Trading in Abstractions – Is This Why We (and Wall Street) are in Trouble?

We are surrounded by financial abstractions we can rarely see, and even less often understand. Trading of securities created by bundling debts, for example, is an abstraction.  While there may be some assets behind those debts (they may be secured debts such as mortgages), the value of a debt is partly comprised of an expectation that the debt will be repaid.  This expectation is an abstraction, as you can’t easily measure it or place a value on it.  This is just the tip of the iceberg, however.  On top of that there are also commodity futures and other financial abstractions where the value is at least partly based on promises, expectations, and hopes.  People buy and sell financial instruments based on abstract notions such as debt every day.  The problem with trading in abstractions is that since there are few real assets attached to them, and thus little real value supporting them, emotions have an inordinately greater impact on how we value them.  Is this a key factor behind the incredible volatility and risk in our markets?  Is the fact that we have extended our financial world into heavy dependency on debt and other abstractions creating major risks for us all?  Does trading in abstractions put as at risk of panic and unrealistic expectations, positive or negative?  Given the enormous scale and presence of debt in our lives today, have we built a house of paper that can dance wildly in the winds of our emotions, hopes, and expectations, and which can therefore make and destroy fortunes within days or hours based purely on the news or propaganda? Given that such matters have become only more complicated over time, and are already beyond the ability of almost everyone to fully understand them, will they continue to become even more complicated in the future?

Have you read your credit card agreement lately? It is a contract that binds you to a complicated web of terms and conditions, but those terms have become so complex and voluminous that practically nobody reads them or knows what they say aside from the attorneys who write them.  Take a look at the terms for any loan you may have and the situation is obvious.  When it comes to debt, 99% of us are dealing with it entirely as an abstraction, and yet holding a lot of it.  For most people, a cancellation of our debt and foreclosure on the assets involved would put us on the street, homeless.  Is it possible that the less we understand debt, the more likely we are to not handle it properly?  Is the overly complex nature of debt directly related to the risks involved in borrowing and lending?  Does the abstract nature of debt, the way we handle it today, already cause people to lost track of their spending and wind up in financial trouble on a frequent basis?

When our debts get rolled up and sold as securities, the situation gets only more complicated. At the point where we don’t understand the agreements we’ve signed, they become abstractions removed from reality.  Debt-based securities have value that is directly driven by the hopes, expectations, and promises involved.  While there are assets involved, the speculative and emotional components of value can vary wildly.  If the buyers and sellers of debt-based securities think positively about their prospects for future repayment, the securities rise in value, and vice versa.  Emotions around security values are always a factor, but this makes the emotions of the traders a key element in the value equation, and greatly increases the volatility and risk in the market.

Futures trading is another instance of abstraction in our lives.  Futures trading, by definition, is where assets are traded before they exist.  Value in futures trading is tied entirely to forecasts and expectations of supply and demand six months or more in the future.  If the trader is pessimistic the value is driven lower, and vice versa.  The emotions of the trader directly affect the value of the securities, and current prices provide little stability to the market.  A clear example is in the way futures trading drives oil and gasoline prices. If the traders’ expectations are that demand will decline, they pay less for the futures involved, and current prices tied to the futures market also decline.  People communicate about such things, however, in the daily course of business, and groupthink becomes a factor.  One influential information source can drive prices up or down in ways that may have nothing to do with facts. Also, emotions may amplify swings in market expectations, increasing volatility and related risk.

The expanding practice of trading in abstractions has hurt us repeatedly. The recent financial “meltdown” in the banking, real estate, energy sector, and other industries has been made worse by the fact that, when the items being traded are abstractions, there is nothing to control or limit speculation, and values can swing wildly with disastrous consequences.  Were previous recessions as well as the great depression all based on or exacerbated by speculation in abstractions?

How much more complicated and abstract can things get? How will debt and other financial abstractions be handled in the future?  Will our financial dealings continue to become more complicated?  Almost nobody understands the arrangements we engage in now, and we are all being harmed by the volatility involved in trading things that have little or no substance, and which are valued almost entirely in the minds of the traders.  While a major effort to reduce the complexity and eliminate the abstract nature of items like debt-based securities is needed, it is unlikely that it will happen.  Like the simplification of tax laws and related regulations, past attempts to decrease complexity have generally led to only more complicated laws and regulations, and have made the situation no better, and often worse.  Is significant volatility introduced into the system by the difficulty the average person has comprehending the financial world in which they almost certainly must live?

Coping with the future effectively will require stable financial markets and security for individuals and organizations. Since the markets are so essential to our financial systems, and finances will be key to achieving a controlled glide path to sustainability, it is likely that the trading of abstractions will be a key factor in the coming decades.  Expectations for future energy production already strongly influence the economic viability of alternative energy sources, and which ones will receive how much support.  If we don’t better regulate our trading systems where abstractions are involved, we could continue to see gross and often unwarranted volatility, and uncertainty could undermine efforts to create new products and technologies we will need.  In the necessary pursuit of sustainability, the last thing we need is the kind of boom-and-crash financial insecurity we are experiencing today.  Perhaps we should be asking these questions of our government and corporate representatives, and asking what their long term plans are to get our financial lives and markets moving back towards stability (and understandability).

As always, I welcome your comments – Tim Prosser


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