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The dangerous complexity of our financial system

December 29, 2011 | 10:37 am

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The financial crisis exposed the world to just how complex and powerful the world's financial system has become.

Since the crisis, there have been discussions about how to rein in that system, but questions have arisen about whether humans are smart enough to do it.

These questions have fueled a debate in recent days that has drawn in some of the smartest minds in the blogosphere and shed important light on the industry that brought the world credit default swaps and synthetic collateralized debt obligation.

It began when Lisa Pollack, a writer on the Financial Times' blog, pointed out that our best minds have become better at abstract thinking, and have applied those skills to designing financial instruments:

The people who are best at such reasoning stay longer in education, and get even better at abstract thinking, becoming even more intelligent… until one day, after many years of study, a good portion of them land in investment banks. So what do you think happens next?

This provoked a lengthy and carefully reasoned essay from Steve Randy Waldman, who argues on his blog that such complexity in our banks is necessary to sustain the incredible affluence of our society. According to Waldman's reasoning, complexity is necessary because it allows people to be essentially tricked into taking financial risks that they would not take if they fully understood the risks. It is only when people take such risks that economic progress happens.

"Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper," he writes.

This drew an impassioned response from Mother Jones blogger Kevin Drum, who was more skeptical of the status quo. It is Drum who makes the point that finance has become so complicated that no one -- not even the smartest banker -- can actually understand it.

I don't think anybody can be said to genuinely understand global finance anymore. We understand certain large-scale features, and we understand certain minuscule details. But the middle ground, where most of the day-to-day action is? It's mostly a mystery. Financially speaking, we are all willing slaves of a capricious and uncaring master.

The discussion has gone on from there. It has produced no clear answer to how the complexity should be dealt with, but it has at least shed some light on just how complex things are. In case that wasn't clear already.

RELATED:

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Financial reform package wouldn't change Wall Street much

--Nathaniel Popper

twitter.com/nathanielpopper

Photo: Traders at an exchange in Shanghai. Credit: China Photos/Getty Images

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