Monday, October 31, 2011

My comments on a recent Prof DeLong Post (partially done)

My comments on a recent Prof DeLong Post (partially done)

Prof DeLong: A Note: Prolegomenon to Any Useful Discussion of Modern American Finance

HA: I have no idea what a Prolegomenon is, but it sounds to me like "something to understand before any useful discussion ...".

Prof DeLong: In a standard economic transaction, it is no mystery where the value to both sides comes from. When I buy a double espresso from Café Nefeli for $2.25, the coffee is more valuabe to me then $2.25 is. Were I to consider only the experience and not worry about fairness consideration--that is, if I did not worry about thinking that I was turning into a chump--I would pay $5.00 for a double espresso (if Café Nefeli were the only possible place I could get one and if that is what they charged) and count myself happy. And sometimes $10.00.

HA: OK, if you say so. Brings to mind addiction theory. If a standard economic transaction is defined by the central tendency, I don't know if it's true that there's "no mystery" where the value to both sides come from. But I feel like I'm quibbling.

Prof DeLong: Similarly, for Café Nefeli the beans, the water, the grinding, the serving, the financing, and the rent, fully amortized, add up no more than $1.50 a cup. Any price between $1.50 and $5.00 a cup (and sometimes $10.00!) leaves both of us better off and happier--them with more generalized purchasing power, and me with caffeine coursing through my arteries.

HA: I don't know what "amortized" means. I don't know what the fuck "happier" means -that's a bit neurochemical (I thank Carl Shulman for helping that epiphay stick in a comment discussion in my old typepad blog) but I have a general hazy intuition that yes, trade can make all parties better off and money can help it happen more efficiently.

Prof DeLong: Financial transactions, however, are different. In normal economic life we are trading commodities we personally value less for commodities we personally value more, we are trading away generalized purchasing power--money--for commodities we value highly, or we are trading away commodities we value little for generalized purchasing power--money--we value more. The sources of the gains from trade are obvious.

HA: papers over information asymmetry, irrational agents, market manipulation, perhaps, but I don't think of Prof. DeLong as hide the ball type with regards to stuff like that. I'm probably niggling again.

Prof. DeLong: But in finance neither side is getting useful commodities. Instead, both sides are trading away claims to a pile of money and getting claims to a different pile of money in return. So how is it that me selling this pile of cash I have to you for that pile of cash that you currently own can be a good idea for both of us? Doesn't one of the piles have to be bigger? And isn't the person who trades the bigger for the smaller pile losing?

HA: hmm, I don't know, but reminds me of the claim I recently read in a Tom Friedman article that Citibank unloaded mortgage backed securities it knew were junk to (shadow bank?) clients like hedge funds.

Prof. DeLong: Almost, but not quite.

There are three ways in which a financial transaction can be a good deal for both sides.

HA: Awesome, looks like I'm about to learn something.

Prof. DeLong: First, people have different time preferences: I have money now that I do not want to spend on some useful commodity until sometime in the future, while you may have no money now and need some but anticipate being flush in the future; then we both benefit if I lend you the money--at interest. Second, risks distributed and diversified are risks dissipated, and so even though the average customer pays money into the insurance system insurance is still a valuable thing to buy because the insurance company pays you when you really need the cash. Third, economies work best when benefits and losses run with decsion-making: those whose actions create or destroy value pay attention when they have "skin in the game", and financial transactions are a good way to make sure they have that "skin in the game".

HA: Okay, I get reason one as differing logistical needs for (liquid) money. Reason 2 as agents all rationally value diversification (but is optimized risk diversification at the agent level optimal as a coordination for the class of agents as a whole? I'd guess no, that the optimum is somewhere in between the spectrum of optimized diversification for system only (defined as the system that algorithmically attempts to maximize the survival of its agent population) and optimized diversification for every agent in the system.

I'm out of time to continue this analysis/dialogue. I hope to finish it at the next opportunity.


  1. I found his post somewhat strange. I thought Andy Harless' perspective (which appears below in the comments) was the standard econ take on speculative markets.

  2. Amortized means a larger cost can be covered in small increments for many marginal units. In computer science we often want to amortize computation to avoid having bad worst-case performance. Delong's individual cup of coffee may not result in them buying another bag of beans, renting more space, or hiring more servers, but those things must be paid for by the aggregate cups of coffee sold.

  3. Hopefully Anonymous said ...
    So they buy coffee by the bag, and the cost is amortized by the hundred cups of coffe sold made from that bag?

  4. That's one kind of amortization, but with most stores materials are not that large a cost (soda is practically free for many places). Other costs are more fixed relative to the variation in coffee sold and can be amortized more the higher sales are. Delong also mentions "the water", but that's practically free in the U.S as well.