Suppose you have money to invest. Suppose you invest in lottery tickets. This is a high risk, high return investment.
Or you could loan the money to a friend. This is a lower risk, lower return investment.
But what if you loan the money to a friend for the friend to buy lottery tickets? This is financial obfuscation. It looks like the money was loaned to a friend, but in reality the money was invested in lottery tickets. The actual risk is much higher than the apparent risk. This is a high risk, low return investment disguised as a low risk, high return investment.
Investors prefer low risk, high return investments. But low risk, high return investments are rare. So there are always opportunities for crooks who can disguise high risk, high return investments as low risk, high return investments. If a crook can fool investors into thinking that the crook's business is low risk, the crook can borrow money at low interest rates. The crook can then invest the money in high risk, high return investments. If the high risk investments pay off, the crook pays low returns to the investors and keeps the rest of the profits. If the high risk investments fail, the crook is bankrupt and the crook's investors take the losses.
The ideal investment for the crook is something which earns a moderately high return most years, but occasionally generates very large losses. If the crook is lucky, the crook will earn high returns for several years in a row, which will earn the crook a reputation as a financial genius, and then the crook can borrow even more money, until the crook's financial house of cards inevitably implodes. Lottery tickets are an example of a high risk, high return investment; but would not work for this scam because lottery tickets lose money most years. This scam usually involves betting that the economy will be moderately prosperous, and that stocks and real estate will increase in value by a moderate amount; for example by selling puts or default insurance (like AIG prior to 2008), or by buying stocks or real estate on margin.
If the crook is lucky, the scheme will appear to be successful for several years. More investors will invest in the scheme. Other crooks and deluded financial entrepreneurs will create additional versions of the scheme. Eventually the scheme may involve a significant part of the financial markets. When the scheme implodes, the whole economy is affected.
After the crash, investors will be much more suspicious of financial obfuscation. It will impossible for crooks to use financial obfuscation. After several years without financial obfuscation, investors will relax, crooks will invent a new form of financial obfuscation, and the cycle will begin again. Fraud causes crashes, crashes cause investor vigilance, investor vigilance prevents fraud, lack of fraud causes investor complacency, investor complacency causes fraud, fraud causes crashes. The cycle is caused by human nature and cannot be avoided.
Wise investors try to avoid investing in financial obfuscation schemes by avoiding new forms of investment and preferring traditional investments, such as by investing in stocks and bonds and avoiding derivatives. However, clever crooks or deluded financial entrepreneurs may succeed in disguising new forms of investment as traditional investments.
Financial obfuscation is made worse by secrecy. Investors often have too little information to judge if an investment is really as low risk as the promoter claims. It might be possible to reduce financial obfuscation and make the economy more stable if the government requires more financial disclosure. However, existing financial disclosure laws produce mostly useless information. The flood of useless information makes it harder to find useful information. Previous financial disclosure laws have been ineffective because of government incompetence. Additional financial disclosure laws are will probably be equally ineffective because the government is too incompetent to make good financial disclosure laws.
Financial obfuscation is made worse by an excessive fear of risk. Financial obfuscation usually hides risk. The more investors want to avoid risks, the more incentive there is for financial entrepreneurs to hide risks. Investors who are focused on avoiding risk are more likely to fall prey to risks hidden by financial obfuscation.
Financial crises are usually caused not by excessive risks, but by hidden risks. But governments usually respond to financial crises by requiring banks and other financial businesses to reduce risk. It is usually easier and more profitable to hide risks instead of reducing risks. So the banks and financial businesses will hide risks so they appear to have less risk. Thus government attempts to reduce risk increase the amount of hidden risk, which will make the next financial crisis worse.
For example, suppose a large corporation has a pension fund. The government wants to ensure that the pension fund is well managed, so the government regulates the pension fund. The workers want their pensions to be safe, so the workers lobby the government to require that the pension fund be invested in low risk investments. The investors in the corporation want to increase profits by reducing contributions to the pension fund, so the investors lobby the government to require the pension fund to invest in high return investments. So the government tries to please everyone by requiring that the pension fund invest in low risk, high return investments. Low risk, high return investments are usually fraudulent. The government's attempts to ensure that the pension fund is well managed causes the pension fund to be badly managed. The mismanagement of the pension fund will probably be hidden for several years, then be exposed suddenly. The government's bad policy makes the next financial crisis worse.
There are certain fundamental risks in the economy, such as the risk of an earthquake or the risk that an expensive factory will become obsolete, which cannot be avoided. These fundamental risks are best managed through diversification. However, government regulations against risk cause many investors to avoid these risks, so these risks are concentrated instead of shared. These fundamental risks are stable and constant. But the perception of risk is unstable and variable. The economy would be more stable if the perception of risk could be stablized. But I think it is not possible to stablize the perception of risk without destroying the free market.
Financial crashes are usually associated with excessive debt. So maybe financial crashes could be avoided if the government restricted debt. However, financial entrepreneurs would probably invent loopholes and workarounds and ways to pretend debt is not debt, so I doubt that any government restrictions on debt would be effective. But most governments encourage debt. The government should stop encouraging debt, so that there will be less debt, which will make the next financial crisis less bad. For example, corporations are required to pay taxes on money paid to stockholders, but not on money paid to bondholders. The government is taxing corporations with less debt and subsidizing corporations with more debt. So corporations increase debt to reduce taxes and increase subsidies. Also, the government requires many insurance companies and pension funds to buy bonds instead of stocks. So corporations increase debt because bonds are preferred by investors because the government requires investors to prefer bonds.
Most corporations raise capital through a mix of stocks and bonds. Most investors buy a mix of stocks and bonds. If corporations issued stock and no bonds, and investors bought stocks and no bonds; the same risks and profits would be distributed to the same investors, so investors would have the same total return, but there would be lower administrative costs, and the whole financial system would be simpler, and it would be more difficult to hide risks.
Risks hidden by financial obfuscation usually involve financial intermediaries with assymetrical terms. For example, if you lend money to a friend and the friend buys lottery tickets with the money; then the friend is a financial intermediary because the friend is borrowing from you and then lending to the lottery; and the terms are assymetrical because the terms of borrowing from you are different from the terms of lending to the lottery. Hidden risks, financial obfuscation, and financial crises could be vastly reduced if the government outlawed financial intermediation with assymetrical terms. However, this would eliminate traditional banking. All retail banks, commercial banks, investment banks, stock brokerages, pension funds, and insurance companies would have to reorganize themselves as mutual funds. Mutual funds are the only financial intermediary which does not have assymetrical terms. Pension funds would have to be defined contribution, not defined benefit.
I think that outlawing financial intermediation with assymetrical terms would be a good idea, but I am not sure about this because it would mean a drastic change in the financial system. Also I am not sure how to reorganize an insurance company as a mutual fund. I think the government should be based on competitive federalism, and a few of the competing governments should try outlawing financial intermediation with assymetrical terms, so we can try it out on a small scale and see if it works.