Wednesday, December 21, 2016

Letter to a young graduate

A student recently emailed me his final assignment, and sent along with it a nice note thanking me for all I’d taught him.

I took the opportunity to share with him a few additional thoughts.

Hi ____,

Thank you for your note. Of course, our goal as faculty is to teach you, but we’re not always sure we succeed, so it’s good to hear about it when we do. And I’ll take your message as permission to try to have one last set of ideas stick with you before I recede into the haze of your college memories.

As you head off to make a career in finance, I find myself torn, wanting success for you but also nervous about where you might find yourself. My relationship with the workings of finance isn’t exactly love / hate. It's more like fascination-and-wonder / rage.

Let me explain.

I think it was in one of the classes you had with me that I addressed the idea of the “real” economy.

The standard terminology is that there’s the “real” economy, where goods are made and services are provided. And there’s the “financial” economy, where people trade stocks, bonds, derivatives, and whatever else they can think of. It’s not “real” because it’s just paper, it’s just ownership or claims on stuff. If you buy a car, you can touch the car, you can drive it. If you pay to go to the theater, or to college, you have the experience of seeing a play, or building your mind. So goods and services are “real,” and then there’s finance.

I understand what those terms are getting at, but I think the use of the word “real” in that particular way is unfortunate.

I prefer to think of the production of goods and the provision of services as the “physical” economy. A car is obviously physical, but so is a visit to the doctor: you had to be physically present, the doctor had to physically examine you, the lab tech had to physically extract blood which would then be physically tested.

I don’t want to use the word “real” for that, because it implies that finance is not real. It’s true that finance isn’t physical, but it most definitely is real. Finance decides whether XYZ Co. gets the loan they’re looking for, and that financial decision determines whether some physical activity of XYZ Co. happens or not. Finance can create extravagant credit, as it did during the housing bubble of the 2000’s, which supported an increase in the very physical activity of home construction. When the bubble burst, the financial way we handled it determined who got physically kicked out of their houses, and the way we responded to the mountain of debt contributed to the depth of the recession, something that obviously played out in the physical economy.

So rather than view the real economy as separate from the financial economy, it’s healthier to think of the physical and financial sectors together making up the real economy.

When people use the term “real” economy for what I call the “physical” economy, the next step for some is to cast finance is an inherently parasitical activity. There’s the real economy, where useful stuff happens, and there’s the financial economy, where people get paid exorbitant sums for moving papers around. (In the Hamilton musical, Thomas Jefferson makes that argument, telling Hamilton that “we do real work, growing stuff; you just move our money around”).

I think that’s a mistaken perspective. Finance plays a necessary role in a modern economy, giving people ways to save for future needs and giving companies and households ways to spend in the present against future earnings. We’re better off having those options than not having them, so it’s good we have a financial sector.

But it’s also an industry that can do great harm, and commit great wrongs.

I’m partway through David Dayen’s book Chain of title, about the foreclosure fraud epidemic that came to light after the housing bubble burst in 2007-08. On one level, much of the activity was simply illegal: presenting clearly faked documents to foreclosure courts as evidence of standing to foreclose: committing perjury by attesting to the validity of such documents; two different companies initiating foreclosure on a property, each company claiming to be the owner of the note; and so on.

On top of the illegality was the immorality. Someone sends in their mortgage payment on time and in full, but the mortgage servicer has added a home inspection, or a new home-insurance policy, or some other fee, without notifying the borrower. The servicer deducts those fees from the borrower’s payment—without telling him—so it turns out that the borrower has not paid in full and is late on part of his payment. Now the servicer gets to charge late fees.

It’s a way for the servicer to make money, but it is at a minimum ripping of the borrower, and it is quite possibly putting the borrower on the road to being foreclosed.

Early in his first term, Obama launched HAMP, the Home Affordable Modification Program, a system of incentives for lenders to work with struggling borrowers to keep them in their homes, avoiding foreclosure. It didn’t necessarily work out that way:
Servicers turned HAMP into a predatory lending program, squeezing borrowers for every payment they could get and then foreclosing anyway. After keeping people in trial modifications for a year, servicers would suddenly reject permanent relief and demand the difference between the trial and original payments, under threat of eviction. Bank of America employees later testified they were given Target and Best Buy gift cards as bonuses for lying to homeowners, denying HAMP modifications, and pushing people into foreclosure. (p. 67-68)
So on the one hand, finance plays a crucial, positive role in the economy, while on the other, it is clearly capable of wreaking great harm. You remember a key idea from the Environmental Economics class: the background of many environmental problems is that what’s good for the profit of a private company is not necessarily good for the society as a whole. The same thing applies here: what’s good for the profits of actors in the financial sector is not necessarily what’s good for the economy as a whole.

The foreclosure crisis has been a particularly gaudy example of this, but it’s inherent in the nature of the activity. There’s so much money at stake that there are really large incentives to find a way around the rules. Some people will find it impossible to resist those incentives. I trust you will not be one of them—though it’s tricky. When you read accounts of people who’ve ended up doing horrible things, they often edged into them by a series of small steps. Each step seemed defensible on its own, but when the person looked back at the whole path they’d walked, they saw that they’d ended up in a very bad place.

On a related note, once you’re aware of the harm that finance can cause—and sometimes has caused—there are implications for how we view others. When we see someone in poverty, or struggling to get by in some way, we usually don’t know the details behind their circumstances. There’s often an assumption that the person is there through some combination of their own poor choices and limited intelligence. Sometimes students will express the view that long-term unemployment is simply a result of people being lazy. There’s plenty of evidence that this is, at best, a very incomplete explanation, regardless of who says it. But it’s particularly rich coming as it sometimes does from students who can’t be bothered to come to class regularly or hand in all their assigned work.

There's another side to the view that others are poor due to faults of their own, and that’s the view that I’m rich due to my own virtues. Again, sometimes that’s true, but there are plenty of exceptions. If I’ve gotten rich because I’ve found a way to commit foreclosure fraud (or some similar financial scheme), then my wealth isn’t rooted in any virtues that we’d like to see become more common. And in fact, my own cleverness in figuring out how to defraud other people is the explanation for why some people struggling to get by. After what some in the financial sector perpetrated in the housing bubble and foreclosure crisis, it’s rich for people in finance to assume that their own wealth stems from their merits, while the other people’s poverty is no more than they deserve.

Changing topics slightly, your first class with me was on climate change. That hardly makes you an expert, but it does mean you know more about the subject than the average American; more, even, than a significant number of college-educated Americans.

You know the scope of the problem and nature of the evidence behind it. You know the basic mechanism of how it works. You know the general areas where solutions are to be found, if they exist at all.

Of course it is beyond the means of any one person to “solve” climate change. And starting off in finance, the effect of your actions will be relatively small. If you advise a couple to buy retirement product “A” rather than “B”, who do you affect? If the couple follows your advice, you affect them (if “A” ends up being significantly different from “B”), and the managers of product A benefit a little, while the managers of product B don’t. And that’s about it.

But if you are successful, you will end up in a position to have much more far-reaching effects. You may be deciding about financing for infrastructure “A” versus infrastructure “B”. “A” might be a pipeline that makes it easier and cheaper to burn more fossil fuels, while increasing the extent of vested interests in support of continued expansion of fossil-fuel use. “B” might be a promising but uncertain project that would provide low-carbon energy.

You’ll have a spreadsheet with payback scenarios for each project and how each possible loan is likely to affect your company’s bottom line.

Will you find a way to think about the broader effects your decision will have?

During the Vietnam War, the historian Barbara Tuchman noted the calls for people not to join the military, because of the nature and conduct of the war. Tuchman agreed with many of the criticisms leveled against U.S. policy, but she had a problem with the blanket moral objection to joining the military. She pointed out that we were going to have a military regardless, so if everyone with a moral compass refused to join, the military would be made up entirely of people without an inner sense of right and wrong.

One could make a similar case about finance today. The financial sector we will always have with us. If everyone of sound morals shuns it, there will be nobody on the inside to point out when wrongs are being committed.

I wish you success in your chosen career.

And if at some point you do find yourself on the periphery of some activity that is questionable—or perhaps even downright illegal—I hope that some of what I taught you helps you find your way toward doing what is right.

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