In Defense of Friction

Our financial lives could use less efficiency and more friction.

Posted Jan 14, 2009

When automobile manufacturers struggle to squeeze as many miles per gallon as possible out of their car designs, any feature of the design that impedes the forward motion of the vehicle--friction, or air resistance--is the enemy. The aim is to design a vehicle that uses every ounce of fuel to move the car forward as efficiently as possible.

And so it is in the world of finance. As historian Niall Ferguson reminds us in his recent book, The Ascent of Money, hard as it is to imagine, people didn't always have money. The invention of money went a long way toward reducing the friction--the inefficiency--in financial transactions. No longer did the farmer have to drag sacks of potatoes to the marketplace to trade for eggs and milk. Money was a medium of exchange that greatly reduced the financial "coefficient of drag."

Arguably, much that has happened in the financial world over the last 200 years can be seen as a continuation of the revolution in efficiency begun by money. Credit, for example, meant that you could go shopping for eggs and milk without even having the money. The farmer could promise to pay it at a later date, after the potato harvest. Nor did the farmer need to save up the surplus from many years of bumper crops before expanding the amount of land under cultivation. It was possible to get the land now, with credit, and pay for it over time, in part with the proceeds from newly cultivated acres.

Much more recently, financial markets have been all about efficiency. This is one way to understand the oft-cited distinction between the "real economy" and the "financial economy." Like point masses moving in frictionless, Newtonian vacuums, financial transactions are so far removed from the material entities that underly them that transactions can occur with lightening speed, with nothing to slow them down. The creation of stock option markets means that you don't have to go to the trouble of actually buying a stock that you are going to be selling soon anyway. You can just promise to buy it and then sell it at a price and date specified by the option contract. And then you can trade the option rather than the underlying stock.

And bundling mortgages into securities reduces the time-consuming, unproductive friction involved in checking the credit-worthiness of each mortgage applicant. You can just let the mortgages of the many work to indemnify the occasional defaults of the few. Similarly, credit card interest rates of 20% or more eliminate the need for credit-card companies to spend time unproductively checking the credit of applicants. High interest rates more than cover the occasional delinquent. Home equity lines of credit mean that homeowners can borrow a big pile of money (or have the potential to borrow a big pile of money), and have it at the ready, even when there is no pressing need. Instead of having to go through red tape to get a loan when your kitchen pipes burst, or your car engine dies, you can just write a check. And A.T.M.'s mean not having to fill out withdrawal forms and stand in bank lines.

Each of these developments has made it easier to do ones business without wasted time and energy--without friction. Each has made economic transactions quicker and more efficient. And that's obviously good. But the current financial crisis suggests that maybe, there can be too much of a good thing. If loans weren't securitized, bankers might have taken the time to assess the credit-worthiness of each applicant. If homeowners had to apply for loans to improve their houses or buy new cars, instead of writing checks against home equity, they might have thought harder before making weighty financial commitments. If people actually had to go into a bank and stand in line to withdraw cash, they might spend a little less and save a little more. If credit card companies weren't allowed to charge outrageous interest, perhaps not everyone with a pulse would be offered credit cards. And if people had to pay with cash, rather than plastic, they might keep their hands in their pockets just a little bit longer. These are all cases in which a little friction to slow us down would have enabled both institutions and individuals to make better decisions. And in the case of individuals, there is the added bonus that using cash more and credit less would have made it apparent sooner just how much the "booming 90's" had left the middle class behind. Credit hid the ever-shrinking purchasing power of the middle class from view.

So perhaps now the time is right to stop worshipping the god of efficiency and bring a little friction back into our lives. One way to do this is to reintroduce transactions that are real transactions--person-to-person and face-to-face. A second is to rekindle certain social norms that serve to slow us down. For example, no one goes bankrupt on purpose, but if bankruptcy became a little more of a disgrace and embarrassment and a little less of a financial strategy, people and firms might do more to forestall it. And if people thought about their homes less as investments and more as places to live, full of the friction of kids, dogs, friends, neighbors, and community organizations attached, there might be less speculation with an eye toward house flipping.

We'd all like a car that gets 100 miles to a gallon. The forces of friction and air resistance that slow us down are an expensive annoyance. But the thing is, when we're driving a car, we know where we're going and we're in control. Fast is good, though even here, a little bit of friction can forestall disaster when you encounter an icy road.

Life is not as predictable as driving. We don't always know where we're going. We're not always in control. Black ice is everywhere. A little something to slow us down in the uncertain world we inhabit may be a life saver.