UnProductive Trillions
There was once a time when I played a lot of poker. From time to time a new player to the group would try to teach us a new game. Naturally, the new player knew the game better than the novices. This gave the teacher an edge over the students. No one cheated, and the new player didn’t always win, but more often than randomness could explain, the teacher was counting his newly acquired chips after the hand.
Remember this little parable, it will become relevant in a just a moment.
Capitalism is based on freedom and that is good. It is also based on the idea that letting a small number of people get rich is a good idea because many important things can only be accomplished by someone, or something, with a huge hunk of money. As a stand-in for any number of good things, I will use the example of building a factory. Unless someone has a huge hunk of money to spend, the factory does not get built, and a lot of jobs do not get created for people who don’t have a huge hunk of money. Deride this idea with slurs like trickle-down economics if you wish, but to me, it makes sense.
If our hypothetical rich person is not going to build a factory himself, then the next best thing he could do with his money is to loan it to someone who will build a factory with the money. Such use of accumulated money is clearly beneficial to all of us. Buying a bond issued by IBM is an example of such a use.
Is buying IBM stock a beneficial use to all of us? Not directly. Should I buy IBM stock tomorrow, not a dime of my money goes to IBM. My money will go instead to some stranger who decides to sell IBM stock tomorrow. But, unless that stranger has the hope of selling that stock at a later date for a profit, the stranger never buys the initial offering of IBM stock. The money from that initial sale went to build factories. So, even though a private stock sale does not aid the economy directly, a functioning marketplace for stock is a price we should gladly pay for providing entrepreneurs a place to raise money to build their factories.
Now, imagine two rich guys puffing cigars in the lobby of a brokerage house looking at a big electronic ticker tape streaming across the wall. Rich Guy One turns to Rich Guy Two and says “I will bet you a million dollars that by the end the next hour, the price of IBM stock will go up (or down, it doesn’t matter in this imagining) 1/8 of a point. Rich Guy Two accepts the bet. An hour later they settle up. Did IBM get a dime from this bet? No. Did this bet contribute to a better functioning market? I don’t see how. Did either of our Rich Guys put any money into the “market?” No. This was a side bet outside the market.
Should we outlaw such side bets? The libertarian in me says No. But, we should prohibit anyone who wants to be a licensed investor of other people’s money from making these side bets. We should drive this stuff off the reputable markets, banish it to private gambling parlors, and prevent banks, governments, pension funds, insurance companies and all other “establishment” financial institutions from this sort of gambling.
Why? First, it involves someone betting on something bad happening. This is activity that any financial market should seek to minimize or avoid. If you can avoid it, and you can, why create a market where anyone can put themselves into a position to directly benefit from the misery of others? Investment, done correctly, should be an act of optimism. (Imagine the mischief horse race tracks would be inviting if they permitted bets on a particular horse to lose.)
Second, because it is a side bet, it is by definition an unproductive zero-sum game. The genius of capital investment is that it is possible for everyone to win. Some will surely win more than others, many will in fact lose, but no one has to lose in order for the market to work. Rich guy loans money to entrepreneur, entrepreneur builds factory, people get jobs, rich guy gets his loan paid back with interest, entrepreneur gets rich, and now we have two rich guys to start the process all over again. A side bet is different. Every dime a winner wins is a dime a loser loses.
So what, you say? It is a free country, you say? Let the fool and his money be freely parted, you say? Well I say not so fast. If the rich are just going to gambol away their money in unproductive side bets, then I say lets just take it away from them in taxes. Whoa! Cry the rich. The economy benefits from us being rich – we invest and we help everyone. We make the pie bigger. We raise the tide and lift all boats. However, there is no rising tide when it comes to side bets. Money changing hands between two rich bettors grows no pie and raises no tide. Such side bets no more help the overall economy than stuffing money into mattresses.
At this point, you are possibly saying to yourself that this is all well and good but isn’t this rant about a rather small issue? And this is where you would be terribly, terribly wrong. I am not talking about two rich guys betting a million dollars. I am talking about trillions (with a T) of dollars being diverted from the pie-growing business every year. I am talking about anything properly called a derivative. I am talking about virtually every (non-commodity) financial instrument traded on the Chicago Board of Trade.
I am not talking about commodities futures contracts. I understand commodities. Commodities serve a valid function. The farmer’s got a crop in the ground and wants to lock-in a price in February because he does not want to risk what the price will be in July. The investor has no crop, but he has money and he is willing to risk it in the hope the price will go up instead of down. It may be a zero-sum game but it serves a useful purpose as long as it is confined to things that have seasons like corn, coffee beans, and pork bellies. When you apply it to IBM stock, or IBM bonds, or the Euro, or anything else that already has a functioning market that is not seasonal, it serves no useful purpose at all.
At this time, dear reader, I invite you to consider the fairy tale of the Emperor’s New Clothes. I have just insisted that the Derivative Emperor is buck naked because all his trillion dollar clothes are unproductive “bets” as opposed to productive “investments.” Ask yourself, do you personally see the Emperor’s fine clothes, or do you just assume the clothes exist because so many rich, smart people insist the clothes are magnificent? If you can’t see the clothes yourself, please keep in mind that all those smart, rich people are highly paid tailors for the Emperor.
The tailors will tell you that the clothes serve the useful purpose of “managing risk.” They will then explain what they mean by that in a way that convinces you that you are dumb and they are smart because you don’t understand a word they say.
When I was young and stupid, say 50, I would see something I didn’t understand that was apparently universally accepted by a lot of smart people and I would presume there was some hidden knowledge I was unaware of that would make it all clear. I am not so trusting anymore.
Because I am no longer intimidated by so-called experts, I have two responses to their claims of managing risks. The first response is succinct: Bull-Pucky.
They make it sound like they invented riskless investment. Cool. Then you read in the paper how these experts lost over 100 billion dollars by their expert management of risk. The County of Orange in California went bankrupt a few years back because the County Treasurer asked an expert to manage risk. The expert then did so by investing in derivatives so complex the Treasurer couldn’t understand them.
The experts pushing derivatives are all smarter than me, but, I am not so dumb that I have lost sight of the following:
• By definition, a derivative is a financial instrument whose “value” is derived from the value of something(s) else. Therefore, a derivative has no intrinsic value. Its only value is the value all parties to the derivative mutually agree that it has.
• Prudent investors have “managed risk” for hundreds of years before derivatives were invented. (Think diversification.) Derivatives could disappear tomorrow and prudent investors will still be able to manage risk.
• Because derivatives are all zero-sum games, the whiz-kids can’t all win unless the amateurs are enticed into playing. (This is a double benefit because the amateurs have to pay large sums of money to a whiz-kid to guide them in playing.)
• The house always wins. Some of these whiz-kids create and sell both sides of a derivative. They become “the house.”
• The higher the potential return, the higher the risk. The expert that claims to be able to produce consistent high returns with low risk is lying. Just because I am unable to figure out exactly how he is lying does not change the fact that he is lying.
• The more complex the derivative, the more the game is stacked in favor of the whiz-kids who actually understand them. (Remember the Poker Game at the beginning of this essay?)
• Investment is risk. To invent riskless investment is to invent riskless risk. The experts have no more discovered how to completely manage risk than they have discovered the perpetual motion machine.
The second response is: even if true, derivatives are not worth the price. Remember the goal: expand the pie, raise all the boats. The rationale of risk reduction, even if true, cannot justify the diversion of trillions of dollars away from productive investment. Gambling bets and investments are two totally separate things. A “bet” on the future price of IBM stock is no more of an “investment” than a “bet” with a bookie on the Kentucky Derby. (A bet placed at Churchill Downs is partially productive because “the house” takes its share to run the race track and pay prize money to the horse owners. But a bet with the bookie does Churchill Downs and the horse owners no good whatsoever. The bookie is a useless parasite to Churchill Downs and the horse owners. Similarly, a derivative whose value is tied to the price of IBM stock is a useless parasite to the New York Stock Exchange and IBM.)
If there were no derivatives, these trillions would not go into mattresses. They would go somewhere more productive than where they are now. A trillion here, a trillion there, and soon you have enough money to build a factory, or two, or a thousand, or 100 thousand.
Remember this little parable, it will become relevant in a just a moment.
Capitalism is based on freedom and that is good. It is also based on the idea that letting a small number of people get rich is a good idea because many important things can only be accomplished by someone, or something, with a huge hunk of money. As a stand-in for any number of good things, I will use the example of building a factory. Unless someone has a huge hunk of money to spend, the factory does not get built, and a lot of jobs do not get created for people who don’t have a huge hunk of money. Deride this idea with slurs like trickle-down economics if you wish, but to me, it makes sense.
If our hypothetical rich person is not going to build a factory himself, then the next best thing he could do with his money is to loan it to someone who will build a factory with the money. Such use of accumulated money is clearly beneficial to all of us. Buying a bond issued by IBM is an example of such a use.
Is buying IBM stock a beneficial use to all of us? Not directly. Should I buy IBM stock tomorrow, not a dime of my money goes to IBM. My money will go instead to some stranger who decides to sell IBM stock tomorrow. But, unless that stranger has the hope of selling that stock at a later date for a profit, the stranger never buys the initial offering of IBM stock. The money from that initial sale went to build factories. So, even though a private stock sale does not aid the economy directly, a functioning marketplace for stock is a price we should gladly pay for providing entrepreneurs a place to raise money to build their factories.
Now, imagine two rich guys puffing cigars in the lobby of a brokerage house looking at a big electronic ticker tape streaming across the wall. Rich Guy One turns to Rich Guy Two and says “I will bet you a million dollars that by the end the next hour, the price of IBM stock will go up (or down, it doesn’t matter in this imagining) 1/8 of a point. Rich Guy Two accepts the bet. An hour later they settle up. Did IBM get a dime from this bet? No. Did this bet contribute to a better functioning market? I don’t see how. Did either of our Rich Guys put any money into the “market?” No. This was a side bet outside the market.
Should we outlaw such side bets? The libertarian in me says No. But, we should prohibit anyone who wants to be a licensed investor of other people’s money from making these side bets. We should drive this stuff off the reputable markets, banish it to private gambling parlors, and prevent banks, governments, pension funds, insurance companies and all other “establishment” financial institutions from this sort of gambling.
Why? First, it involves someone betting on something bad happening. This is activity that any financial market should seek to minimize or avoid. If you can avoid it, and you can, why create a market where anyone can put themselves into a position to directly benefit from the misery of others? Investment, done correctly, should be an act of optimism. (Imagine the mischief horse race tracks would be inviting if they permitted bets on a particular horse to lose.)
Second, because it is a side bet, it is by definition an unproductive zero-sum game. The genius of capital investment is that it is possible for everyone to win. Some will surely win more than others, many will in fact lose, but no one has to lose in order for the market to work. Rich guy loans money to entrepreneur, entrepreneur builds factory, people get jobs, rich guy gets his loan paid back with interest, entrepreneur gets rich, and now we have two rich guys to start the process all over again. A side bet is different. Every dime a winner wins is a dime a loser loses.
So what, you say? It is a free country, you say? Let the fool and his money be freely parted, you say? Well I say not so fast. If the rich are just going to gambol away their money in unproductive side bets, then I say lets just take it away from them in taxes. Whoa! Cry the rich. The economy benefits from us being rich – we invest and we help everyone. We make the pie bigger. We raise the tide and lift all boats. However, there is no rising tide when it comes to side bets. Money changing hands between two rich bettors grows no pie and raises no tide. Such side bets no more help the overall economy than stuffing money into mattresses.
At this point, you are possibly saying to yourself that this is all well and good but isn’t this rant about a rather small issue? And this is where you would be terribly, terribly wrong. I am not talking about two rich guys betting a million dollars. I am talking about trillions (with a T) of dollars being diverted from the pie-growing business every year. I am talking about anything properly called a derivative. I am talking about virtually every (non-commodity) financial instrument traded on the Chicago Board of Trade.
I am not talking about commodities futures contracts. I understand commodities. Commodities serve a valid function. The farmer’s got a crop in the ground and wants to lock-in a price in February because he does not want to risk what the price will be in July. The investor has no crop, but he has money and he is willing to risk it in the hope the price will go up instead of down. It may be a zero-sum game but it serves a useful purpose as long as it is confined to things that have seasons like corn, coffee beans, and pork bellies. When you apply it to IBM stock, or IBM bonds, or the Euro, or anything else that already has a functioning market that is not seasonal, it serves no useful purpose at all.
At this time, dear reader, I invite you to consider the fairy tale of the Emperor’s New Clothes. I have just insisted that the Derivative Emperor is buck naked because all his trillion dollar clothes are unproductive “bets” as opposed to productive “investments.” Ask yourself, do you personally see the Emperor’s fine clothes, or do you just assume the clothes exist because so many rich, smart people insist the clothes are magnificent? If you can’t see the clothes yourself, please keep in mind that all those smart, rich people are highly paid tailors for the Emperor.
The tailors will tell you that the clothes serve the useful purpose of “managing risk.” They will then explain what they mean by that in a way that convinces you that you are dumb and they are smart because you don’t understand a word they say.
When I was young and stupid, say 50, I would see something I didn’t understand that was apparently universally accepted by a lot of smart people and I would presume there was some hidden knowledge I was unaware of that would make it all clear. I am not so trusting anymore.
Because I am no longer intimidated by so-called experts, I have two responses to their claims of managing risks. The first response is succinct: Bull-Pucky.
They make it sound like they invented riskless investment. Cool. Then you read in the paper how these experts lost over 100 billion dollars by their expert management of risk. The County of Orange in California went bankrupt a few years back because the County Treasurer asked an expert to manage risk. The expert then did so by investing in derivatives so complex the Treasurer couldn’t understand them.
The experts pushing derivatives are all smarter than me, but, I am not so dumb that I have lost sight of the following:
• By definition, a derivative is a financial instrument whose “value” is derived from the value of something(s) else. Therefore, a derivative has no intrinsic value. Its only value is the value all parties to the derivative mutually agree that it has.
• Prudent investors have “managed risk” for hundreds of years before derivatives were invented. (Think diversification.) Derivatives could disappear tomorrow and prudent investors will still be able to manage risk.
• Because derivatives are all zero-sum games, the whiz-kids can’t all win unless the amateurs are enticed into playing. (This is a double benefit because the amateurs have to pay large sums of money to a whiz-kid to guide them in playing.)
• The house always wins. Some of these whiz-kids create and sell both sides of a derivative. They become “the house.”
• The higher the potential return, the higher the risk. The expert that claims to be able to produce consistent high returns with low risk is lying. Just because I am unable to figure out exactly how he is lying does not change the fact that he is lying.
• The more complex the derivative, the more the game is stacked in favor of the whiz-kids who actually understand them. (Remember the Poker Game at the beginning of this essay?)
• Investment is risk. To invent riskless investment is to invent riskless risk. The experts have no more discovered how to completely manage risk than they have discovered the perpetual motion machine.
The second response is: even if true, derivatives are not worth the price. Remember the goal: expand the pie, raise all the boats. The rationale of risk reduction, even if true, cannot justify the diversion of trillions of dollars away from productive investment. Gambling bets and investments are two totally separate things. A “bet” on the future price of IBM stock is no more of an “investment” than a “bet” with a bookie on the Kentucky Derby. (A bet placed at Churchill Downs is partially productive because “the house” takes its share to run the race track and pay prize money to the horse owners. But a bet with the bookie does Churchill Downs and the horse owners no good whatsoever. The bookie is a useless parasite to Churchill Downs and the horse owners. Similarly, a derivative whose value is tied to the price of IBM stock is a useless parasite to the New York Stock Exchange and IBM.)
If there were no derivatives, these trillions would not go into mattresses. They would go somewhere more productive than where they are now. A trillion here, a trillion there, and soon you have enough money to build a factory, or two, or a thousand, or 100 thousand.