Finance Followups
Cross-posted from Putanumonit.com.
In Defense of Finance generated over 110 comments across WordPress, LessWrong and the Reddits, as well as in personal communication. As predicted, I learned a lot.
In this post I’ll address some of these comments and offer follow up thoughts that didn’t fit in the original essay because they’re more speculative. Also, becase that post ran to 5,500 words already.
People said: “I don’t buy this, fuck capitalism!” If you want to stick it to capitalism, you can gift a donation to a creator publishing his work online for free.
People said: “Finally someone gets it and does the math right!” If you think I get it and I do the math right, you can forward me job offers at lucrative hedge funds, PE firms, and startups.
People said that it’s overly defeatist to claim that finance won’t improve no matter how we try to fix it, we just have to live with it. But that’s not quite what I think.
Finance improves itself, mostly after crises. In 1929 we learned that established company stocks are riskier than we thought, and in 2000 we learned the same about startups. Financial institutions learned how to deal with 20% interest rates in 1980 and with 0.02% rates in 2010. After 2008 we learned that 6% is too low of an equity ratio for banks, that rating agencies with no skin in the game are useless, and that CDO-Squared are really dumb. Hopefully, we also learned some generalizable math lessons, such as the fact that lack of correlation in normal times (e.g., in mortgage default rates) doesn’t imply lack of correlation when a crisis hits.
We’re on the cusp of the longest period ever between recessions in the US. In the decade since 2008 the Middle East has gone crazy, Europe has gone crazy, Venezuela has gone crazy, elections have gone crazy, the weather has gone crazy, the Cubs have won the World Series, Leicester won the EPL, Bitcoin rose and fell and rose and fell and rose. Throughout all of this, the bankers and traders have kept their nose down and didn’t recklessly endanger the world.
One day after this generation of financiers will have been gathered to the Hamptons, a new one will arisethat does not know The Big Short and they’ll do something really dumb to cause the next financial crisis. But for now, finance seems less of a global threat than Twitter.
Turkeys in the Jungle
People said that I defended the parts of finance that are easy to defend, such as banks making loans to businesses, and didn’t address the whatabouts. What about high-frequency trading firms? What about mutual funds that charge 2%/20% to underperform indices? Payday loans? Penny stocks?
I don’t have a knockdown argument for those and perhaps there isn’t one – perhaps the above are actually net harmful to humanity. But I have a useful and very stretchy metaphor: finance is a jungle.
First, finance is a jungle in the colloquial sense of a hypercompetitive environment. Financial firms compete with each other, and it’s hard for any of them to build moats or acquire monopolies. Changing your bank or brokerage is a lot easier than changing utility providers, social networks, or even fridges. So if a hedge fund makes money doing something that seems inefficient or bad for customers, you have to answer why it has not been competed away by someone better.
Second, finance is a jungle in the sense of being a complex, interconnected ecosystem. Another lesson we should have learned from 2008 is that banks, hedge funds, insurance companies, and government agencies depend on each other in critical and opaque ways. Eliminating a class of instution from the financial system is like eliminating some annoying insect from the jungle: it could make things a little bit better, or it could bring the entire thing crashing down unexpectedly.
But the more I thought about this metaphor, a new picture came to mind. Finance isn’t just a jungle of sharp-toothed jaguars, venomous frogs, and vicious parasites. It’s a jungle surrounded by turkey farms that send fat, defenseless birds by the millions running into the deadly forest. These turkeys are most of the people you know.
People are breathtakingly stupid about finance. And by “people” I mean “average Americans”. This isn’t because Americans are less financially literate than the rest of the world, it’s just that the best data available about financial idiocy concerns the “average American”.
The average American has more than $5,000 in credit card debt, on which they pay more than 15% interest. The average American doesn’t know how much debt they have or how much it costs them.
Less than two in five Americans have enough savings to cover an unexpected $1,000 expense. The median income in the US is $59,000, so all it would take to save up $1,000 for the average American is to only spend 98% of what they make for a single year. The average American can’t do that.
The smart American isn’t much smarter than the “average”. Married couples with postgraduate degrees fall into spirals of debt for no reason other than their own poor planning. One of my smartest friends was paying 9% on a loan while investing in funds that wouldn’t return that much in a good year. One of my smartest coworkers told me yesterday that he won’t fund his 401k for the first six months of 2019 because of a “hunch”, thus foregoing six months of expected positive returns. Many smart people told me they like getting a tax refund, not realizing that it means that the government earned interest on their money for a whole year instead of them.
I often hear from people who tell me they loved Get Rich Slowly, but then admit that their own money is in hand-picked stocks or savings accounts.
And these same people expect to be able to buy whatever they want whenever they want at the swipe of a card. They expect their cash to be available at any ATM in the world, with no fees. They expect their retirement to be provided for, even if they do not provide for it themselves.
The worst aspects of finance are a direct result of the average person being stupid about finance. People expect to beat the market, so they pay brokerages and make their pensions invest in high-fee funds. People don’t understand debt and interest, which fuels bubbles and crises from MBS to student loans.
It is not clear that government regulation will help. For one, outlawing stupid behavior (like day-trading stocks) will often just shift people to stupider behavior (like day-trading movies). For another, if people aren’t smart enough to deal with personal finances, how could they vote intelligently for financial policies on a national level?
The only solution to this is financial literacy education, and I’m doing what I can to help my readers with that. That’s one of the reasons I wrote In Defense of Finance: when you stop hating finance you can start to understand how it works, and when you start to understand how it works you can make it start working for you
Maybe. But I suspect that financial literacy education will be about as successful at improving people’s financial choices as education about diet and exercise are at improving people’s weight. (Which is to say, not at all.)
People may not know how much debt they have or how much it’s costing them, but they know they have debt and they know it’s costing them. They know they should save, but saving doesn’t trigger a release of endorphins or dopamine or whatever in the brain that you get from buying a more comfortable car or clothes that you adore or even from donating.
Sure there’s a few edge cases, like your friend that wants to invest before paying off loans, that might be helped by some financial education. But chances are good that even he is more influenced by reward structures than by ignorance; investing can feel like gambling, which is risky, and therefore fun to people who like risks...in a way that paying off debt obligations is not.
I’m not better at saving than my husband is because I’m more financially literate that he is. He’s worked as an accountant; I’m pretty sure he knows more than I do. But I’m better at saving than he is because risk is extremely unpleasant to me, unpleasant enough to override my desire for most things that I want to own. He likes risk more than I do, and so he doesn’t have the same incentive to resist the urge to buy things, so he doesn’t resist those urges.
There’s an annoying catch here. I think financial education can help if it comes with really actionable suggestions. Instead of just talking about general principles, the vast majority of people would do better by following some super simple guidelines like:
Don’t take credit card debt unless it’s to save a life.
If you have debt at >5%, pay it right away before doing anything else. Devote at least 20% of your income to paying off the debt, regardless of how much you make.
After debt is taken care of, put 20% of your income in a global stock index fund 401k each month on autopilot.
Whenever you think “I’ll buy this thing so that people think I’m cool” consider whether when you see people on the street with the thing you actually think they’re cool.
But whenever you write something like that, people will flood you with nitpicks about some convoluted case where the specific advice doesn’t apply. In this way, people who understand the math and only need the general principles prevent everyone else from taking the simple and useful advice that would benefit them.
I think your second and third bullet points would make great laws. That might not be what most people have in mind when they talk about “finance regulation”, but it’s an area where the government could force people to act in their own long-term interest instead of responding to shorter-term incentives. (And if people want to nitpick exceptions, many exceptions could be written into the law.)
People’s spending (bullet points #1 and #4) might respond to laws that limit advertising, but I don’t know what else. I think your #4 is one of those suggestions that doesn’t intuitively grasp the scope or nature of the problem, like people who suggest that exhausted parents of newborns sleep when the baby sleeps. People who buy things so that others think they’re cool are rarely consciously aware that that’s a significant motivation for them, and they aren’t going to stop and perform mental gymnastics before purchases. I have a friend who is in debt because shopping makes her feel better when she’s stressed. Most purchasing incentives like these are deeply rooted and not easily solved, even with education.
When governments are actively complicit in damaging the financial interests of citizens, it is perverse to legislate fixes before ending the active harm.
https://www.fool.com/retirement/2017/01/07/heres-what-americans-are-spending-on-lottery-ticke.aspx
In the event legislation like you suggest ever becomes even remotely plausible, please find me, I’d be happy to wager that it’ll pass with exceptions for the purchase of government-sponsored lottery tickets.
It could be libertarian bias, but I think almost all financial advice would turn into a horrible grotesque if someone turned it into binding law. Politicians are financial idiots, and they will legislate based on what their financial idiot constituents will approve of, not what will make people financially secure in the long term. What politician ever has even the incentive, let alone the knowledge, to do the latter?
Take Social Security for example. It’s basically a Ponzi scheme that can only be sustained long-term by doing things that harm everybody, like excess inflation or excluding the people who paid for it (high earners) from receiving it. How is that different from an average financial idiot person taking on credit card debt and then making suboptimal life choices to keep the interest payments at bay? The difference is only in the national scale of the stupidity.
People make bad choices all the time when it comes to money, food and romance. But when politicians jump into those areas they make terrible laws, and those are much worse than mere bad choices.
I don’t think everything politicians touch turns to crap. Some, but not all.
“Mandating 401k donations” would probably look a lot like replacing automatic Social Security paycheck withdrawals with automatic 401k paycheck withdrawals. A phase-over plan could include sucking it up and using taxes to pay premiums for people who are already withdrawing SS and people within, say, 10 years of being able to do so, while younger people get the amount that they have already paid into Social Security simply deposited into their 401k for them.
Mandating paying off debt would be trickier to enact, because we don’t have the kind of intermediaries who currently handle that. But it might be worth a trial run.
There’s not enough written about the basic problem with democracy and libertarianism: a large number of humans are incompetent at understanding the world well enough to make sane plans for any reasonable goals, and are unable to follow them even when they do.
“raising the sanity waterline” is a topic that comes up occasionally, but it’s overwhelming and depressing, and I know of no good ways to accelerate it.
By the way, it makes me angry that we talk about median and quintile incomes, and compare that to average debt. Comparing a stock to a flow is bad, and using an average for a non-normal distribution is a crime. We should compare income to median/quintile finance charges (in addition to total debt).
$1,000 to cover an emergency isn’t a measure of wealth, it’s a measure of liquidity. For this reason it makes sense to compare it to income. If you have $200,000 in student debt but still have a couple thousand in your checking account in case your car breaks down, you would count as having the money the way the survey was run. Using the word “savings” in that sentence was probably a bad choice on my part.