I'm shocked-shocked-to find thrt gambling is going on in here!

Attitudes to finance began to change in Renaissance Italy, and the change accelerated during the Reformation in northern Europe. As the size and risk of purely financial transactions increased, the gambling element became harder to ignore. Financiers had a choice between claiming that gambling is good and claiming that finance is not gambling. Most of them chose the latter (in theory, anyway; in practice, a good many of them were serious professional gamblers on the side).

Some of this is just euphemizing, the way Hollywood producers who spice their movies with carefully calibrated amounts of goodlooking young people running around in their underwear claim they are not pornographers, or people who alter their moods with caffeine, nicotine, or alcohol say they do not use drugs. Gambling, pornography, and drugs are for sleazy lowlifes-nothing to do with buying stock, reading D.H. Lawrence, or taking Prozac prescribed by an MD.

If you like to make these distinctions, it's fine with me, but don't blind yourself to the reality of the associated businesses. This chapter is not about silly things people said to avoid using the word gambling with respect to finance; it's about silly things people did.

Let's start with an easy one: British premium bonds. These are the most popular individual investment in Britain-23 million citizens own $50 billion worth (£27 billion). They are sold by the National Savings and Investments agency of the British government. Each £1 invested in these bonds gets you a number, and every month there is a lottery drawing. Two lucky numbers collect £1 million first prizes, and there are over a million other prizes, going down as low as £50. There's only about 1 chance in 24,000 of getting anything at all in a given month, but unlike a regular lottery ticket, the premium bond does not have to be torn up after the drawing; it has a chance of winning again next month.

I hope no one will argue that premium bonds are anything but a prepaid strip of monthly lottery tickets. Nevertheless, from the government's point of view, they are just like any other government bond. The government gets money today and pays out interest every month to the bondholders. Instead of paying the same amount to every bond, as is the usual practice, the government pays 50 to 1 million times face value on a million bonds, and nothing at all on 26 billion other bonds. That doesn't matter to the government, only to the bondholders.

The National Savings and Investment web site offers two choices: "guaranteed returns" and "high potential returns." The guaranteed returns are standard investments such as fixed-rate government bonds and savings certificates. There are two options for high potential returns: the premium bonds and the "guaranteed equity bond," a similar bond for which the payout is based on the performance of the stock market rather than a lottery drawing.

Conventional financial theory says there's a world of difference between the (gambling/bad) premium bond and the (investing/good) guaranteed equity bond. From an investor's point of view, the only difference is distribution of payouts. The premium bond is riskier than the guaranteed equity bond if you buy only one, but safer if you buy a large number. Whereas the premium bond has a known expected return, you have to guess about the guaranteed equity bond, but it appears to be about the same. A major disadvantage of the guaranteed equity bond is that it will deliver its highest returns when most people are least likely to need them-when the economy is good, there are plenty of jobs, and other investments are doing well. From the government's point of view, there's no difference at all. It gets money today and either distributes monthly interest payments to bondholders via lottery or invests the monthly interest payments in the stock market according to a complex formula and returns the winnings (if any) to bondholders.

But you could argue that the difference is that the guaranteed equity bond causes the government to invest the monthly interest payments in the stock market. That means the government is buying stocks from other investors. Those other investors might take the government's money and make real investments-say, buying newly issued stock directly from companies. In that case, the guaranteed equity bonds resulted in real money being devoted to real economic effects. But what if that didn't happen? What if the government didn't buy stock? What if the people who sold stock to the government just spent or hoarded the money, and the people who bought the guaranteed equity bonds used money that otherwise would have been invested in real economic activity? Then the guaranteed equity bond has exactly the opposite effect, taking money that was used for investment and devoting it to gambling.

If all of this is sounding impossibly abstract, you're right. The simple truth is that no one knows the effect of offering premium bonds versus guaranteed equity bonds versus straight bonds versus straight stocks. There's no grand theoretical answer, or if there is, no one has found it yet. The bald truth is that both these products, and all retail financial products, are designed for their appeal to investors, not their subtle effect on the economy. If investors like to gamble-and most people doissuers will find ways to accommodate them.

Virtually all financial products and institutions have some deliberately added risk, beyond anything that can be justified as naturally arising out of life or economic activity. Some of it, like the lottery numbers drawn in premium bonds, is done to increase appeal to investors, the way packaged food often slips in a lot of sugar and salt. Economists are often uncomfortable with this fact because conventional utility theory argues that investors shouldn't like the extra risk. We'll see the hole in that argument in the "Utility Belt" chapter (Chapter 10). But as a result, many economists prefer to ignore premium bonds entirely and deny the existence of risk additives in other financial products. If you want to make a living in finance, or use financial products wisely, you have to understand the additives.

Not all food additives are to make the food more appealing to consumers; preservatives and stabilizers are there for the convenience of the packager. Of course, "preserve" and "stable" sound nice-you wouldn't say "we put stuff in this food so even bacteria won't eat it." Financial institutions add risk to assets for the same reason: so people won't consume or hoard them. Other additives ensure the correct amount of clumping in food-you don't want some things to crumble or other things to cake up. Adjusting the risk in exchange markets, rather than the assets themselves, changes the distribution of wealth among investors. If security ownership is too concentrated or too dispersed, it causes real economic inefficiencies. The polite phrase for this processing is capital formation.

A capital asset is one held for the purpose of making money. That's got nothing to do with the asset; it's all in the mind of the owner. The father of a friend of mine was a General Electric engineer who carried two identical pens in his shirt pocket protector. He bought one himself for personal writing and took the other from the office for company work. Both pens were assets, but only the second one was a capital asset. In order for the economy to grow, people have to be persuaded to use assets to make money, rather than hoard them or use them for personal enjoyment. An important role of financial institutions is to encourage this kind of thinking.

One of the best ways to form capital is to concentrate assets. Suppose 1,000 people each have $1,000 under their mattresses for emergencies. Talk them into holding a lottery and letting one lucky person win the entire million and-voila!- instant capital. Nobody keeps a million bucks under their mattress; most people i j would invest it. Some people would spend it, but that's okay, too. Spending adds to business profits, and the profits add to capital. Moreover, increased business profits encourage other people to invest. There's another advantage, too: The 999 losers will engage in economic activity to rebuild their emergency funds, which is going to create more capital as well.

Conventional economics treats the stock market as a convenience for people who want to buy and sell stocks-sort of an eBay for stocks. But that doesn't begin to explain either the number or the volatility of stock market transactions. Only a tiny fraction of stock market trades are to change the exposure of an end investor to the market; most are zero-sum bets of one investor with another. If the stock market as a whole goes up 10 percent during the year, the average investor, of course, makes 10 percent. But individual investors will have returns all over the map, from -100 percent (losing all their money) to +1,000 percent or more, by picking winners and daytrading. If you want to understand the stock market, the volatility around the mean is a lot more important than the mean 10 percent. That's what all the traders are excited about, that's what stock market analysts write about, that's what people sue about, and that's what mutual funds (except index funds) advertise. That's why the stock exchange was built and why it makes a difference. That's the secret to making a living there or using it wisely as an individual.

Another capital formation trick relies on gambler psychology. If you put your money in a checking account, it stays the same every day. You'll put money in or take it out according to whether you need it. That's not much good for capital-most investments require having money for an extended period of time, and they have uncertain return. If you put your money in a mutual fund instead, the fund will either go down or go up. People hate to sell at a loss, so if the fund goes down, they'll do without rather than sell the fund to get money to buy things. If the fund goes up, people want to put more money in mutual funds-after all, they just made money.

Another use of gambling in capital formation is most important during bad times. When the economy is bad, there are almost no good fundamental investments. Of course, this is precisely the time it's most important to encourage people to form capital. If you don't, the bad times will never end. Most financial market transactions are zero sum. A bond has a borrower and a lender; any money the borrower makes comes from the lender. If I buy euros with U.S. dollars, someone else is on the opposite side of that trade. If I sell my GM stock to invest in Ford, again someone is on the other side of that. Therefore, even if the average return on investments in the economy is negative, a lot of smart or lucky people will be making money. In the 1970s, for example, when stock and bond prices were falling, commodity prices were going through the roof. In the 1990s, we had a run of years in which leveraged interest rate bets won big. When that crashed, emerging market investments took off. When they crashed, Internet stocks soared. Whatever happened, there was some attractive new sector to convert your excess funds into capital. If no one gambled against the grain in good times, there would be no winners to inspire people in the bad times.

I don't claim that gambling is essential for capital formation. Some day, a sensible economist may open a "health food store" institution that serves financial products with no added risk. Fully informed investors may maximize utility by converting parts of their income into capital. Some people might claim this has already happened, citing low-cost index mutual funds as examples. I think there's more added risk than meets the eye in those, but I agree that they involve less risk than active mutual funds or direct stock trading. But I think there's a reason that gambling has always been the dominant technique for capital formation, and I expect it to continue for the foreseeable future. If you want to understand the financial markets, you have to understand the risk additives.

Financial institutions are responsible not only for capital formation, but for capital allocation as well. Which projects will get the scarce capital? You might think that these decisions should be made by committees of experts, with degrees and extensive business experience. It turns out that those people do a terrible job of it, whether they are employed by the government or in the private sector. This is especially true in dynamic sectors of the economy. Capital allocation is more like a game than an art or a science, and games players seem to do the best job of it. Successful financial markets have to attract traders with the right kinds of skills, which means devising the right kinds of games. Economists tend to assign traders passive roles, filling orders and providing liquidity to cover short-term imbalances. Real traders are not like that at all. They are essential and highly paid participants at the core of financial markets. In fact, they are the only essential. With good traders you can form and allocate capital without a building or regulations or centralized information. Without good traders, those other things are no more efficient than government-run programs.

Traders have important roles even after they stop trading. Fortunes made buying and selling securities have underwritten economic revolutions. The impact of this money is much greater than fortunes gained in business or other ways. Former traders have also moved on to new jobs that influenced the economy without direct investment.

HEDGING BETS

Risk denial led to absurdities such as the refusal to use probability theory to price life insurance until the 1830s. For 250 years before that, the basic mathematics had been applied to games of chance, but insurers had to claim that life insurance was deterministic sharing (determinism and sharing were popular among Protestant religious leaders) rather than a bet that you would die. After all, everyone dies, so life insurance is not a bet but an investment.

This was not just a verbal formula; the refusal to use mathematics led to huge mispricings. Government annuities were sold at the same price to people of any age. Insurance companies failed to gather the statistics that would lead to rational actuarial predictions.

After enough losses, some anonymous genius came up with the answer. Insurance, the revised argument goes, shares the same mathematics as dice or roulette, but it differs in an essential respect. Gamblers create risk artificially for entertainment, while insurance allows people to hedge risk that occurs naturally. So insurance companies can use the mathematics the dice players invented without being sinful gamblers.

Thus was invented the concept of hedging, making a bet that is risky in itself but reduces your overall risk. It sounds great, but it fails more often than it works. Many financial disasters can be traced to people who thought they were hedging. The problem with the idea of hedging is that it depends crucially on the scope of your analysis. When you look at a larger picture, what seemed to be a hedge turns out to increase risk.

The other trouble with the hedging explanation is that it isn't true. Life insurance does not hedge the risk of dying-it has no effect on that. In principle, it could be used to reduce the financial consequences on your dependents if you die early. If that's what people used life insurance for, then young wage earners with lots of dependents would need a lot of life insurance, while single and retired people would need little or none. About half the people alive today will consume more than they earn over the remainder of their lives. They should hold negative amounts of life insurance (a life annuity is a form of negative life insurance-you get paid for living longer rather than for dying early).

The numbers show that the amount of life insurance held is unrelated to the amount of risk that is supposedly being hedged. If anything, there is a negative correlation: People who need a lot of insurance are less likely to have it than people who need negative insurance. In the United States, the aggregate amount of life insurance held is roughly equal to the financial exposure of individual families, but it's held by the wrong families. Overall, life insurance exaggerates the financial impact of people dying early; it does not hedge it.

I'm not against insurance. Some people do buy it to hedge. Every day someone's house burns down, and she collects from an insurance company to cover the loss. Some young wage earners scrimp on their budgets to afford enough insurance to pay off the mortgage and put the kids through college if the grim reaper calls early.

But let's be realistic. Most people, including most college graduates and most wealthy people, play the lottery. Many people spend large amounts-$50 or $100 per week. For amounts like this you can buy insurance policies with payouts similar to large lottery prizes. Typically, the state takes 55 percent of the lottery player's dollar off the top, then the federal government takes 28 percent from any wins (plus the state dips again). For serious players, there is another tax. Because they use smaller prizes to buy more tickets, the state's effective share rises from 55 percent to about 85 percent. So for every lottery dollar spent, the serious long-term player expects to get back about 10 percent.

Doesn't it make sense that at least some of them would prefer to buy a life insurance policy on a convenient spouse for the same amount that will pay off with certainty and gives them back an average of two or three times what they pay in, or more, instead of 10 percent? What if the premiums were tax deductible, unlike lottery tickets, and the winnings tax advantaged? Wouldn't it be crazy if none of them did it? The demographic evidence suggests that people who hold otherwise hard-to-explain amounts of life insurance are similar to heavy lottery players, except they are richer.

Proceeds of voluntarily purchased life insurance are spent more like lottery winnings than as if they were replacing the lost income of a wage earner. Life insurance holders get good press and lottery ticket buyers get bad, so you might think the insurance payouts are placed in sensible investments to support widows and orphans, while lottery winnings are wasted in wild debauch. In fact, both of them tend to be used to make permanent increases in the social status of relatively young people (for example, sending children to college) and to make a permanent lifestyle change for older people (for example, selling the suburban house and buying a condo in Florida). For most purchasers of each product, it is the only financial product likely to accomplish the goal. Life insurance is more sure, but it requires someone to die to collect. It makes the most sense when the desired lifestyle change is only for one.

Once insurance companies accepted gambling analysis, they funded enormously useful research about risk. On one hand, the development of actuarial science led to important progress in the field of Statistics, with a capital "S." On the other hand, companies gathered volumes of data about the risks people face in everyday life, statistics with a lowercase "s." Hundreds of millions of people were allowed to make bets that improved their lives. They got reasonably fair odds and didn't have to break the law to bet. Tax rules were skewed in their favor instead of heavily against them, as with casino gambling and poker.

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