I’ve been getting a lot of concerned feedback from people I respect on my claim that status quo finance requires opacity and some degree of trickery in order to function. (See previous posts.) If prosperity is connected to “opaque, faintly fraudulent, financial systems”, is that an excuse for looting and predation by financial intermediaries? Won’t it be used as one?
Though it may be counterintuitive, rather than excusing misbehavior, opacity in finance implies that misbehavior of intermediaries must be policed more vigorously and punished more punitively than in a world that could be made transparent. If finance were as transparent as baseline neoclassical models suggest, there would have been no “flaw” in Alan Greenspan’s ideology, and no need to regulate markets or root out fraud. Creditors would themselves vet and monitor their financial arrangements, would assume risks in full knowledge of all potential mishaps ex ante, and could therefore be required to accept responsibility for losses ex post. There would be no need for any heavy-handed meddling by the state or vitriolic second-guessing by nasty bloggers. The harms of malinvestment would be internalized by investors who were capable of bearing the risks. When things go wrong, it would be none of the rest of our business.
It is when the relationship between capital provision and investment choice becomes intermediated and opaque that we must impose institutions of accountability. If we permit you to invest other people’s money behind closed doors, if, even worse, we institute society-wide cons (deposit insurance, rating agencies) to trick people into bearing the risk of your schemes, then it is absolutely essential that you perform your duties to a very high ethical standard, and that you have strong incentives to deploy the pilfered capital well rather than to squander or expropriate it.
Opacity creates a very serious technical problem: as we allow finance to be opaque and complex, it may become difficult to police and impose good incentives. So we may, as a society, face an unpleasant tradeoff. Tolerating more opacity may help mobilize capital for useful purposes, but any benefit may be offset by a diminishment of our capacity to regulate and police. At one extreme of opacity, financial intermediaries simply steal everybody else’s wealth. That’s no good. At the other extreme, if we insist on perfect transparency (without big changes in how we organize our affairs), the result will be extreme underinvestment. Which is no good either.
There are some issues that we’ll need to unpack. When we talk about “transparency”, a core question is transparent to whom? My thesis is that status quo finance must be opaque to beneficial investors, that is to the innumerable people who must be persuaded to bear some portion of the risk of aggregate investment when their informed preference would be to defensively hoard. That does not mean that finance must be opaque to, say, regulators, who themselves participate in the con by assuring people it is “safe to get in the water”. (Ultimately it cannot be made safe.) In theory, we could design a system that is opaque to the broad public, but transparent to regulators who police the intermediaries. That is the architecture that our present system strives for. But the many practical problems of this architecture are widely known: the capital allocators are more numerous than the regulators, and as a matter of practice, they tend to be much better remunerated (a fact which itself is a kind of regulatory failure). If bankers wish to invest recklessly (or simply to loot) and it boils down to a cat-and-mouse competition, the bankers are likely to win. The potential spoils from looting are very large, large enough that bankers can offer to share the spoils with regulators or the politicians who control them, leading to revolving doors and see-no-evil regulation. Regulators are supposed to stand in as agents of people who’ve ceded control of capital to opaque intermediaries, ultimately the broad public. But it is difficult to prevent them from being “captured” — socially, ideologically, and financially — by the groups that they are supposed to regulate. Regulators themselves often prefer opacity and complexity for reasons analogous to those that sucker end-investors. Regulators don’t like to fight with their friends and future benefactors, and they fear the operational and political headaches that would come with reorganizing large banks. But they don’t like to be put in a position where misbehavior is plainly before them, so inaction would be unmistakably corrupt. They find it a great relief to be persuaded that “sophisticated risk management” models, rating agencies, and “market discipline” mean they don’t have to look very hard or see very much. It seems better for everyone. Everyone gets along and feels fine. Until, oops.
All that said, to the degree that we can maintain high quality supervision, regulators who pierce the veil of opacity, prevent looting, and ensure high quality capital allocation are a clear positive. If we posit very good regulators, there is no tradeoff at all between supervision and effective capital mobilization. On the contrary, opaque finance is unlikely to deploy capital effectively without it, since, with actual capital providers blind, there is no one else to provide intermediaries with incentives to invest carefully rather than steal. An opaque financial system is an argument for vigilant regulation, not deregulation. If regulators allow themselves to be blinded by complexity and opacity, if financial intermediaries are permitted to arrange themselves so that legitimate practices and looting are difficult for regulators to distinguish, that becomes an argument for very punitive regulation whenever plain misbehavior is discovered, because as the probability of detection diminishes the cost must increase to maintain any hope of effective deterrence.
I am pretty pessimistic about this architecture. I think that high quality financial regulation is very, very difficult to provide and maintain. But for as long as we are stuck with opaque finance, we have to work at it. There are some pretty obvious things we should be doing. It is much easier for regulators to supervise and hold to account smaller, simpler banks than huge, interconnected behemoths. Banks should not be permitted to arrange themselves in ways that are opaque to regulators, and where the boundary between legitimate and illegitimate behavior is fuzzy, regulators should err on the side of conservatism. “Shadow banking” must either be made regulable, or else prohibited. Outright fraud should be aggressively sought, and when found aggressively pursued. Opaque finance is by its nature “criminogenic”, to use Bill Black’s appropriate term. We need some disinfectant to stand-in for the missing sunlight. But it’s hard to get right. If regulation will be very intensive, we need regulators who are themselves good capital allocators, who are capable of designing incentives that discriminate between high-quality investment and cost-shifting gambles. If all we get is “tough” regulation that makes it frightening for intermediaries to accept even productive risks, the whole purpose of opaque finance will be thwarted. Capital mobilized in bulk from the general public will be stalled one level up, and we won’t get the continuous investment-at-scale that opaque finance is supposed to engender. “Good” opaque finance is fragile and difficult to maintain, but we haven’t invented an alternative.
I think we need to pay a great deal more attention to culture and ideology. Part of what has made opaque finance particularly destructive is a culture, in banking and other elite professions, that conflates self-interest and virtue. “What the market will bear” is not a sufficient statistic for ones social contribution. Sometimes virtue and pay are inversely correlated. Really! People have always been greedy, but bankers have sometimes understood that they are entrusted with other people’s wealth, and that this fact imposes obligations as well as opportunities. That this wealth is coaxed deceptively into their care ought increase the standard to which they hold themselves. If stolen resources are placed into your hands, you have a duty to steward those resources carefully until they can be returned to their owners, even if there are other uses you would find more remunerative. Bankers’ adversarial view of regulation, their clear delight in treating legal constraint as an obstacle to overcome rather than a standard to aspire to, is perverse. Yes, bankers are in the business of mobilizing capital, but they are also in the business of regulating the allocation of capital. That’s right: bankers themselves are regulators, it is a core part of their job that should be central to their culture. Obviously, one cannot create culture by fiat. The big meanie in me can’t help but point out that what you can do by fiat is dismember organizations with clearly deficient cultures.
But don’t my paeans to the role of opacity in finance place arrows in the quiver of those seeking to preserve and justify financial predation? Perhaps. People who benefit from corrupt arrangements will make every possible argument to rationalize and preserve their positions. But the fact that ones views might be misused doesn’t mean we should self-censor. I was rude, in the previous post, to assert categorically that my argument “is true”, but I do think that it is. My tone was sardonic and bleak, and perhaps it ought not to have been, but these ideas have always been “out there”, and it’s best we acknowledge and deal with them. Nearly every proposed financial regulation is greeted with stern warnings that it will cause “credit to contract”. It is worth trying to understand the mechanics of real-world capital mobilization, and its role in underwriting prosperity (or perhaps militarism). I don’t think we have to fear talking about this stuff. The proposition that looting and misdeployment of capital serve the public good is easy to debunk. The proposition that there are arrangements which serve useful purposes but also create space for corruption is not controversial. We need to understand how institutions actually function and how they are abused if we are to have any hope of minimizing their pathologies while preserving their benefits. And we have to understand the purposes our institutions actually serve if we are to have any hope of replacing very problematic arrangements with something better.
P.S. I should define what I mean by “transparent” and “opaque” investment. An investment is transparent if the investor is well informed ex ante of the potential risks of the use to which her capital will be deployed, and fully assents to bear those risks, such that there is little question or controversy ex post over who must bear losses should the investment not work out. An investment is “opaque” if the apportionment of potential losses is not well specified and clearly assumed by capable parties ex ante, so that in a bad outcome, allocation of losses would foreseeably become a subject of conflict and controversy ex post. Investments in which losses will “clearly” be borne by the state are opaque, because the actual incidence of those losses (in terms of taxation, inflation, or foregone government spending elsewhere) are unknowable ex ante and a matter of political conflict ex post. Transparency is ultimately about the quality of loss allocation.
Opacity and transparency are matters of degree, not binary categories. Questions of transparency cannot be resolved by legal formalism, but are matters of practice and expectation. Fannie Mae securities may have specified in big, bold text that they were not obligations of the United States government, but expectations of purchasers of those securities were not consistent with the formal disavowal, and those investors did not fully assent to bear the credit risk. The allocation of losses from Fannie Mae securities was determined ex post by a political process, not ex ante by informed acceptance of risk. So Fannie Mae securities were opaque investments. The degree to which an investment is transparent is contestable, a matter of judgment not a matter of fact. In the previous piece I argue that index funds are now opaque investments in the United States. I’m sure there are others who would dispute the point.
I think the degree to which investment in aggregate is mediated transparently vs opaquely is an important characteristic of a society.
P.P.S. It’s worth noting that, for now, in the US, savers are enthusiastically entrusting their resources to the state and opaque intermediaries. Deposit insurance and modest inflation expectations have been sufficient to prevent commodity hoarding and other nonintermediated, low return means of preserving wealth. For the moment, the bottlenecks to capital mobilization are at the interface of bankers, borrowers, and entrepreneurs, and in the reluctance of government to invest directly. (More fundamentally, perhaps the bottleneck is an absence of the security and demand that might inspire borrowers and entrepreneurs.)