Sunday, April 26, 2015

Is Finance Eating The World?

In 2011, venture capitalist Marc Andreessen wrote a much vaunted essay in the Wall Street Journal entitled "Why Software Is Eating The World". The phrase "XYZ is eating the world" has become standard fare for explaining how some new technology is disrupting old ways, and improving the lives of consumers in the process. Generally, this is seen as a good thing. Sophisticated (i.e. non-Luddite) commentators rightfully fret over the effects of technology on employment and inequality, but it is virtually unheard of for anyone to criticize the improvements offered by advances in technology.

Finance, on the other hand, continues to be reviled as an industry. It's pretty difficult to get the Tea Party and the most left-leaning wing of the Democratic Party in the US to agree on anything, but suspicion of, and antipathy towards, the financial industry seems fairly unanimous. Some of this is self-inflicted, through a never-ending series of scandals and understandable concerns about the power of the finance lobby. But we rarely hear the mainstream media articulate things the industry does well, or even the notion that finance can disrupt staid industries for the better. Take, for example, a steady drumbeat of positive press about the solar industry. My impression is that potential disruption to the archaic utility model is widely considered a good thing, with interlopers like SolarCity generally garnering positive coverage. Rarely covered, though, is that finance (and its red-headed stepchild, securitization) is an intrinsic part of SolarCity's business model. The company itself dutifully discloses in its annual report, "Our future success depends on our ability to raise capital from third-party fund investors to help finance the deployment of our residential and commercial solar energy systems." One might go so far as to argue that SolarCity is in the business of creating safe assets, and solar systems are merely an input in the process. So maybe, then, it's finance that's eating the world.

I can't imagine many people would be comfortable uttering that last sentence. The entry of finance into hitherto pristine fields such as commodities (that's sarcasm) has given rise to an ugly word, "financialization". The debate continues as to whether financialization has contributed to heightend volatility in these markets. To some extent, it seems clear that a common investor base increases the covariance of assets. But financialization may be getting a bad rap when it comes to creating increased volatility. In an excellent article on Keynes's approach to endowment management, Chambers and Dimson highlight his sensitivity to liquidity risk. Ever incisive, Keynes wrote, "Some Bursars will buy without a tremor unquoted and unmarketable investments in real estate which, if they had a selling quotation for immediate cash available at each Audit, would turn their hair grey. The fact that you do not [know] how much its ready money quotation fluctuates does not, as is commonly supposed, make an investment a safe one." Financialization may merely reveal the underlying volatility of asset classes such as real estate and commodities, which is unsurprising given the long known inelasticity of supply and demand. Did a move to spot market pricing create the vicious fluctuations in the iron ore market, as has been argued by some industry executives? I, for one, am skeptical. Furthermore, financial players clearly provide liquidity and produce information for markets. 

Finally, a common criticism is that financial players are merely engaged in rent-seeking, rather than generating genuine social value. A recent article by Harvard economics professor Sendhil Mullainathan captures these concerns, which I share. Mullainathan's balanced treatment does, however, do a nice job of addressing the ambiguity of what constitutes rent-seeking. Thankfully, this doesn't need to be decided in a court of law by a Solomonic judge. The market is a wonderful device for decentralizing this judgment, and it usually works quite well. Broadly speaking, I think we have passed the days when the average person in finance made extraordinary sums disproportionate to his value (and a damned good thing too!). As examples, this has manifested itself in industry job losses and unceasing pressure on fees to investment managers. At a higher level, the combination of government regulation and investor pressure have convinced most large financial firms that simpler, more robust structures are preferable. The market, in other words, has penalized firms for being unwieldy and producing little value in return for increased complexity. 

None of this should be misconstrued as my saying that the industry is omniscient or morally unblemished. It merely means that we should continue to encourage the expansion of finance, even though mistakes will be made. Experimentation is a messy affair, and is particularly challenging in financial markets, which are complex adaptive systems that can be highly unpredictable. But as Mullainathan writes, "I hope [students going into finance] realize that they have the potential to do great good and not simply make money. It may not be how the industry is structured now, but idealism and inventiveness are two of the best traits of youth, and finance especially could use them." I'm reasonably optimistic that creative finance and dynamic technology will continue to disrupt stale models of thinking, benefiting end consumers. After all, if finance is eating the world, perhaps the world is ripe for eating. 

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