Opaque finance, again, and solutions

There a few people whose work I more respect than Yves Smith at Naked Capitalism. She is a tireless researcher, remarkably immune to the bleary-eyed depression I experience when digging through the obfuscatory minutia of financial industry predation. I have and will continue to hold Smith in very high regard, whatever her regard for me.

However, in a recent post, I think I have been treated unfairly. I think no fair reading of my financial opacity piece, alone or with its two followups, could characterize my position as “extoll[ing] deception and theft”. The first piece is not satirical, in the sense of advancing a position which its author does not hold. But it is hyperbolic and sardonic, in the sense of laughing into ones execution. I think it is true that the business of banking, in order to effectively perform its social function of mobilizing resources at scale, necessarily involves a degree of deception. It must work to persuade a variety of stakeholders that their claims are very close to risk-free when in fact they cannot all be. That a degree of deception, or at least obfuscation, is inherent to banking does not justify all possible misbehavior. If you must lie for some greater good, you are especially bound to put the proceeds of the lie towards the greater good, and not just run off with the cash. Nothing justifies the sort of looting to which no one has called attention more assiduously than Smith. However, the opacity built into the very structure of modern banking systems, irreducibly if they are to perform the work we now delegate to them, renders it nearly impossible to prevent the pillage. Far from hagiography, in my mind this thesis is bitter eulogy for the hope that a banking system like ours can be “reformed”. I think that we need to find other, very different, means of performing the functions that status quo banks currently perform, so that we can encourage the institutions that currently dominate to wither into obscurity. I know this is a tall order.

That existing institutions are difficult to police doesn’t mean that we shouldn’t do our best while we are stuck with them. It certainly doesn’t mean that when we discover violations of the rules we impose to manage this conundrum, the violators shouldn’t be held accountable. On the contrary, ordinary principles of deterrence suggest that difficult-to-uncover crimes should be punished much more harshly than crimes for which detection is likely. I have never advocated any lenience. I think we should expose and punish relentlessly. But I don’t think we’ll get very far, because bankers will respond with capital strikes, motivated both by both cynical politics and genuine fear. Without alternatives, we will find ourselves unable to tolerate credit slowdowns, and we’ll end up with politicians who help engineer cover-ups. Over the short term, we are addicted to bubbles and bezzles. Over the long term, opaque finance makes important contributions to economic development. We need new institutions that replace existing banks, or we will lack leverage to effectively police the old ones.

This is a judgment call about which reasonable people can disagree. Smith thinks that finance prior to the 1980s worked well, and represents a model to which we can return. Carolyn Sissoko, who knows more about the history of banking than I ever will, thinks eliminating limited liability for banks will resolve the problem. I enthusiastically support that reform, but believe it would leave us in a painful state of macroeconomic withdrawal absent other changes. I think we are in a bind.

Since my opacity posts, I have been thinking more macroeconomically, and trying to come up with solutions. I do have some ideas. I think we should we rely less on personal savings and more on a basic income for insurance by ordinary households against economic risk. I think “risk-free” savings should be placed directly with the state, rather than via the Rube Goldberg machine of bank deposits and a state guarantee. Quantities of truly risk-free savings should be carefully rationed. Beyond that ration, systemic risk should be borne by savers via toleration of inflation. I think we should regulate aggregate demand (in practice, probably target NGDP) by modulating the flow of transfers to the public (“quantitative easing for the people“, “monetary policy for the 21st Century“, “helicopter drops“), and emphatically not by adjusting the price or regulatory scrutiny of bank credit. To replace the role of banks in ensuring sufficient availability of investment capital, the state should subsidize investment by riding along, directly and explicitly, with very simply constituted private investment funds that meet certain criteria. (The state would do so as a senior creditors or via some form of matching equity. However, we will have to be wary of letting more explicit state involvement politicize the investment process. A legal, commercially-viable abortion clinic or gun range should have the same access to government supported, privately allocated credit as a flower shop. The criteria for government co-investment should be as mechanical as possible to prevent quid-pro-quos where politicians exchange investment subsidies for promises of having favored projects funded.)

I don’t know whether any of this will ever become politically possible. In the meantime we are stuck with a system that has “criminogenic” built into its very roots. I don’t applaud this; I can barely live with it. But I do think it is a fact. We’ve got to police the system we have with as much muscle and tenacity as we possibly can. No one contributes to that more than Yves Smith does, and for that I thank her very much.

Note: In her post, Smith asked me to comment about differences in my treatment of health care and finance. I think there’s something interesting to talk about there. That will be a second post.

If you do want to evaluate my opacity theory, I ask that you include the third piece of the series in your reading list, which is written with more care and gentler rhetoric than the first two. The first two posts probably were too belligerently written. Still, this series really did feel like violating a taboo.


23 Responses to “Opaque finance, again, and solutions”

  1. stone writes:

    I think replacing current taxes with a flat tax on gross asset values and replacing all means tested welfare benefits with a citizen’s dividend might sort things out. We currently rely on credit expansion and as you say that relies on bankers being confident that they will get their loans repaid. However if everyone received a citizen’s dividend, everyone would have the financial freedom to start up enterprises etc. Credit would then be less of a constraint. A tax on gross assets would ensure that wealth was put to use in a way that gathered an income stream to pay the tax with. Bubbles would no longer be a necessary route to prosperity. Personally I don’t think bubbles even increase global prosperity now. IMO much of the benefit from bubbles is simply a transfer from the rest of the world to the bubbling country by capital flows to bid up the prices of pre-existing bubble assets. We get say minerals and timber from Congo and in return elites there get account statements about the bubbling stocks and bonds and real estate they own here.

  2. Sergei writes:

    I think she has a very binary black/white attitude. Yes, bankers have, *esp. recently*, proved to be quite bad. No, banks are generally good and quite needed. Mixing the two is the worst mistake one can make while trying to understand either.

  3. diego espinosa writes:

    Hedging against uncertainty should be done by households rather than the state. I would argue the lesson of the GFC is that technocratic promises of stability caused households to adapt by levering as much as possible, as well as by abandoning liquidity hedges. This was an example of how state-level insurance alters the fitness rule and results in a homogeneous system exposed to catastrophic loss. Further, giving the state control of capital allocation is a recipe for cronyism. Perhaps the crony’s would be different, but cronyism overall would rise.

    Technocratic rule works by generating gains from increased stability and extracting a large part of those gains as economic rent earned by a minority. The problem is that when the underlying fragility shows itself, it is un-hedged households that pay the price rather than cronies.

    One could think of strong deflation as a major force in interrupting inter-generational wealth transfers (as firms and financial intermediaries fail), whereas high inflation is a means of steadily syphoning wealth from the middle class. The system you describe is much more prone to the latter than the former.

  4. Luis Enrique writes:

    Nice response. This is an example of Yves taking the least charitable possible interpretation of someone, to the point of absurdity. Sometimes I wonder if she errs similarly elsewhere, for example when writing about government constrained by politics. But perhaps her work on finance has taught her the least charitable interpretation tends to be the right one.

  5. Greg Taylor writes:

    Yves post was not a fair characterization of the totality of Waldman’s work at Interfluidity or the financial opacity series in particular. Any reasonable refutation of Waldman’s thesis in that series would need to provide some sort of real or imagined example of transparent finance. I’ve not seen one to date.

    Yves Smith often claims that finance was not opaque in the 50s, 60s and 70s. That is unfortunately not true and plenty of people suffered at the time because of it. The Fair Debt Collection Act and laws against redlining weren’t passed until the late 70s, The Home Mortgage Disclosure Act became law in the mid 70s, the Fair Credit Reporting Act passed in the early 70s, and the Truth in Lending Act in the late 60s. The transparency introduced by these laws is taken for granted today but consumers were regularly shafted before their enforcement.

    While I disagreed with Steve’s thoughts on financial opacity at the time (comment #15 on his original post) I saw value in it then as I do today. Attempting to refute his argument forces you to think about what it would take to eliminate opacity from finance. It was an enlightening yet depressing exercise for me.

    You could make some headway with plain vanilla contracts as advocated on this blog. But human variation in the ability to comprehend risk creates the information asymmetries exploited by financiers. As long as consumers make financial decisions regarding retirement, insurance, and mortgages the financier will have much greater knowledge of the financial risks and how to value them. Western societies have always been plagued by these financiers taking advantage of this asymmetry.

    Our society allows people to exploit their knowledge, skills and abilities to make a living. Variation in financial knowledge is not going away so how can you get rid of opacity in finance? To me, that was the point.

    Unlike Steve, I’ve given up on the potential for macroeconomics to provide solutions to this problem – or just about any others. I look for insights at the micro level. We need to find ways to value the sanctity of transactions – each party making sure that a “meeting of the minds” occurs. How can we build a culture that ensures that each looks out for the interests of the other when making transactions? Empathy that leads to trust.

    Macroeconomic approaches I’ve seen essentially ignore that dynamic. I believe they are doomed to fail. The sanctity of the transaction is only way I can see to meaningfully reduce opacity, whether in the financial, health care, education or any other sector.

    I really like Interfluidity. When I can understand Steve, he forces me to think deeply. Even when I can’t understand, the effort is still worthwhile.

    Steve – don’t worry about what Yves thinks of you. Probably a great deal more than she lets on in her post. Obviously your 15 month old series on opacity stuck in her mind – probably because it was nearly impossible to refute and implicitly called into question much of her work.

    I left a comment similar to this on her blog but was disappointed in her piece and especially the commentary. I see a great deal of similarity between the values expressed on Interfluidity and Naked Capitalism and find the tone of her piece distressing. It destroys community among folks that should be kindred spirits. It bolsters Jonathan Haidt’s questionable argument that those on the left of the political spectrum lack a moral foundation that values loyalty, authority, and sanctity – a foundation required to bind groups together. After seeing Yves piece, I’m starting to agree more and more with Haidt.

  6. Al writes:

    If you were surprised by Smith’s article, and if you think that this follow up will contribute to her understanding, then you never truly appreciated her work. Naked Capitalism is not a site for intellectual ruminations. It is a focal point for the identification and castigation of evil doers. Why would she adjust her opinions of a wrong doer given further explanation? For the sake of truth? Wrong incentive schema.

    Check out her reconstitution of Bill McBride’s call on a housing market bottom. She transformed his argument that troughs form in sales volume prior to price into a cheering squad for a housing bull market. Naked Capitalism is still a great site to find negatively skewed commentary and fact aggregation about the finance industry. It is not a good site for nuanced arguments or the depiction of “truth”. You use the right tools for the job.

  7. K writes:


    Let me tell you why you are objectively wrong (and just ignore why you are morally wrong).

    Market cap of publicly listed companies is about $16Tn in the US. There is at least that much again in outstanding corporate bonds. Total deposit? About $7Tn. Those $7Tn of deposits are backed by assets that are vastly less risky than the typical corporate balance sheet. Banks don’t have risky assets; they just have very little equity. So in terms of notional, the amount of risk assets in public markets that are funded by government guaranteed liabilities is less than 20%. And if you look at it in terms of risk weighting, I’d bet it’s way less than 10%. You think the equity and corp markets couldn’t absorb that?! The idea that we are all just to pussy to bear the risk, apart from being extremely offensive, just makes no sense *whatsoever* when you look at it in the context of the risk we are already bearing in publicly traded securities. Seriously, the US banking system was bailed out with well under $1Tn in new equity. The stock market swung like twice that much a day during some days in November ’08.

    The problem is not that the banking system has to bear a huge amount of real risk. It doesn’t, as anybody who has ever naively tried to walk into a bank and try to convince them to invest in a business can attest. The problem is that the system is so pathetically fragile that when it suffers a comparatively puny loss it simply collapses. The answer as John Cochrane points out in one of his last posts, is simply to deleverage the banks. This is not a constructive line of reasoning.

  8. K writes:

    If you are wondering how to creat $7Tn of risk free assets for grandmothers here’s the recipe: take $16Tn each of stocks, corps, and govt bonds. Repo the portfolio at the Fed with an 85% haircut. Odds of that portfolio ever losing 85%? Zero. Need for banks to create deposits? Also zero. It’s not that hard.

  9. [...] See full story on interfluidity.com [...]

  10. stone writes:

    I’m not sure that Yves Smith is being entirely fair in implying that all we need to do now is to instill in our financiers the moral compass of the post WWII period and then we would have a stable financial system that served the wider economy (I hope that is not a gross mischaracterisation). IMO WWII rebooted what was basically an economic system that had tangled up and stalled. WWII destroyed so much wealth and redistributed what little was left; it created a clean slate and the post WWII period was like the new growth after a grassland fire. I guess our system both depends on the opportunity for massive wealth inequality as a lure and also depends on not having the tangled consequences that result from massive wealth inequality. I guess we are now reaping the consequences of what has been a multi-decade long ongoing process of upwards redistribution. The financiers of today are faced with just such a vast mountain of financial assets to extract a return with. Those financial assets were being built up back in the good old days but had yet to balloon into a threatening ratio versus the size of the real economy. People say that the problem is simply that banks have too much leverage but isn’t growth of private sector debt such as that the way that nominal increases in private wealth have built up? If the 2008 crisis had been left to rip and “the sucker had gone down”, then holders of bank bonds (I guess mostly other banks?) would have suffered a massive write down and much of the nominal increases in private wealth of the past few decades would have been wiped off. Basically I guess it would take something like that to get us to a place where leverage was “appropriate”.

  11. Peter K. writes:

    @10 Financiers weren’t that moral or risk-averse in the 1920s either so there’s probably something to the idea that WWII was reset of sorts.

    Basically the shadow banking system needs to be regulated as the banking system was in the post war era which was free from bank runs. And the financial system needs to be taxed. We need better countercyclical polices. I’d support Waldman’s more fundamental reforms long-term.

    Some of our comrades have an irony deficiency. (For me it’s a helpful coping mechanism.) I once heard a story about a leftist groupuscle that was recruiting for the cadre. They lined up the candidates and proceeded to tell the funniest joke in the world. If you kept a straight face and didn’t laugh you were accepted into the group.

    Smith is overrated. I found Waldman’s discussion/debate with Tim Duy, Krugman, etc., for instance, on the Platinum Coin, the floor system and monetary base well-informed and thought-provoking.

  12. stone writes:

    @11, I hope both Steve Waldman and Yeves Smith both keep up doing their fantastic blogs – there has been so much great info and insight from both of them.

    Personally I wonder whether the ultimate fix for the banking system might be to just have lending by shadow banks. So lending institutions would never be able to hold deposits. Transactions and deposits would then be administered by institutions such as paypal. To avoid runs on the shadow banks, they could be obliged to match the maturity of the debt securities they sold to the loans they made and they could also be obliged to keep the loans on their books until they matured. Under such a set up I don’t think their would ever be any need for government backstops or tinkering with the financial system. I also think it would avoid credit bubbles. Equity financing would be better able to compete with debt financing.

  13. drfrank writes:

    Diogenes, a Cynic of ancient Greece, wandered the world carrying a lamp by daylight in fruitless search of an honest man. He was exiled from his native Sinope and disinherited by his family–they were bankers in the business of creating M2–for disclosing their practice of shaving a bit off the coins.

    One can think of a host of socially acceptable activities where more than a bit of dishonesty is tolerated: theater, advertising, politics, every kind of selling. And then there is diplomacy and polite behavior. Depending on your class or the color of your skin or your political outlook, you might be inclined to think the justice system is intolerably opaque.

    Dreamy macro solutions are fun to think about, but practically speaking the Federal deposit insurance scheme could be used to force banks to disclose their level of risk taking. The regulatory system of assessing capital adequacy by calculating ratios of capital to assets leaves wide open the question of valuation of adversely selected assets, troubled loans–what a bank examiner would categorize as Substandard and Other Assets Especially Mentioned. I have long been in favor of banks disclosing a quick ratio of good assets (cash, Treasuries and loans categorized Pass by examiners) to FDIC insured liabilities. A retail customer who elects to maintain demand deposits at a bank with a low quick ratio ought to demand compensation in the form of higher interest rates, and thus market forces could be used to regulate risk taking.

    Meanwhile. RSWaldman has not responded to Yves’ basic question: why is he so much more enraged by evidence of gouging in health care than in banking? Why is opacity tolerable in banking but not in health care? From a public health perspective, one might argue that the damage done by banking is far worse than petty stealing of hospitals.

  14. Walter writes:

    Personally, I find interfluidity a much more engaging source than Naked Capitalism. Yves choices of guest bloggers, her lack of thoughtfulness (as this recent post shows), and the community of commenters that have gravitated to the site all turned me away from her and Naked Capitalism in favor of better bloggers. Reading the comment thread on her post just reinforces for me that Naked Capitalism is not about understanding, but about anger, recriminations, and a false sense of moral superiority.

  15. studentee writes:

    “Some of our comrades have an irony deficiency.”

    This is simply a sign of your privilege. It’s okay for you to feel irony about things like bankruptcy, as they don’t affect you.

    Are you intelligent enough to explain why you think Yves is wrong here? Judging by your performance on other blogs, methinks not.

    We’re all looking forward to Waldmann’s next post. Let’s not let this devolve into who’s the true leftist, etc.

  16. mpr writes:

    @13 I don’t think SRW claimed that opacity was the problem in healthcare; the problem was egregious over billing. In fact in the original article one of the examples was of a couple whose hospital made them pay a huge sum of money up front.

    You can disagree with his thesis on the necessity of opacity in finance. However since I guess no one believes in the necessity of egregious over billing in healthcare, there’s no possible inconsistency.

    This kind of strained and shrill NC post is exactly the reason I visit that blog less and less often.

  17. Alex Godofsky writes:

    In what universe would the public tolerate the downward modulation of a basic income payment?

  18. I lost respect for Yves Smith some time ago: http://reservedplace.blogspot.co.uk/2011/10/naked-hypocrisy.html

    Yves’ sympathy with anti-finance campaigners may be genuine, but she has a metropolitan sense of entitlement that I found similar to the investment bankers I met pre-crisis. That, and a thin skin.

    I commend Influidity for not succumbing to the temptation to take adverts and make a little money out of your popularity.

  19. Phil Koop writes:

    “Carolyn Sissoko … thinks eliminating limited liability for banks will resolve the problem.”

    Many commentators on the current crisis have waxed nostalgic for the 19th century system of limited liability joint stock companies as being paragons of highly aligned incentives and minimized agency conflicts. But that is not how contemporaries saw the matter. One is struck by the similarities between contemporary public reactions to the panic of 1866 and modern-day blog comments about “banksters”. I think you would profit by reading a scholarly account of the matter, such as this one that can be freely downloaded from Wikipedia: http://web.archive.org/web/20060117181428/http://www.ehs.org.uk/ehs/conference2003/assets/Taylor.doc.

    Briefly, joint stock companies such as Overend & Gurney did not in fact have unlimited liability, but rather could call on their shareholders for more capital up to a limit, 2x or 3x the initial subscription. The system was therefore one of mandatory leveraged equity in which the credit was extended not by a brokerage or third party but by the creditors of the company one invested in. There was no guarantee that shareholders could meet this call and many in fact did not, despite far more punitive bankruptcy laws than we have today. Thus, bank depositors were not always made whole on their principal “after a delay”, and even when they were, the delay itself was often sufficient to bankrupt them. Overend and Gurney caused more than 200 knock-on bankruptcies, with associated deadweight economic losses. There is therefore neither a theoretical nor an empirical reason to believe that this institutionalized system of leverage was more stable than our own arrangements. (An aside: has everyone already forgotten the kerfuffle over Lloyd’s and “the names”?)

    The root of the public dispute in the aftermath of this collapse was between those who thought that limited liability was the cause of the problem and should be rescinded and those who thought it should be extended in order to eliminate the “de facto” unlimited liability implied by large albeit limited capital calls. In the event, the latter party won, making use of liberal arguments about personal responsibility that were remarkably similar to justify our own financial deregulation.

    All of this seems to support the call for truly unlimited liability. But it is important to be honest about what that implies: a plutocratic oligarchy to control the entire economy. Rule not of the 1% but of the 0.01%.

    *Of course* nobody needed the joint stock company much before 1826: hardly anybody had any money! It was the invention of a middle class that had assets to invest which was the joint stock company’s reason for being. And if we are to return to the system of complete private ownership and unlimited liability, we have to live with the implications: either wealth must be far more concentrated than it is today, or else much wealth cannot be productively invested.

  20. [...] On the Skills Gap in the US Labor Markets Lead (exposure) in the Time of Standardized Tests Opaque finance, again, and solutions Rahm on the Ropes Financial Transactions Tax Introduced Again—Can It Pass This Time? Why Workers [...]

  21. [...] by the powerful” in the sphere of finance. This post is a second response; the first is here. In a nutshell, Smith wonders, why so much outrage for rapacious hospitals when I give a pass to [...]

  22. Peter K. writes:


    As The Joker would say, “Why so serious?”

  23. studentee writes:

    ‘As The Joker would say, “Why so serious?” ‘

    Because the stakes are so high. Why aren’t you more serious?

    You really should sit back and let the intelligent people discuss.