The Profit Motive Behind Financial Complexity

by: Noah Smith

Economist George Akerlof has spent much of his celebrated career thinking about how trickery and deceit affect markets. His most famous insight, which won him the 2001 Nobel Prize in economics, is that when buyers and sellers have different information, lack of trust can cause markets to break down. In those models, no one actually ends up getting tricked — everyone is perfectly rational, so even the possibility of getting cheated causes them to stay prudently out of the market. But in his book “Phishing for Phools,” written with fellow Nobelist Robert Shiller, Akerlof goes one step further. Much of the actual, real-world economy, he says, involves trickery and deception.

A recent paper by economists Andra Ghent, Walter Torous and Rossen Valkanov may shed some light on the question. Ghent and her co-authors look at mortgage-backed securities, which figured prominently in the crisis. They try to measure how complex various products were, using measures like the number of pages in the prospectus, the number of tranches in the security and the number of different types of collateral.