Financial Engineering For Better Accountability

Nassim Taleb has a book titled Skin In The Game. I haven’t read the book itself, only a couple articles along the same lines. At the risk of misunderstanding his thesis, I’m going to share my comments.

For my generation, it seems like our only stake in “the game”, is our actual skin. We can work our butts off, without significant reward or opportunity. On top of that, the 2008 crisis showed us how our prospects can be completely devastated by irresponsible choices of parties who are apparently outside the reach of accountability.

The truth is, this “asymmetry” of opportunity and responsibility is not new. Blacks, immigrants, and women, as well as the domestic populations of our trading partners, dealt with this “asymmetry” long before millennials started staying in college longer to postpone careers in a bad job market.

These historically marginalized groups were the last afforded real opportunity, and the first to face harsh realities when something went wrong. This was excused as the way things were done.

Today’s financial precarity may not be as severe or arbitrary as what those groups faced historically, but it’s unique for two reasons:

  1. It’s more widespread: it’s the norm in certain class and generational groups.
  2. It’s completely unnecessary: never before has human society more prosperous and empowered than we are today.

“Financial Engineering” Is Not A Bad Word

Financial engineering has a bad rap, because it is often applied for irresponsible opportunism, instead of effective incident management in critical situations.

Taleb and other financial gurus might label these situations as “tail risk”. But that term only captures the probabilistic rarity of these events, not the underlying social or political problems.

The first concern of financial engineering, like any engineering discipline, needs to be failure. Failure protocols make a HUGE difference when it matters the most. Would you want to get on the road in a vehicle that hadn’t been tested for safety?

Today, we save lives by engineering cars to handle crashes, and buildings to handle earthquakes, but we fail to apply these ideas coherently to our financial systems.

What Is A Failure Protocol?

A failure protocol is what you do when “shit hits the fan”. It’s sometimes human nature to avoid, evade, deny, postpone, and ignore failure as much as possible. But this is not really effective or excusable in the modern world.

In your group or organization, when a failure happens, does everyone run for the exits as fast as possible? Or do they clean up the mess, carefully take things down, and take responsibility?

When you look at the anatomy of something like a bank run or a market crash,
this is essentially what is happening. Savers or investors are unprepared to support or stand by their commitment, so pillaging a dying corpse becomes the go to option.

There is nothing wrong with getting out of a bad investment, but if you are financially secure yourself, I think this should be done carefully and responsibly. You should 1) Warn others. 2) Exit incrementally. While this won’t get you the most money out of the deal, I think it puts you in a stronger position moving forward, especially if it helps salvage individual and group relationships that could prove valuable later.

In this regard, the movie It’s A Wonderful Life, gives pretty good financial advice.

Final Thoughts On Finance

I’m not a fan of using interest rates to “price credit”. Lending at high interest rates has nothing to do with growth or opportunity cost, and everything to do with opportunism, greed and exploitation.

Commerce itself is the benefit of credit. Often, the principle of comparative advantage is poorly applied to discussions of international trade, but in a local economy, credit is critical for facilitating real comparative advantage. Not only does credit help people apply their skills where they’re most valuable, but it’s often what gives them any opportunity in the first place. There is no comparative advantage without first having a baseline of economic opportunity.

To improve how our society offers credit, I think we need different language to communicate how credit is priced. In addition to APR, whenever you get a long term loan, they should also tell you two other numbers:

  • TIP: Total Interest Percentage
  • MIP: Maximum Interest Percentage (A cap on total interest plus all fees and penalties for any late payments)

I think a 30 year mortgage with a 30% TIP, and a 50% MIP could be completely reasonable. Money is not a limited or finite thing, there’s not any opportunity cost inherent in creating more money, the real concern is healthy management of all risks involved. Sometimes people don’t ask whether they are shooting for the best outcome in a small number of scenarios, or for a good outcome in the maximum number of scenarios. These two very different strategies can actually involve the same interest rates, because interest rates are an average of all outcomes!

If you’re a central bank, you simply issue money to buy assets. That’s how money gets created. It makes no sense for central banks to orchestrate a system where borrowers must compete with each other based on interest rates. As a central bank, your decision to facilitate a credit worthy loan at a 5% rate, shouldn’t preclude facilitating another loan at 0.5% APR. You get the most benefit by issuing both loans if they are actually a good use of money, and not by enforcing an arbitrary rate by which to compare lending opportunities against each other. Credit worthy lending can be self limiting, because responsible borrowers and lenders come to agreement based on the opportunities available. A limited money supply, or competitive borrowing, is an ineffective way to limit lending, because it fails to adapt to the uniqueness of each opportunity. Independently evaluating each loan and fiscal spending opportunity is the best way to ensure full resource utilization.

What would Total Interest Percentage (TIP) and Maximum Interest Percentage(MIP), look like for a home loan today? A decent rate on a 30 year mortgage might be 3.9% APR. If you start with a $100,000 principle, and make equal monthly payments over 30 years, you’ll end up paying about $70,000 in interest, which would be a 70% TIP. The MIP could easily be much more than this. You are paying 70% more, just based on when you pay for it. Effectively, the bank builds a house for you up front, and then you build 2 slightly smaller houses for them over the next 30 years.

Often, when we talk about interest rates, we ignore the issue of volume. Let’s say a DVD costs $20, and you can rent it for $1/day. The first day you rent a DVD, you’re probably paying for the use, but each day after that, the rental fee becomes nothing more than interest on an outstanding loan. That interest rate amounts to 5% per day, but by the same token, the MIP is capped at the price of buying a DVD you don’t want.

And yet, $1 seems like a reasonable charge for holding a DVD an extra day.

But let’s consider the $18 trillion of treasury bonds held by the public. If we were to pay that same 5% just every quarter, instead of every day, the interest would amount to $3.9 trillion dollars each year, not a small sum by any means.

Some may worry that with a large national debt, there’s a significant risk that interest rates could rise suddenly, and then interest payments would spiral out of control. But in fact, the greater the volume, the smaller the risk of rates rising.

Not only is earning a large amount of money difficult, but spending a lot of money is difficult too. Lottery winners can end up wasting a lot of money, and sometimes they even end up in a worse financial position!

If you consider the volume of savings in treasury bonds, zero or negative rates can make a lot of sense. What would U.S. bond holders buy if we paid back the national debt? Are there really $20 trillion dollars worth of spending opportunities that the private market could provide that wouldn’t depreciate or carry unnecessary risk?

As MMT economists like Stephanie Kelton clearly articulate, the only spending limitations of monetarily sovereign federal governments are domestic resource capacity and political agreement. Further, treasury bond interest payments are a completely discretionary reward given to savers.

I think with proper financial engineering, including some banking reforms, city and state governments could enjoy a comparable position, where the terms of their bond issuance are discretionary, and they have a flexible and fair channel for depreciating their assets, a “failure protocol”, if you will. To dis-incentivize such failure, full time employees of city and state governments could receive bonuses in the form of bonds, so they are vested in long term financial outcomes. Additionally, local financial institutions should be allowed to use these bonds as reserves on their balance sheets. Banks and Credit Unions are often more relevant as local financial institutions, even though they are primarily subject to federal rules. Furthermore, bond repayment should follow TIP and MIP principles, and the amount payed in each payment period, or even the total amount repayed, should adjust if tax revenues diminish.

While smaller polities are much more dependent on external resources and trade than nation states, they have the potential to help ensure local resources are not wasted and applied effectively, especially labor and land. In terms of management and responsibility, I would argue that local political entities are much better suited to maintain a public job program or a job guarantee than the federal government.



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