to actually make anything (or at least not anything new.) Financers won’t “risk” their money on anything that does not fit into their mathematical models, things like new products, new technologies, or actual production plants. In today’s market, the funding that years ago helped start Ford would have gone instead to the buggy whip makers and horse farms (based of course on triple AAA solid gold multi-variable analysis of historical returns for buggy whips versus the unquantifiable returns for the newfangled car.)

Why, so that Steve can pump himself up on a weak story?? Dah…

Wasn’t it not long ago that investors had brazenly ignored risk in the hopes of higher profits. Subprime mortgages, overleveraged investments, commodoties, etc were not risk-free or risk-averse. I have to side with Yves here…it seems as though investors knew that there were risks present, although they might not have accurately assessed it.

In addition, I’m not sure how accurate your argument about real estate is. Real estate had ceased being a big draw for investors before the current crisis even started, 2-3 years ago. Obviously real estate was less “safe” than we thought it was, but it wasn’t exactly a high growth area either.