Tuesday, October 07, 2008

Inherent gamblers
Investment banks are dead.
Or are they? Investment banks may have shut shop, sold their pants to someone, or let someone else share their trousers but is the American habit of ‘investment banking’ dead? That habit of gambling on the markets, creating money out of thin air, packing and re-packing BBB rated bonds in a magical way such that they come out the other side as AAA bonds?

I don’t think that art is dead. In fact it can’t die. It is somehow ingrained in the genes of the Americans because their economy was never a savings economy. It’s always been consumerist. And that is why you can take out the investment banks but you can’t take out the investment baking from an American.

There is a wonderful book called “A World of Chance” written by Canadian economists Reuven and Brenner. Amazon.com introduces the book with this statement:

Although financial markets often try to distance themselves from gambling, the two factors have far more in common than usually thought. When, historically, there were no financial institutions such as banks, lotteries constituted the ways by which expensive items were disposed of, and governments raised money quickly. Gambling tables fulfilled roles that venture capital and banking do today. 'Gamblers' created clearinghouses and sustained liquidity. When those gamblers bet on price distributions in futures markets, they were redefined as 'speculators'. Today they are called 'hedge fund managers' or 'bankers'. Though the names have changed, the actions undertaken have essentially stayed the same. This book shows how discussion on 'chance', 'risk', 'gambling', 'insurance', and 'speculation' illuminates where societies stood, where we are today, and where we may be heading.

So it wasn’t yesterday, or last week, or sometime in 2007 that investment banks were characterized (even chided) for being gamblers. Subprime didn’t pull their towel and make them naked. They were gamblers all along. It was gambling that created the insurance industry and the futures markets. Remember the first pork futures markets in Chicago where people gambled on pigs that eventually led to the creation of CBOT? Gambling has been part of American life all along right from wild, wild, west days where cowboys bet on poker and women to the present day $800billion bail out package.

Someone said, think of America as a town with one casino, in which the only economic activity is gambling. Most people lose, but the casino keeps lending them more money to play. Eventually, of course, the casino must go bankrupt. At this point, the townspeople people vote to tax themselves in order to bail out the casino. Collectively, the gamblers cannot help but lose because the odds of winning are never 50:50; individually they nonetheless hope to win their way out of this whole system and make it big in life. After all it is the land of opportunities. The frequency of the casino going bust varies but history shows it keeps happening once every decade – sometimes more severe and sometimes less so. And of course the gamblers go through a period of ‘depression’.

Why do Americans gamble so much? Again the book “A World of Chance” gives an interesting insight:

If people reach the age of fifty or fifty-five and have not "made it," what are their financial options to still live the good life? Except for allocating a few bucks to buy lottery tickets, it is hard to think of any other option. If people find themselves down on their luck and see no immediate opportunities to get rich, what can they do to sustain their hopes and dreams? Allocating a fraction of their portfolios with a chance to win a large prize is among the options. And when people are leapfrogged - that is, when some "Joneses" who were "below" them jump ahead - how can they catch up? They will tend to challenge their luck for a while, taking risks that they might have contemplated before in business, financial markets, and other areas but did not follow up with action.

But that wouldn’t happen in India. Because we have been (and that is rapidly changing) a savings economy. People abhorred the concept of having debt on their personal balance sheets. Our savings attitude prevents us from gambling. We behave like the ants and Americans like the grasshoppers. But unlike the grasshopper that dies, there is always a casino that bails them out. And the casino is funded by rest of the world and grasshoppers themselves.

Have a look at the following two charts. The first one shows the population pyramid of USA for the year 2000. There is an increasing bulge in age group 40+ who have not yet “made it” in their lives. The bulge will have actually shifted upwards if you were to look at a 2008 chart. With failing pension funds, increasing healthcare, high inflation and depressing mortgage industry, what hope do they have other than to gamble?
In the chart below, an astounding 70% of the American household earns less than USD 70,000 a year. Divide that by an average family of four you get USD 1500 per month per person. So when one fine day the neighbor “Jones” bucks the trend and makes it big it is not difficult to see why a combination of ageing population plus the sinking feeling of not having ‘made it’ big in life lures them to gambling (read investment banks and hedge funds).

Unfortunately for Americans they need to keep taxing themselves ($800 billion is just the start) to keep the casino functioning but in the long run it’s just another cycle in their long gambling history and this too will pass.

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Blogger Prasanna Kumar said...

Interesting article, Thanks Teshu for your views on America and its financial system, long time back I read a book called “Against the gods” by Peter. L. Bernstein. The author talks about how the risk taking attitude (the carve to gamble) of man was the soul reason behind all the technological advancements, and the globalization that we see around us now. But don’t you think that a country is different from what a casino is where the citizens are more than the players in the casino, a player in the eyes of a casino is just a commodity which carry’s some value, but I would like to believe that a country is more than just a casino. I believe that an economic system which involves trading of goods with real value will be stronger than the economic systems that we see around us, which only allows everyone to live our lives on EMI’s or in the other sense which always tries its best to make everyone be in debt always.

5:08 pm  
Anonymous Anonymous said...

Teshu, thanks for your review. The gentleman above commenting on your review is right: and the "secret sauce" for a country - at least that's what I found - is when you combine incentives for risk-taking with institutions that prevent mistaken bets taken from lasting too long - keeping all parties accountable. For the moment the US stumbled on such combination better than other societies. Even if at present some accountability was lost. I believe it will sustain this hard to replicate uniqueness, and accountability will be restored. Time will tell. I make brief reference to the above in World of Chance, but it's in Force of Finance that I explore the above. Thanks, Reuven Brenner

1:08 am  
Blogger Teshu said...


I am quite thrilled that you could actually drop by at my blog, read my review about your book and share your thoughts.

You mention that risk-taking + accountability = secret sauce for progress. If I could take the liberty to interpret accountablity as being regulated then the secret sauce has failed. Infact I have always been a strong opponent of regulation of entities because I believe the markets are smarter than any bunch of regulators. Freddie and Fannie were highly regulated - infact defacto govt entities - yet they slipped on the carpet. Had they not been so highly regulated (giving psuedo confidence that all is well) - the markets would have forced them to keep their books open to public scrutiny. Anyways I will elaborate on my thoughts on this in my next posting and would surely look forward to your comments on that.

I haven't yet read your book Force of Finance - but will make attempts to do so.

10:03 am  
Anonymous Anonymous said...

Thanks. No, accountability is not regulation. It's a maze of institutions to enforce checks and balances to prevent too much corruption, lasting too long. They are there not for telling you what to do, but what NOT to do. Think about how you sustain trust in a family (and how to restore it when suddenly lost). It's through a maze of custom, tradition (transferred by example), institutions (religious among them), and laws too. There are many ways in which you can lose this capital, allowing it to depreciate. There are no recipes how to restore it: If your find that your kid lied to you, cheated - what do you do? Take away his allowance? Send him to the army? To the monastery? Different societies found different ways to generate trust. What are the institutions you need for generate the trust needed for financial markets to emerge and function - and why Western Europe was the first to have such markets - all that you'll find in FoF, chapter 1, and they are linked to political institutions. It's not accidental that the vocabulary of finance derives from "trust": "well, "trust", "security," "bonds" (that were supposed to "bond" - and you may know that in the past England had its prisons full of those not paying their debt, and that at one point countries defaulting on their debt was enough to bring about a military blocade - look up the financial history of Latin America). Best, Reuven Brenner

8:50 pm  
Blogger Teshu said...

Reuven, once again thanks for sharing your very insightful thoughts. In a day or two I will write my views on this interesting topic - especially the part about kid telling a lie and the act of reprimand. Is there a mail id that I could reach out to you on - so that I can mail a copy of my arguments? I surely would enjoy hearing your views. It is not often that I get to engage in a healthy debate with a renowned economist :-)

11:20 pm  

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