Of Wall Street, Casinos and Derivatives

One common way of explaining "what went wrong", involves differentiating the Wall Street Casino, personified by excessive derivative trading, from the "productive economy".

This explanation fundamentally misunderstands the nature of free markets. Properly understood, free markets are Casinos. Every economic choice one makes -- of school, profession, employer, etc... -- is a bet. Above all, entrepreneurial activity -- the engine of a free market economy -- is bet-driven.

Imagine, for example, believing that parents in a particular city will increasingly demand environmentally friendly toys and therefore thinking about opening an environmentally friendly toy store. To do so would bundle a number of bets, first of all on the evolving demand for environmentally friendly toys, but also on demand for toys in general, on the real-estate, demographics and economy of a particular geographic area, on your ability to recruit, retain and motivate a staff, and so forth.

Underneath all the obfuscating mumbo-jumbo, derivatives are tools that allow free market actors to hedge their bets, which, by itself, facilitates economic activity.

To the environmentally friendly toys store example: If you believed strongly that demand for environmentally friendly toys will increase relative to toys in general, but are afraid that the market for toys in general may be about to collapse, you would choose not to open the toy store. On the other hand, if you were able to purchase a derivative that allowed your store to make money even if the market for toys in general collapsed, so long as the market for environmentally friendly toys collapsed less, you might choose to open that store.

Derivatives, like any security, are rendered dangerous when employees of institutions both too big to fail and too big to manage bet the house with them.

While no one, in our political arena, would claim to be opposed to free markets, one can see in various proposals, a frightening ignorance on the part of many, from both parties, who would "regulate" them.