Fun with More Impractical Flash-Based Internet Tools...
Wingnut Harmonic Convergence: Hoover Institution Department (Or, Denouncing the Illiterate Brown People Is Best Done by Somebody Who Knows How to Spell "Dam" and "Roll")

DeLong Smackdown Watch: Goldman-Sachs and ABACUS

It's "Have a Cow," Robert...

Robert Waldmann:

Robert's Stochastic thoughts: Brad DeLong clears his throat. I throw a cow. He wrote

The win-win benefits of trading money for money--where are they? It turns out that they are there. There are, actually, four:

  1. Trading money now for money later: people who want to save now and spend later can make win-win trades with people who want to spend now and save later.
  2. Risk: people who are unusually averse to risk in general can make win-win trades by trading off some of the risks that they are bearing to people who are unusually tolerant of risk in general.
  3. Insurance: people who are holding a lot of one big risk can reduce the risk of catastrophic loss by paying a great many others to each take a small piece of that risk.
  4. Information: people who have information that prices are going to rise can make win-win deals with people who have information that prices are going to fall--although here the win-win is not for the participants in the trade: for them it is zero-sum, and the winners are those others who observe the market price at which the trades occur.

I comment. Ahem. Your fourth win-win "Information:" is not like the others. You redefined win-win to mean "socially desirable" and decide that, if a third party wins, it is a win-win. Also, as you understood when you were in high school and Grossman and Hart figured out when you were in college, information does not explain trading. If the only differences across people were that they had different information then trades couldn't be win-wins. If it were common knowledge that everyone is rational then trades couldn't occur. It is not unusual for someone in a type 4 trade to think they are in some other sort of trade. In theory there are no type 4 trades which are known to be type 4 trades.... Obviously not everyone is rational (who ever thought everyone was). In particular, there is a group which keeps writing papers which correspond to actual financial markets and keeps being ignored. I forget who they are, but they have created a subfield of Lake Wobegone finance in which everyone thinks they are relatively more informed than they are. Obviously this is what's normally happening -- traders think their trades are profitable, because they think the traders on the other side are irrational....

It is obvious that the synthetic CDO market was type 4 Wobegone finance. The Case-Shiller assets are better for hedging of all risk except specifically for RMBS default risk.... Basically ACA had to know that their counterparties were someone like Paulson. Now there was fraud all right. ACA didn't know that their counterparty was uhm helping them choose underlying assets for the synthetic CDO. However, if they thought they were selling insurance, then they were dangerous fools such that taking their money is a public service....

I think type 4 trading reduces the valuable information in prices. The trades can't exist in Nash equilibrium. Therefore finance theorists assume that there are some irrational traders. Then finance theorists (except for DeLong et al) assume that the volume of irrational trade is exogenous. They conclude that anything which causes high trading volume causes prices to be closer to fundamental values. That's a pretty direct passage from an unjustified assumption to a conclusion. I think it is obvious that higher trading volume causes greater price volatility and that this volatility is always vastly greater than the volatility of fundamental values. So I think that, aside from not being an argument that type 4 trades are win-wins, your argument has it backwards. I think that real world type 4 trading reduces the information content of prices -- because it is fundamentally irrational. So less of it would be better. Goldman Sachs has damaged its reputation as a fair broker with this scam. I think that is an excellent thing, because that reputation caused people to trade if they thought they were smarter than average. Fear of being cheated by Goldman Sachs makes up for irrational overconfidence and will lead the economy towards where it would be if everyone were rational.... [W]hat's bad for Goldman Sachs is good for the world.