Wednesday, October 22, 2008

What are Financial Institutions for?

Steve Randy Waldmann (emphasis added)
Any claim that a financial innovation has achieved a concrete, positive end is a sure sign of disaster, or (in the unfortunate lingo of economics) a distortion. The purpose of a financial system is to solve a collective optimization problem whose solution we cannot guess a priori. If we are very sure that welfare is maximized by vastly expanding the housing stock and making homeowners of people who otherwise might not buy, then the government should just tax to build McMansions, and auction off the oversupply. More generally, one cannot judge a financial system by any particular outcome, because all financial systems make mistakes, and the mistakes always look good while they last. We judge financial systems by the performance of the economies they guide over time.
From this post by Arnold Kling, which also has a nice explanation of the role of equity in promoting truth-telling.

I suspect that the main reason we have bad financial institutions is that individuals are irrational. I can well imagine that it is easier to market a Ponzi scheme (suitably dressed up) than an incentive-compatible financial contract. People think they are smarter than they really are. As a result, bad financial institutions satisfy customer demand, just as politicians offering free lunches satisfy voter demand.
is interesting in light of this
They found, for instance, that "individuals who scored in the 12th percentile believed that their general reasoning abilities fell at the 68th percentile". Curiously, even the top students "tended to overestimate" the incompetent ones. But at least they were better at assessing themselves.

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