Thank god for hedges by mattsteinglass
September 18, 2008, 8:25 am
Filed under: Economics

I am curious about Megan McArdle’s continuing belief that complex derivatives make the financial system less risky, rather than more risky:

What standards should we use for evaluating derivatives? Derivatives don’t just create risk; they can also lower it, by allowing firms to hedge.  When Robert Shiller tells me that overall they’re a good thing for the financial system, I’m inclined to listen.

I guess what I’m wondering is, if we hadn’t had all these complex new derivatives, would we have seen four independent investment banks go under this week rather than two? Would the Dow have fallen 800 points yesterday instead of 400? How many massive and unprecedented crises would we have seen in the past 8 years without the revolution in complex derivatives? Because it doesn’t seem to me like people on Wall Street are feeling much safer these days than they did 15 years ago.


3 Comments so far
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Wow, I try to read people I disagree with, but this verges on idiocy.

Comment by Mal Armstrong

You know, I agree with you. Same thing’s true with Nuclear Power – we would have zero risk of nuclear terrorism or nuclear war if we simply hadn’t developed all those complex new atomic weapons.

And you know what? Guess how many people died in car crashes 150 years ago. Answer: None. How many massive and unprecedented deaths would have been avoided if we had just not bothered inventing gasoline engines?

Snark aside, there are several meaningful comments worth making here.

1. Derivatives are a technological advance, and they can be used well, and they can be used poorly. Blaming the derivatives for causing the financial mess makes for good blog snippets, but if we were to hit the rewind button, get rid of ‘complex derivatives’ and then hit play again, we might find that the world, while perhaps less volatile, also had a lot less growth, leaving a lot more people mired in poverty. I’m not claiming I know this for a fact, but I’m always suspicious of claims of ‘if only we hadn’t done X, things would be much better now’.

2. It is clear to me that the complexity of the derivatives “got away” from the traders/bankers/etc. I.e. they thought they were smarter than they actually were, and could not understand the long (multi-year) consequences of their actions. I find interesting parallels in the social re-engineering passion of many liberals – who believe that, given the right models and policies, they can mold the world to be a better place, with no downside. Ahem. If people who can lose their jobs if they screw up can’t properly understand the risks of complex models, why, in any universe, would I want people who would have virtually no consequence for error mucking around with the fabric of human society – a system that is not only far more complex than trading derivatives, but one that is constantly evolving, specifically to get around these types of social policies?

3. I find you to be more intelligent and circumspect than most of your liberal brethren, which is the only reason I’m bothering to post here.

4. I’m a libertarian, not a Repub, and I can promise you I’m not going to be voting for McCain, for what it’s worth 🙂

Comment by jb

jb, I think your comparison to nuclear power is a good analogy within its limits. Nuclear power does a lot of great things, and it has required the institution of a vast federal regulatory apparatus to forestall its huge risks. Same with cars. Far be it from me to say something like “complex derivatives are bad and we should ban (lots of) them”; I lack the expertise to say something like that and I also think that, as the nuclear analogy suggests, it is simply meaningless and stupid to try to take a Luddite approach to these things. The only question here is this simple claim that the explosion of complex derivatives over the past 15 years makes financial markets, on balance, less risky. If one doesn’t accept what’s happening over the past year and especially the past week as evidence that they make financial markets on balance more risky, then what kind of evidence would be acceptable?

I’m sure Robert Shiller is incredibly smart and I will read the first chapter of his new book, available on line, when I get a chance, but the general public consensus is that complex derivatives are making things riskier under “exceptional” circumstances that may not be all that exceptional, and I don’t see how one can defray that consensus by saying “Robert Shiller says no.”

Comment by mattsteinglass

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