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Imagining a law - Input Junkie
June 14th, 2012
12:36 pm

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Imagining a law
It would be nice if people weren't allowed to invest in things they don't understand, especially if they're investing other people's money.

There are some practical problems with a law like that-- I can't imagine an fair, efficient test which would check on understanding.

On the other hand, maybe "we made investments we didn't understand" shouldn't be a legally or socially acceptable defense.

This entry was posted at http://nancylebov.dreamwidth.org/544131.html. Comments are welcome here or there. comment count unavailable comments so far on that entry.

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From:pickledginger
Date:June 14th, 2012 04:47 pm (UTC)
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I'm pretty sure it's more of a self-incrimination than a self-defense.
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From:madfilkentist
Date:June 14th, 2012 05:03 pm (UTC)
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If I make a bad investment, it's my choice and my responsibility, and it's not the business of any governmental authority to decide I'm too stupid to be permitted to do it.

"You made investments you didn't understand" shouldn't be a legally punishable action.
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From:nancylebov
Date:June 14th, 2012 05:07 pm (UTC)
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What would you think of a clause in contracts for banks and investment funds forbidding them from making investments they don't understand?

Edited at 2012-06-14 05:19 pm (UTC)
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From:osewalrus
Date:June 14th, 2012 05:54 pm (UTC)
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Actually, we do it the other way. Common law used to impose a fiduciary duty. We then allowed people to waive it. Waiving this is in one of the little clauses with fine print you sign when you invest -- along with waiver as against any possible conflict of interest as long as they were disclosed in paragraph 4(c)(iii) above.

In theory, investment firms should compete on the basis of how well or poorly they protect clients. But they don't, for various reasons I will not elaborate on here but which have to do with more recent developments in behavioral economics. If you are interested, the key word is "shrouded attributes."
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From:nancylebov
Date:June 14th, 2012 09:03 pm (UTC)
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So we get more and more of "We'll make you an offer you can't understand"?
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From:osewalrus
Date:June 14th, 2012 09:08 pm (UTC)
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Yes.

The other problem with this approach is that it also ignores negative externalities. I did well in 2008 betting on collapse. Go me! But it still sucked for me because society as a whole did poorly.
From:nancylebov
Date:June 14th, 2012 11:00 pm (UTC)
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How did you choose 2008? Did you just expect an end to the real estate boom, or did you expect the end of the boom to do huge amounts of collateral damage?
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From:osewalrus
Date:June 15th, 2012 10:43 am (UTC)
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You may recall I blogged about it some on LJ, but didn't broadcast my portfolio choices. It was clear for some time that consumer spending based on credit in the U.S. was unsustainable. I began to anticipate a crash in the financial services sector as early as 2006 (sorry, would take me too long this morning to hunt down links, but you can flip through my LJ calendar to find if curious). But nothing dramatic happened. Defaults (for credit cards and mortgages) kept rising, but the major financial institutions holding that debt did not appear to be suffering. By 2007, I was wondering if I had underestimated the overseas growth of major U.S. financial institutions or if my understanding of the economy was just wrong.

Then in summer 2007, the subprime crisis hit. Ah, the missing piece! Losses to financial institutions had been masked by ridiculous profits from sub-prime loans and subsequent bundling. The rising default rate had been accepted by the market as insured against by loan bundling -- now the chickens were coming home to roost. I blogged that the crisis needed to be contained quickly -- as the Savings and Loan crisis of the 1980s had been. I proposed a solution similar to one Barney Frank proposed in legislation (Frank's was actually better than mine) -- banks would buy the defaulted loans at a price calculated to keep the banks afloat but provide a sufficient penalty to teach them not to take these kinds of risks.

But Frank's legislation went nowhere. Financial institutions fought for more money and most legislators (and the public) did not appreciate the scope of the potential crisis. I cannot claim to have foreseen the full scope of the crisis, but it was pretty obvious to me that the entire financial sector was infected. I became alert to other ripples. Lehman Bros had tried to sell themselves to a large British firm, which had backed off during the "due diligence" phase. Commodity prices were climbing, putting even greater pressure on consumers for debt-financed spending. Credit card companies were jacking up fees to make up for the growing defaults, a process which increased defaults.

Again, few people realized just how precarious the financial situation of the average American home was. I saw it all around me in my middle class neighborhood in my affluent county in DC. I saw constant reports about it issued by various left-leaning and progressive think tanks and advocacy groups. (New America Foundation, for example, had been warning about the growth in personal bankruptcy and the unsustainability of consumer spending absent real income growth since 2004). It was clear we had become caught in a viscous cycle where financial institutions would continue to increase fees and interest rates on consumers still making timely payments to compensate for losses from the growing number of defaults, which in turn increased the number of defaults. The meltdown I had predicted in 2006 was finally falling into the anticipated pattern.

By January 2008, it was clear that nothing would be done as a policy level until far too late. So I sold my stock and put it into funds that were linked to developing countries like Turkey and Brazil.
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From:nancylebov
Date:June 15th, 2012 01:47 pm (UTC)
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Thanks for the details. I didn't remember what you'd written about this.

If The Big Short is accurate, then almost no one was able to figure out the scale of the derivatives disaster before it happened-- the specifics were fairly well concealed.

It's a pleasure to see how much can be figured out with a combination of good sense and public information, though quite a melancholy pleasure in this case.

I'm guessing that safe investments will be harder to find next time-- all parts of the world will be more similar.
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From:osewalrus
Date:June 15th, 2012 01:51 pm (UTC)
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Depends on what you mean by safe.
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From:osewalrus
Date:June 15th, 2012 01:54 pm (UTC)
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Part of the problem is that people focus on their specialty. Try explaining to a subprime guy how his business was impacted by rising credit card rates and you get a blank look.

It's like those old tv specials for kids that were supposed to explain how complicated ecology is, where someone wipes out a local insect regarded as a pest and before you know it everyone's favorite plants are gone because said insect was the food source for a critter that pooped out a vital nutrient that supported some other critter in the chain, etc. And all those were linear. This is complex.
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From:whswhs
Date:June 15th, 2012 03:13 pm (UTC)
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Ironically, you could have found quite similar concerns about the unsustainability of the real estate boom in the writings of libertarians, especially those influenced by Austrians such as Hayek and Mises or their American follower Rothbard.
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From:osewalrus
Date:June 15th, 2012 03:25 pm (UTC)
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Hayek wrote about the collapse of financial markets in 2008? That is more than "ironic" given that he was dead for some time before that, it is frikkin' astounding! Citation please, particularly to his discussion of the sub-prime collapse and its relationship to contracting consumer credit.
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From:whswhs
Date:June 15th, 2012 05:24 pm (UTC)
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The phrasing "libertarians, especially those influenced by Austrians such as Hayek" does not refer primarily to Hayek himself but to more recent writers who were influenced by him. Try reading what I actually wrote before you attempt to be sarcastic about my wording.

On the other hand, in a sense it's perfectly correct to say that Hayek wrote about the collapse of financial markets in 2008, just as it's correct to say that Isaac Newton wrote about the moon landing in 1969: That is, both of them provided theoretical frameworks that applied to events that they would not live to see. That's what theory is for. Hayek's theories may have been right or wrong, but to suggest that they could not be applicable to the financial collapse of 2008 because Hayek was dead by then suggests that you completely don't understand what a theory is.

As to citations, I don't see a single citation or link in your long comment, so I don't see why I should meet a standard of discourse that you don't think applies to you. I wasn't attempting to prove anything or convince you of anything anyway; I was simply making a remark. I don't think our debating it here would go anywhere, and as it would be massively off topic, I doubt it would entertain anyone else.

The video "Fear the Boom and Bust" not only is entertaining but gives an honest presentation of both Keynes's and Hayek's perspectives on the larger subject. Though it doesn't have footnotes or references, either.

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From:agrumer
Date:June 15th, 2012 05:25 pm (UTC)
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I think he means modern libertarians influenced by Hayek, Mises, and Rothbard. If he'd meant the guys themselves there ought've been a comma after "by Austrians".

Not that links and citations would be a bad idea.
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From:pickledginger
Date:June 14th, 2012 05:15 pm (UTC)
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I believe she may have been referring not to individual investors but rather to institutions that, through negligence, have breached their fiduciary duty to their clients.

Such malfeasance theoretically may be covered under current law, but if so, the enforcement is ... unimpressive.
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From:agrumer
Date:June 14th, 2012 06:07 pm (UTC)
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How about "you commented on a post you didn't understand"?
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From:anton_p_nym
Date:June 14th, 2012 05:07 pm (UTC)
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On the other hand, maybe "we made investments we didn't understand" shouldn't be a legally or socially acceptable defense.

In parallel with "I didn't know the gun was loaded" not being an acceptable defense. I concur.

-- Steve'll take the advice of Warren Buffett, and not invest in anything whose workings he doesn't understand.
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From:nancylebov
Date:June 14th, 2012 05:18 pm (UTC)
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Another protection (I'm not sure if Buffett includes it) is "Don't invest with anyone who gets angry when you ask for an explanation". That would have been enough to protect people from Madoff and Enron.
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From:whswhs
Date:June 14th, 2012 05:31 pm (UTC)
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I'd note that being unable to understand a law is not a defense against breaking it—"ignorance of the law is no excuse"—even though the sheer volume of American law is now so great that trained lawyers cannot know all of it, and virtually no one can understand it, given the horrendous jargon it's written in.
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From:osewalrus
Date:June 14th, 2012 05:50 pm (UTC)
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We used to do this under a liability standard. As the person investing my money, you owed me a fiduciary duty to understand what you were doing as measured against the standards of the profession. it was as squishy as any other professional standard is, but it at least imposed some responsibility to understand what you were doing.
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From:whswhs
Date:June 14th, 2012 06:37 pm (UTC)
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You know, that's a valid point. It's like the duties of trustees.
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From:pickledginger
Date:June 14th, 2012 09:43 pm (UTC)
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Is there still any remnant of this in civil law?
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From:kgbooklog
Date:June 14th, 2012 09:43 pm (UTC)
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My idea is to treat publicly traded companies as titled property, so any changes in ownership would involve all the taxes, fees, and paperwork as when you buy a car. The goal here would be to get speculators out of the stock market and leave the companies in the hands of investors that actually want to company to prosper in the long term.

Actually, I've never understood why we have a stock market in the first place, since its only purpose seems to be causing boom/bust cycles in the economy. But that may be because I don't understand it (and some days I wonder if anyone does), and so my investments are all in CDs.
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From:sodyera
Date:June 15th, 2012 08:54 am (UTC)
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As revealed in a news article I saw yesterday, the real tragedy is that The Bank around the corner is laying ever more complex trip wires to make up for all the other schemes they'd used to profit from their "customers" before the new set of regs kicked in. Now their policy is to literally nickel and dime us to death. One Bank exec admitted on camera that even he didn't understand the picayune rules changes they're levying.
From:paulshandy
Date:June 26th, 2012 06:59 am (UTC)
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It depends, are they asking for a government bailout or not?

But then it seems to me that the sheer amount of commentary and decisions made about things people don't understand is staggering. Heck, if I'd understood the publishing industry before I started writing novels, I would have made some very different decisions.
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