"Vague thoughts on a Sharp Essay
Brad DeLong wrote a brilliant little essay on "The Hidden Purpose of High Finance"
This is a "project sindicate" project, so I think fair use requires me to only quote Brad when he is quoting Keynes except for 3 words, 2 in the quote below and "eggplant."
He dismisses the efficient markets hypothesis half way through and says that high finance has two socially useful effects that it wouldn't have if everyone were rational. In each case the effect is to promote savings. They are
1) the illusion of liquidity. Brad quotes Keynes "the fact 'that each individual investor flatters himself that his commitment is ’liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk....'"
2) the fun of gambling makes us invest more. Keynes again "[t]he game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll...." Brilliant, OK so much of the brilliance in Keynes's.
After the jump, my rambling thoughts.
update: Brad has a longer essay which anticipates many of my comments on his shorter essay.
That is a brilliant essay. I would say advantage 2 disciplining managers is upside down. Without high finance we wouldn't have the separation of ownership and control in the first place. High finance creates a principal agent problem and does a little tiny bit to solve it. Advantage 2 is really a cost.
The eggplant wedding cake analogy is excellent (although a student of Larry Summers ought to have allowed the use of ketchup).
I think on balance we are not gamblers. Some people are and specialists profit from them. The key point is if enjoyment of gambling caused us to save and invest more, then stocks should be overpriced compared to treasury securities. Ooops Mehra Prescott. Looks like, on balance, people act risk averse. I am assuming that almost all of the risk of investing in stock is due to noise. If the desire to gamble caused increased investment, then the patient trader (imagined by Keynes embodied by Buffett) would avoid common stock like the plague. In the data, quite the contrary.
Liquidity is valuable even without irrationality. I think you are right that the price of liquidity is based mostly on the irrational sense that liquid assets are safe,that is each persons guess that he will guess what the crowd will do before the crowd -- will sell before the peak etc. The theoretical effort to explain the price of liquidity in a model in which the average investor is rational and not irrationally convinced that he is smarter than the average investor is eggplant and ketchup souflé takes great effort, has little substance and is likely to collapse.
You are aiming to find hidden purposes of high finance which are socially useful. "Purpose" here is used in a quasi religious way as "social function." I think you are being diplomatic, but it is almost as if you believe the invisible hand can work without rationality. I'd say the purpose is definitely to separate fools and their money. It works very well at that. What is the purpose of a Casino ? Do casinos achieve that purpose ?
I'd distinguish between high finance (joint stock limited liability corporation, index fund) and really high finance, (call it stoned finance) CDS, CDA etc. A lot of new financial instruments are there to help people hedge. The reconciliation of a great desire to hedge and rationality is the absurd assertion that they are hedging real risk on untraded assets. In fact, people hedge, because they think that they can make more money out of a mispriced asset that way. The demand is based on a huge number of people the average one of which thinks he is above average. Helping compulsive gamblers get in tens of billions over their heads is not socially useful.
That's what Value Investing does, as well:
"Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies."
"The demand is based on a huge number of people the average one of which thinks he is above average."
My main man says:
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks."
"Helping compulsive gamblers get in tens of billions over their heads is not socially useful."
"The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell."
It is the attitude, intention, or use, that determines the value of any given investment. I argue that CDSs, CDOs, etc., have valid uses, which are admittedly a small part of good and sensible investment. You focus on the products, while I focus on the intentions. That's our difference. In other words:
"Meaning just is use"