Alchemy of Finance

Steve Waldman riffing off on a statement by Arnold Kling that the key job of the financial system is to intermediate, to transform long term risky capital into short term liquid capital. As he rightly points out, there is no magical way to do this except through a misdirection of people and an implicit government guarantee of all capital.

This goes to the heart of the current financial crisis, that an intermediary could take on all sorts of risks funded via capital which they classified to their investors as risk-free.

Steve Waldman goes on to list a number of suggestions of what can be done in the future such as dis-intemediate, through equity arrangements rather than debt. But even equity arrangements need intermediaries and as long as people are not aware of the risks that they are undertaking or the intermediary obfuscates the risk.

A big reason for this is the bank depositors, house buyers, investors, insurance buyers have been innured to the fact that they are carrying any risk. Most people don’t expect to sell their cars or electonics at a higher price than what they bought it for. These are not seen as store of value, but rather consumption goods.

What a majority of people want it a store of value which will protect them against rising cost of consumption in future. The government should issue Inflation adjusted bonds and go on a campaign that this is the only reliable store of value. In every bank branch there should be signage just like there is on cigarette packets that there money is at risk with photographs of people made destitute by foolish investments. Everytime someone buys any asset which they buy simply because they think it will go up in value, governments should proactively start a Public service campaign which talks about how asset prices tend to fall after they have gone up. They do it for cigarettes, AIDS, STDs, flu epidemics, so why not for financial epidemics. It’s not bullet proof but atleast a counter-balance to the irational exuberance of people.


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