just some notes.

Financial Fascinations

May 31, 2021

I was writing a bit about Ha-Joon Chang’s book Economics: The User’s Guide the other day. I had just completed the book and wanted to jot down a few thoughts. As I usually open up Wordpad whenever I want to write on my laptop, it wasn’t completely surprising that my weird refusal to save documents would eventually lead me to lose the writing to Windows Updates.

Anyway, as the document had grown full of random notes, most having nothing to do with the book, it actually felt liberating to be now presented with an entirely empty sheet of digital paper.

So the book. As I wrote in my previous post - when I had just started reading it - Chang does a great job of giving you a clear honest breakdown of economics as a field of study. He follows that up with a brief balanced piece of history, which sets you up to dive deeper into any specific part of economics or finance you are interested in.

I was particularly fascinated with finance.

To understand finance though, it makes sense to look at its original purpose, which is to raise capital or to spend said capital on entrepreneurial activities. What this amounts to on a very small scale is that you would ask your friends and family for money, which you would then use to start a business. So you might buy stock, production capacity, or spend the money on marketing.

On a larger scale, this would be banks and investment firms raising money from wealthy individuals, governments and companies. And then using that money to buy or invest in different types of assets in the hopes they will appreciate in value.

These days finance has grown to be much more than its original purpose. In fact, finance has grown to be a gargantuan set of activities. Whenever things grow to be on a larger scale, there needs to be some way to regulate or organise things. The financial market has been set up to be that instrument of organisation for finance, with investment banks as its manager(s).

The Financial Market

On the financial market, companies can offer a part of their business for sale, which translates into shares. Selling shares of their business on the market allows the companies to raise the aforementioned capital to finance whatever entrepreneurial activity they deem smart or advantageous.

Investment banks are the brokers of these deals. Plus they also play the game itself, meaning that they buy and sell shares too. On top of that, they assist in companies buying other companies or help facilitate their mergers. Basically, whenever large sums of money take the stage, investment bankers are directing its movement.

Now to get to my fascination with finance. Chang explains in his book that investment banks over the years started to get more and more creative in their pursuit to make more money off their self-built and maintained financial markets. Playing the facilitating role and buying and selling regular shares will only get you that much money. So what they needed was a line of products that would get people (in this case investment funds, pension funds, governments, etc.) lined up around the block. And the only way to do that is to promise more profit with lower risk.

In come financial derivatives.

The foundation of these products is debt. When a bank lends a person or business money, the bank stands to profit off that loan by receiving payments with interest. In a perfect world, the loan is fully repaid, and the banks receive a little extra on top for taking the risk. Because there is a risk. The person might not be able to repay the loan.

These outstanding loans can be sold. Say I lend someone 10,000 euros and then my neighbour wants to take that loan off my hand for 12,000 euros, knowing that when the loan is fully repaid he stands to rake in 15,000 euros because of the interest, we could strike up a deal. I would make less money but would have sold off the risk, while my neighbour takes over the risk, but will make more money when the loan is successfully repaid. It’s all about how much either of us trusts the person that has to pay back the loan.

Banks do these types of things on a large scale. They hand out loans for all types of things, and then they offer up these loans for sale. They are called bonds. Basically, the banks are trading in debt.

Now trading in debt is risky, depending on how realistic the loan is. When a loan was given to buy a home - a mortgage - the debt is backed up by the value of the property. So when the debtor cannot pay the mortgage, the bank still has the value of the house. This is relatively safe if the price that was paid for the house was solid. However, as we know from real-life experience, the housing market has been known to blow up in fantastical ways to result in house prices skyrocketing to unrealistic heights.

Given this knowledge, that people need to pay prices for houses that do not value their intrinsic value, while combining this with a very unstable job market (as in, anyone could lose their job at any time), as a bank you would be hesitant to lend out money.

However, when you know that you can make a lot of money by trading those debts, you might be willing to neglect that hesitancy to lend out money. In fact, you might be feeling incentivized to lend out even more.

Still, who is willing to buy those risky debts?

Well in their current form, not a soul. And this where we really get to the point of my fascination, I promise.

Pooling and scheming

What bankers decided to do, is to pool all those mortgages into one big bond, which they would then offer up for trade. So the idea here is that if you combine thousands of those loans, sure a few might default, but a lot of them would turn out to be profitable. The risk thus spreads out, and the product becomes attractive enough to invest in.

Banks would use the money they made on those bonds to hand out even more loans, which then are converted into new bonds, and then sold off on the financial market again. They pretty much created a money-making machine, feeding on itself.

It stands to reason that if banks were happy to keep this scheme going, and if regulators were happy to not interject, the logical end of this financial scheme surely would be pursuit. And this is what happened, and is still happening.

Chang explains the financial simulacra that were created much more deftly and correctly than I can, but allow me to paint a picture.

When you derive a new product out of a combination of other products, the foundation is still the individual old products. You didn’t create something intrinsically new, you just repackaged it differently. And when you then create another new product out of a bunch of the derived products, you are still not creating anything new, you are just creating more distance to the original debts.

And while these newly devised products are promoted as safe (“we are spreading the risk”, “we have restructured it so you will be the last to incur a loss”) they do not eliminate any of the underlying risks, they just obscure it. So as Chang puts it: “You could say that derivatives are bets on how other things are going to unfold over time”. The value of the product you just bought has no intrinsic value but instead derives its value from who knows what. It could be the credit card of an irresponsible student in Utah. And yes, we just bought into a bet that he will pay off that credit card in time, or at all.

A Financial Simulacrum appears

Part of the reason that these products have not only been created, but are also heavily traded is what Christophe Schinckus argues is a two-prong virtualization. In his paper he speaks of a “symbolic virtualization” of the financial reality, which needs a bit of context.

The sophistication of these new products require a certain “professionalization” of the people holding them. Because what do you own? It’s relatively easy to wrap your head around owning a house, a piece of art or an expensive watch collection. But how do you handle a financial asset. What happens is that you hire a financial expert.

As the financial expert needs to prove their worth, the average investment horizon shortens (“show me some return on investment!”). The financial market responds by offering more product and catering specifically to these new professionals via advertising and personalized products that will “definitely help them to strengthen their portfolio!“. A new reality appears . Schinckus explains:

“If we consider, following Shiller (1999), that investors pay much more attention to conversations, rituals and symbols, we can conclude that financial adverts and mass media are culturally dedicated to the symbolic (and hence material) perpetuation of the contemporary financial markets. We can then observe a “symbolic virtualization” of the financial market which now appears as a game that we have to play if we want to be in .”

Secondly Schinckus speaks of a “technological virtualization”, with automatic trading and e-finance as the main drivers. “This technological evolution represents means to move closer to our idealized conception of the efficient markets (no transaction cost, availability of information,…) on which all theoretical models are built.”

Schinckus goes on to argue that “the double virtualization (symbolic and technological) observed in the financial world transforms the financial market in a cultural simulacrum, a hyper-reality which has no referent anymore (but which still have some impacts on the economic reality)“.

So what we got is a reality that basically created itself to serve itself. A reality in which products with almost no intrinsic value are traded at hyper-speed either because the computer said it’s the best choice, or because we’ve bought into a financial culture in which we just follow the latest trends and fear to “lose out”, even if we do not understand what we’re buying. A devastating simulacrum which is paradoxically unreal, yet its impact as real as anything.

Fascinating stuff.

Debt as the main driver

I hope you share some of my fascination and quite possibly disgust for all of this. Finance itself is obviously not a bad thing. It’s the fuel that keeps the economy going. It helps people start businesses, or businesses to invest in new technologies.

However when finance forget its original purpose and instead becomes a game of trading debt in ever more creative ways, with the only goal being to shift capital from the poor to the rich, it deserves more than just a bit of scrutiny. It deserves to be overhauled.

Since debt is the main driver in all of this, I found it more than apt to continue my reading with a book that is specifically about it. I’m talking about Debt: The First 5000 Years. It’s a very prolific book by the late anthropologist David Graeber.

As for Chang’s Economics: The User’s Guide, I can recommend it as a great primer on economics. If you’re completely new to economics it will guide you through the field, and if you already know your way around a little bit, it could act as a great refresher. Fair warning that the book is a little dated with regards to the real-life numbers sections.

Links of note: