A Lesson in Finance

I love Brad DeLong's writings. Not only is he smart, he (like Paul Krugman) writes in an accessible prose. They see their job as economists to go beyond simply extending the academic edifice into an even higher and more inaccessible ivory tower. They bring economics to the masses.

Here is a bit from an article by Delong in Business World that looks at high finance and gives you a quick-and-easy lesson in finance theory:

No one questions the usefulness of "low" finance.

The ability to use checks, banknotes, and credit cards rather than having to cart around chests of silver, scales, and reagents to assay purity, and needing armed guards to protect the silver (and more guards to watch the first set of guards) has obvious efficiencies.

So does the ability of households to borrow and lend in order not to be forced to match income and expenditure every day, week, month, or year.

But what use is "high" finance?

Economists’ conventional description depicts high finance as providing us with three types of utility. First, it allows for many savers to pool their wealth to finance large enterprises that can achieve the efficiencies of scale possible from capital-intensive modern industry.

Second, high finance provides an arena to curb the worst abuses by managers of large corporations. Managers’ fear that if the stock price drops too low they will be out on their ears provides a useful restraint.

Finally, high finance allows for portfolio diversification, so that individual investors can seek high expected returns without being forced to assume large, idiosyncratic risks of bankruptcy and poverty.

But these are the benefits of high finance as they apply to the ideal world of economists — that is, a world of rational utilitarian actors who are skilled calculators of expected utility under uncertainty, who are masters of dynamic programming. We do not live in such a world.

Economists have spent their lives attempting to evolve theories that would account for how salient features of reality might emerge if we did live in their ideal world, but since we don’t, their theoretical enterprise is of doubtful utility. It is like describing how one could bake a delicious wedding cake using only honey, bicarbonate of soda, and raw eggplant.

If we take the world as it really is, we see that high finance performs two further tasks that advance our collective welfare. It induces us to save, accumulate, and invest by promising us safe, liquid investments even in extraordinary times.

...

Seventy-three years ago, John Maynard Keynes thought about the reform and regulation of financial markets from the perspective of the first three purposes and found himself "moved toward... mak[ing] the purchase of an investment permanent and indissoluble, like marriage...." But he immediately drew back: 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...."

Moreover, for Keynes, "[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...."

It is for these reasons that we have seemed frozen for the past generation or two whenever we have contemplated reforming our system of financial regulation. And it is why, even in the face of a severe financial crisis, we remain frozen today.

That short essay explains what high finance is and why it is so hard to reform it even in the teeth of the current debacle.