Arnold Kling  

The Three S's of Finance

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Think of financial intermediation as consisting of three S's:

Spreading (that is, using diversification of risk)
Selecting (that is, choosing the right risks to take)
Signaling (that is, convincing people that the intermediary is sound)

In my favorite example of fruit trees subject to disease, spreading means investing in a portfolio of fruit trees, so that you are not dependent on one tree. Think of an index fund.

Selecting means choosing carefully the trees in which one invests. This means spending money to gather data and developing skills to process that data in a way that allows the intermediary to select the trees least likely to suffer from disease.

Signaling means doing something to convince investors that you are skilled as an intermediary. How can an investor tell the difference between an intermediary that is skilled at selection and one that is merely pretending to be skilled? There are various signaling mechanisms. Banks used to present consumers with fancy lobbies and immaculately dressed employees in order to signal soundness. Today, they put the "FDIC insured" symbol on the door to signal soundness.

Signals can lose their credibility. AAA-rated asset-backed security is no longer a trusted signal.

I think that focusing on the signaling aspect of finance is an appropriate role for Masonomics. There is a lot that one can do with this approach.

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COMMENTS (4 to date)
Lee Kelly writes:

"Knowledge is a scarce resource" - for me, this is one of the core principles of Masonomics. But recently I feel like some Masonomists have forgotten it.

When the real estate bubble popped, it seems to me that more than material resources became scarcer, but knowledge too. The state of knowledge in the economy is an objective fact which must be reflected in prices. It irks me that so many economists seem to consider it unimportant, and shrug it off as a mere drop in confidence, because I think falling confidence is a manifestation of the sudden scarcity of knowledge.

Real knowledge cannot be substituted with inflated prices. If AAA-rated asset-backed securities are genuinely bad signals, then trying to raise confidence in them, or clear the market with inflation, is not good economic policy.

Someone should be talking about this more, and Masonomists seem ideally suited to the task.

fundamentalist writes:

Good point, Lee! I agree completely. Reading Hayek and Mises I am stunned by how much knowledge mainstream economics has left behind. The economic debates of the 1930's is full and fascinating and ranged over vast amounts of literature and time. By comparison, modern econ seems emaciated and stunted. I earned an MA in economics and had a great deal of difficulty understanding Mises and Hayek because of the limited amount of economics I learned in school. And I have found that trying to discuss Austrian econ with other mainstream econ professionals, especially PhD's, is almost impossible because they simply can't understand the concepts that were common currency in the 1930's. Of course, that may be due to the attitude that they don't want to learn anything new, too.

M writes:

One way to signal soundness is by having a stock that pays a high dividend. A bond rating can be faked. An actual money payout can’t.

Charles Ponzi writes:

A bond rating can be faked. An actual money payout can’t.

Well, the payout may be real (actual money), but the signal of soundness may still be false:

Consider a company that pays out big dividends by simply using later investors' capital to pay the dividends to earlier ones: actual money payout, but not exactly sound.

Hmmm... That gives me an idea! (I should share it with my buddy Franklin, too.)

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