The Point of Financial Systems

While I personally find the complexities of the financial system fascinating it is important to remember (especially with lots of people currently questioning it’s usefulness) what the purpose of the financial system is. Brad DeLong (who uses Apture on his blog) sums up an old Robert Shiller paper on the purpose of financial systems and the problems, distortions, and inefficiencies they face:

Financial markets are supposed to tell the real economy the value of providing for the future–of taking resources today and using them nor just for consumption or current enjoyment but in building up technologies, factories, buildings, and companies that will produce value for the future. And Shiller has more than anyone else argued economists into admitting that financial markets do a really lousy job. The prices that financial markets feed the real economy value safety too much, are also much too frightened of risk, on average are too low–that is, greatly undervalue the worth of providing for the future, and are also grossly excessively volatile. Depending on the date, the same flow of rationally-expected future profits and values can vary in its price by a factor of three depending on what Akerlof and Shiller call “animal spirits”

Both group think and excess volatility are topics that everyone is very aware of right now but I few people would cite excessive risk aversion as a problem after the subprime mortage debacle. I do, however, agree that when it comes to investing in the future investors are very risk averse, at least when it comes to industries that they don’t fully understand. The problem was not that people knew that subprime mortgages were extremely risky but took the risk anyway, they understood subprime loans quite well but made the (fatal) assumption that house prices would continue to rise forever.

When it comes to the kind of risks that innovative startups face (“is this technically possible?”, “will people really find it valuable?”, “can we figure out how to monetize it?”) I do believe that most investors, even most (not all!) venture capitalists tend to be too risk averse. Paul Graham recently wrote an excellent essay on the topic and I believe that creating the next generation of successful companies will require investment in big and bold ideas – even if some of them (especially in biotech) will take significant time until they make money. The eventual payoffs will be worth it.