A Note: Prolegomenon to Any Useful Discussion of Modern American Finance (Brad DeLong's Grasping Reality...): In a standard economic transaction...
...it is no mystery where the value to both sides comes from. When I buy a double espresso from Café Nefeli for $2.25, the coffee is more valuabe to me then $2.25 is. Were I to consider only the experience and not worry about fairness consideration--that is, if I did not worry about thinking that I was turning into a chump--I would pay $5.00 for a double espresso (if Café Nefeli were the only possible place I could get one and if that is what they charged) and count myself happy. And sometimes $10.00.
Similarly, for Café Nefeli the beans, the water, the grinding, the serving, the financing, and the rent, fully amortized, add up no more than $1.50 a cup. Any price between $1.50 and $5.00 a cup (and sometimes $10.00!) leaves both of us better off and happier--them with more generalized purchasing power, and me with caffeine coursing through my arteries.
Financial transactions, however, are different. In normal economic life we are trading commodities we personally value less for commodities we personally value more, we are trading away generalized purchasing power--money--for commodities we value highly, or we are trading away commodities we value little for generalized purchasing power--money--we value more. The sources of the gains from trade are obvious.
But in finance neither side is getting useful commodities. Instead, both sides are trading away claims to a pile of money and getting claims to a different pile of money in return. So how is it that me selling this pile of cash I have to you for that pile of cash that you currently own can be a good idea for both of us? Doesn't one of the piles have to be bigger? And isn't the person who trades the bigger for the smaller pile losing?
Almost, but not quite.
There are three ways in which a financial transaction can be a good deal for both sides.
First, people have different time preferences: I have money now that I do not want to spend on some useful commodity until sometime in the future, while you may have no money now and need some but anticipate being flush in the future; then we both benefit if I lend you the money--at interest. Second, risks distributed and diversified are risks dissipated, and so even though the average customer pays money into the insurance system insurance is still a valuable thing to buy because the insurance company pays you when you really need the cash. Third, economies work best when benefits and losses run with decsion-making: those whose actions create or destroy value pay attention when they have "skin in the game", and financial transactions are a good way to make sure they have that "skin in the game".
Those three sources of value for both sides in financial transactions are powerful.
They motivate net investments and drawdowns, insurance and diversification, and the creation of equity interests for managers, partners, homeowners, and others.
They drive perhaps 1/1000 of the transactions we see on financial markets each day.
All the other transactions are driven by two different factors:
First, in some transactions one or both sides are simply swept up in the excitement of the game. Second, in many transactions one or both sides has simply gotten the odds wrong, and they do not understand what they are doing.
Many economists these days talk about trade in financial assets as being motivated by "disagreement": I think I can make money by doing X, you think you can make money by doing Y, because we disagree about how the world works both X and Y are compatible, and so we trade and we both go away happy--until time passes, uncertainty is resolved, and I learn that you were right and I was an idiot.
"Disagreement"does not, however, capture what is going on.
Sokrates famously said that even though he was completely ignorant he was nevertheless the wisest man in Athens, because he knew that he was completely ignorant. Similarly, If I am completely ignorant about any financial asset, I nevertheless know one very very important thing: I know--unless saving or dissaving, insurance or diversification, or skin in the game considerations apply--that you cannot possibly know less than I do, and the fact that you think this is a good price for you to sell to me is a powerful reason for me to conclude that it is a bad price for me to buy at. When economists say that a financial transaction is motivated by "disagreement", what they mean is that there is not in fact value being created for both sides, and that the more ignorant party is being conned--perhaps by their counterparty, but most likely by themselves.
Overwhelmingly, this last factor is necessary to drive the vast majority of trades we see in modern financial markets. Look at any trade, and the odds are that on one side you will find people who know less than their counterparty and yet have not asked themselves the obvious question: "if this is a good price at which to buy, why are these people who know more than I do about the situation selling?"
If you don't start thinking about finance in this way--don't start by classifying those who trade into savers, borrowers, risk-bearers, risk-shedders, principals, agents, gamblers, and marks--you do not, I think, have any chance of conducting a serious analyses of modern finance.
A serious analysis has to start by dividing transactions into those we like and those we do not like. We like diversification and insurance. We like saving, investing, and repayment. We like transactions that give decisionmakers skin in the game.
The business of originating and greasing such saving, diversification, and incentive transactions is an extremely valuable contribution to society. We want to make sure that everybody knows the value of saving, diversification, and incentive transactions and that the costs of and barriers to them are as low as possible.
But there are also the--more numerous--transactions we do not like.
We do not like transactions motivated by the thrill of the game. The professionals in Las Vegas sell you the thrill of the gamble in a much more entertaining form and at a much lower price than your investment advisers and investment counterparties do. And there is no societal value at all created at all by selling somebody something for more than you know it is worth. Finance as casino and finance as confidence game should not play a major role in any financial system. We want to minimize such transactions.
And if your business model is not just to profit from the gamblers and marks, but to dissipate society's resources by inducing additional gamblers and marks to enter finance and play with higher stakes at games in which you are the house or have the aces up your sleeve--then it would be better for all the rest of us if we could figure out a way to transfer you from the financial sector to some activity with a higher societal value added. Perhaps we could use more unicycle riders to entertain commuters waiting for their express busses.