Perhaps it's not a problem with finance but a problem with other industries that don't pay their people well. Who is to say that a CDO isn't a valuable economic activity?
If creating a CDO creates more value to the economy than designing an automobile why shouldn't engineers focus on building those?
People forget that prices and money are essentially information about the supply and demand of a good. As we progress in the information age deriving information from price will consume and produce ever more of our GDP. Spending money efficiently and directing it to the right purposes is a VERY valuable thing for a nation to do. Perhaps, dare I say it, more valuable than engineering widgets.
If YC had engineers figuring out algorithms to determine the best startups and they found one that worked it would be a very valuable piece of information. Or more relevantly, what if you had a site that required a lot of bandwidth and you could buy a bandwidth future? If you could buy that sort of thing you could offer 4 year contracts to your customers with out taking on any risk.
How about this instrument, a YC Summer 2014 startup future, it estimates the expected return from S14 and pays you if the return is less than expected. YC could sell them today and gain the advantage of knowing how many startups they could fund in S14. It would allow all sorts of people to pool their knowledge about what the Summer 2014 startup scene is going to be like. You might want to buy one right before the S14 season because you know that some great startup is applying, etc. If you held office space in SOMA you could use this as a hedge against losses incurred due to a poor S14 startup season.
Most complicated financial instruments are actually risk mitigation and/or information pools. The fact that that kind of thing is pricable due to these engineers spreads all sorts of great information to our economy that you can use to make informed decisions about how to conduct your affairs and you don't even need to participate in the market to use it.
Want to know what the best guess as to the price of oil in 6 months? Check the oil futures market. This one number contains the all the information known to man, vetted by experts as to what the supply and demand of oil is going to be in a few months. It also allows anyone with new knowledge to monetize that information and communicate it to all participants almost instantly. Southwest can offer cheaper flights because they use oil and jet fuel futures to buy jet fuel, the brilliant thing is that Exxon also gains knowledge of what Southwest and every other airline expects their passenger load to be in a few months and can make decisions accordingly.
It all comes down to allocation of capital, though. It's all economic overhead. How much are we spending to efficiently allocate capital? About nine percent of the whole economy, apparently.
That's assuming that all that work does end up effectively and appropriately distributing capital at the end of the day. If you read up on the recent financial bust, you'll quickly realize that all is not well in the world of finance. Many complicated instruments such as CDOs have sometimes not been designed to benefit the buyer. Papers have been written establishing that it is impossible to know if a CDO has been designed to fail. Check out propublica's reporting on magnetar for an example of how CDO trading flew off the rails.
I could go on. Suffice to say that there are regulatory issues (no regulation, basically) there are issues with defining, standardizing, and regulating these complicated derivatives, there are issues with high frequency trading, issues with predatory consumer financial services, and finally there is the giant issue of a clear moral hazard now that the government has saved everyone's tail.
> How much are we spending to efficiently allocate capital? About nine percent of the whole economy, apparently.
What is the optimal amount we should spend to efficiently allocate capital? I don't have a principled reason to be able to pick a number; all I have is a gut feeling, which isn't worth anything.
The problem isn't the ability to create financial instruments. It's the fact that the people that created and purchased these ill-advised investments were given the resources of those that didn't make bad decisions (through inflation and taxes).
It's easy afford outrageous salaries when your revenue comes from government assisted theft.
I definitely agree with you that the bailouts are a huge problem, however, it's not like the alternatives presented for engineers in the article also don't get a sizable portion of their funding from the gov't.
Given that schooling is heavily funded by the gov't it would only seem natural to follow the funding train. They're practically begging people to go to engineering school and become a financier the way they fund things.
Your argument falls apart at the predicate. CDOs (and other exotic financial instruments) do not provide real value, not in the long term, anyway. This argument is exactly how Wall Street bankers & traders justify their crappy activities.
"CDOs provide value! We're making people rich!"
> People forget that prices and money are ... information
No, prices and money are imaginary measurements of imaginary things that do not exist except in our collective consciousness[1]. Cars, computers, buildings, aircraft... these things are not imaginary and provide real value.
To understand what I mean by "imaginary" you have to understand (and accept) that a dollar, or a pound, or a real, or whatever, represents our agreement that we'll all play the same game. It doesn't represent a real thing. Google and Facebook provide information about actual things, like people, places and events.
Money provides information about itself. Which, hey, I like having an agreed-upon exchange rate so I can trade my labor for stuff (RIP Carlin). The problem is that exotic derivatives create an insane level of abstraction to the terms of our social agreement. Once you take away the ability of people to understand what money is for (I mean, seriously, buying insurance against the failure of a company you don't own? slices of a house's future value?) that agreement starts to corrode.
And yeah the short-term profits of these abstractions does create PROFIT, but it's an unsustainable cash flow. It didn't arise from producing a better quality product.
To say that Google's search service and CDOs are essentially the same thing shows a pretty poor understanding of both concepts.
I find your arguments plausible, but many finance companies were bailed out in a big way by the government recently. I think it's possible that some of these companies were playing games that gave them a high probability of a decent gain and a small probability of a catastrophic loss. It seems unlikely that playing this sort of game contributes to more accurate pricing.
Well actually some of the guys who did VERY well did so by buying CDSs (credit default swaps) against CDOs (collateralized debt obligations) it's very likely that the bubble was curtailed before it got even further out of control as some very smart individuals were able to short the housing market via a CDS against a CDO. This pricing differential was essential to Goldman getting out of CDOs and into CDSs against CDOs after they figured out what John Paulson and others were up to.
The price increase in CDSs against CDOs in retail mortgages alerted Goldman to the fact that people were very interested in a CDS against what they thought was a very solid asset (CDO consisting of residential mortgages).
This is also why AIG got bailed out, GS had enough CDSs with AIG that if AIG went so would GS. I definitely agree with you that in the long run bailouts create an atmosphere of moral hazard and irrational exuberance.
The problem also largely stems from political economics, as a representative you want to remain elected, therefore if you can kick the economic collapse can down the road a few years or spread its impact over many years you can stay in office. Therefore the rational economic choice for politicians is to favor bailouts. Very few people will not vote for you because 5 years later their taxes are 10% higher, but most will not vote for you if they lose their job. By the same token most people would rather take a 10% pay cut for 10 years than have no income for 1.
So give the YC futures market idea a couple years. What would the result be? My guess:
The biggest beneficiary would be banks. They would be trading it with a focus less on spotting good companies and rather on extracting profits from the activity of trading. Computers would be doing most of the trading. They'd have algos less focused on the quality of the applicants and their ideas, and more focused on how [black box X] can take money out of the system overall. The startup community would stop applying to YC because it's much more excellent to work at a bank, finding ways to manipulate the YC stock for fun and profit.
Complex financial derivatives may not be as tangible as other engineering endeavors, however they do have tremendous value to businesses looking to hedge their risk and offer flexibility to their business models. The economic collapse caused by these complex financial instruments was not due to the Phd's that created these derivatives, but by the traders that didn't full understand the limitation of the risk models, as well as the moral hazard in packaging toxic assets into CDO's knowing they would easily be able to pass it along. Having said that, I'm glad I didn't sell my soul and become a banker ;)
If creating a CDO creates more value to the economy than designing an automobile why shouldn't engineers focus on building those?
People forget that prices and money are essentially information about the supply and demand of a good. As we progress in the information age deriving information from price will consume and produce ever more of our GDP. Spending money efficiently and directing it to the right purposes is a VERY valuable thing for a nation to do. Perhaps, dare I say it, more valuable than engineering widgets.
If YC had engineers figuring out algorithms to determine the best startups and they found one that worked it would be a very valuable piece of information. Or more relevantly, what if you had a site that required a lot of bandwidth and you could buy a bandwidth future? If you could buy that sort of thing you could offer 4 year contracts to your customers with out taking on any risk.
How about this instrument, a YC Summer 2014 startup future, it estimates the expected return from S14 and pays you if the return is less than expected. YC could sell them today and gain the advantage of knowing how many startups they could fund in S14. It would allow all sorts of people to pool their knowledge about what the Summer 2014 startup scene is going to be like. You might want to buy one right before the S14 season because you know that some great startup is applying, etc. If you held office space in SOMA you could use this as a hedge against losses incurred due to a poor S14 startup season.
Most complicated financial instruments are actually risk mitigation and/or information pools. The fact that that kind of thing is pricable due to these engineers spreads all sorts of great information to our economy that you can use to make informed decisions about how to conduct your affairs and you don't even need to participate in the market to use it.
Want to know what the best guess as to the price of oil in 6 months? Check the oil futures market. This one number contains the all the information known to man, vetted by experts as to what the supply and demand of oil is going to be in a few months. It also allows anyone with new knowledge to monetize that information and communicate it to all participants almost instantly. Southwest can offer cheaper flights because they use oil and jet fuel futures to buy jet fuel, the brilliant thing is that Exxon also gains knowledge of what Southwest and every other airline expects their passenger load to be in a few months and can make decisions accordingly.