More and Better

After the wholesale discrediting of the strong form of the efficient markets hypothesis, Robert Shiller may be the most respected financial economist in the world at the moment. This is what he has to say on the last page of Justin Fox’s The Myth of the Rational Market:

Finance is a huge net positive for the economy. The countries that have better-developed financial markets really do better. . . . I think that we’re less than halfway through the development of financial markets. Maybe there’s no end to it.

I think Shiller’s first and second sentences are almost certainly true. There is a strong correlation between having a high material standard of living and having a relatively sophisticated financial system; think of the United States, Japan, and Germany as opposed to Zimbabwe, for example.  But you can’t infer that more financial market “development” is always better. (I’m not saying that Shiller necessarily believes that, but most of the defenders of financial innovation take it for granted.)

Just because something is good, it doesn’t necessarily follow that more of it is better. Take food, for example. It’s pretty obvious that over a wide range – say from 0 to 1500 calories per day – more food is better for you. For most people that range probably extends up to 2000 calories or a little more. After that, not so much.

I and others have made this point about financial innovation. You could make a similar argument about health care technology. To a point, using more technology – scans, implants, drugs, etc. – does correlate with better outcomes. Beyond that point, if the technology is being used instead of preventative medicine and old-fashioned doctoring, it doesn’t provide much incremental value, and may actually hurt. (If, in addition, the high use of technology is pushing up the cost of health care and making it unaffordable for millions of people, then it may really hurt.) Really all we’re talking about is the fact that marginal returns tend to diminish, and they can diminish to zero.

I’m not saying that we should put a lid on financial (or medical) innovation once and for all. As the economy changes over the next decades and centuries, the financial system we need will change as well. But this fallacy that more of a good thing must always be better is so simple and so deep-seated that it’s worth being aware of it.

B y James Kwak

60 responses to “More and Better

  1. Financial market “development” doesn’t necessarily mean that there’s more finance. When Shiller says that we’re less than halfway through, and that there may be no end, I seriously doubt that he means that the financial sector will double in size and possibly grow forever.

    In this quote, I’d wager that “development” means something closer to “accumulating wisdom”, which is clearly something that financial markets are still doing and must do much more of.

  2. Carson Gross

    Say it with me kids: association does not imply causation.

    I assert, without proof or expertise, that we would be better off today with a simpler, less bubble prone financial sector where leverage limits (and only leverage limits) were tightly regulated by stupid, mirthless accountants whose only reaction to any proposed accounting innovations was a gutturally grunted “NO!” Our best students would become scientists, engineers, entrepreneurs and doctors (at least until we socialized medicine) rather than bankers or politicians.

    Truly, God help us if we are only half way through the financialization of our economy.

    Cheers,
    Carson

  3. Finance in America has become a vacuum for sucking up capital. Astronomical wages paid out to execs in a sector that absorbed astronomical funds from a bailout when innovation proved to offer only a mirage. Combine that with the astronomical losses most people have seen in their retirement and college portfolios. Finance isn’t always a “net positive.”

    Also find it hard to separate America’s prosperity from the physical bounty we have been graced with. Incredibly fertile land, abundant fresh water, room to grow crops, no costly, deadly and ongoing wars on our territory are elements that vastly differentiate us from places like Zimbabwe. Can’t simply attribute our good fortune to our beloved financial sector….

  4. That’s a great post James. I recently promised myself I gotta put Kafka on my “must read” list. Now I’m thinking I gotta put Robert Shiller on my “must read” list. Too much stuff, you can never get around to all of it.

    But that’s a super outstanding post James, I think your writing is getting better. I like the comparison you make between caloric intake, the use of technology in health care, and financial innovation.

    This is why I keep saying credit default swaps should be OUTLAWED. Credit default swaps should be illegal. Right now the minuses far far outweigh the pluses. Why not walk away from CDS’s for maybe 5 years? A 5 YEAR MORATORIUM ON CDS CONTRACTS OR TRADES. Let some of these high paid professors and think tanks try to create some tests on these instruments. Using poker chips or whatever with students as market participants in some game. These instruments haven’t really been around for what, 5 years??? Let’s take a couple steps back, let the market stabilize again over a 5 year period, then if we decide these things are worth another look fine. Bring them back in 2014. But it’s crazy to step back into this when we still don’t know all the permutations that come out of credit default swaps.

    Who will provide the insurance for the next economic crisis that comes??? Who CAN provide the insurance necessary for the next crisis???

  5. I have to disagree (surprise!). I’m not saying that financial innovation is ALWAYS good. In fact, I would argue that there are more people in your camp these days than in mine. I would argue that innovation is good in aggregate, just as it is in every other scientific field. If we look at scientific innovation and invention across the last 100 years, not every individual accomplishment has turned out to be a winner for society. However, because society is good at cutting the losers and running with the winners, innovation has tended to be a net positive in the technological sense.

    I would say the same about finance. The problem isn’t financial innovation per se, its making sure that we are flexible enough to determine which innovations are really useful, and which are actually harmful. Sometimes those answers won’t come for many years. I’m sure that after Hiroshima and Nagasaki, many people believed that splitting the atom was a net negative for mankind. Fast forward 50 years, and nuclear technology presents one of the only viable alternatives to our dependence on fossil fuel based energy.

    As for CDS, or CDOs, or what have you – its important to realize that the failing of the efficient market hypothesis has nothing to do with financial products in and of themselves. Rather, markets fail because of the participants – the humble human being. Bubbles have existed long before CDOs in much more vanilla products, such as stocks, real estate, and tulips. Unfortunately regulator’s are so product-focused that they forget about the underlying human nature that drives the market.

  6. You draw interesting analogies between the abundance of food and the abundance of medical technology as well as with the abundance of financial ‘innovation’.

    I’d throw in the abundance of ‘news’ brought to us by our current 24 hour news cycle. News is something of obvious value when it is scarce. It seems we have evolved to desire a nearly unlimited amount of anything purporting to be news. Much as we’ll take on board unlimited amounts of fat and sugar if we don’t think our way around our instinctive behavior.

    Are you aware of anyone that has done or is doing any work on a more general understanding of the disutility of such abundance?

  7. Also find it hard to separate America’s prosperity from the physical bounty we have been graced with. Incredibly fertile land, abundant fresh water, room to grow crops, no costly, deadly and ongoing wars on our territory are elements that vastly differentiate us from places like Zimbabwe.

    This is right, and we can go further with it.

    The fundamental reason for the alleged (i.e. measured purely in materialistic terms) prosperity of modern civilization, and the basis of its vaunted productivity, has been the one-off shot of cheap, plentiful fossil fuels.

    Only fossil fuels enabled the Industrial Revolution, prior to which material living standards had changed little throughout history, and only fossil fuels “proved Malthus wrong” in allowing homo sapiens to temporarily overshoot normal environmental limitations.

    Now that we enter the transition of fossil fuel depletion, civilization will revolve back to its natural, pre-industrial baseline.

    As for the finance “industry”, it contributed little but complexity and volatility during the fossil fuel blip. It helped make the whole structure more top-heavy, more interdependent, less resilient, less robust.

    It’s a big part of the reason why the restoration of normal conditions of civilization will be far more turbulent and impose far more suffering than had to happen.

    That’s its great crime.

  8. Whoops, I screwed up the italics. The quoted part ends with “Zimbabwe”.

  9. I think it’s well-established that financial market development isn’t always good for growth.

    The experience of the 90’s shows that financial market deregulation and opening the capital account (which ought together to increase the size and complexity of a country’s financial sector) was not beneficial for many developing countries, and in some cases was even harmful.

    Even the World Bank explicitly recognizes this- one of the best analyses of the experience is in their publication “Economic Growth in the 1990s”:

    http://www1.worldbank.org/prem/lessons1990s/

    There is a lot of data to support the claim that institutions are what drives economic growth. An interesting hypothesis, that I am sure Simon Johnson would love, is that a measure of institutional quality could include both the strength and size of financial institutions, and the quality of institutions that regulate financial institutions. In that model of institutional quality, having institutions that were stronger than the ability of a country to regulate them would have a negative impact on institutional quality, and hence on economic growth.

  10. i’m going to assert, without proof or expertise, that people without proof or expertise should design the efforts of large sectors of the economy.

    i’ll start by hiring some physicians run software companies.

  11. winstongator

    Are Zimbabwe’s political problems due to a poor financial system, or are its financial problems due to a poor political situation?

    The Heritage foundation puts out an index of economic freedom and correlates a score on 10 subjects – relating to taxes, govt spending & other things – to per-capita GDP. If you do individual correlations, the biggest impediment to high GDP is govt corruption. Higher taxes correlated with higher pc gdp from the year I checked.

    Is the financial sector today a net positive or negative on overall corruption levels?

  12. I have to agree that too much of anything can turn bad. However I don’t think we’ve even come close to reaching the pinnacle of financial engineering. Whether this is for better or worse only time will tell. The most recent round of engineering was lauded as genius and failed to do anything other than creating a massive market failure in banking that called for an incredible amount of government intervention in order to prevent a full on depression. Sorry for the run on sentence.

  13. One of the famous design slogans is: More is less Mies van der Rohe, Buckminster Fuller and Philip Glass among its famous practioners.

    Perhaps the financial industry has something to gain from this theory.

  14. My take on Schiller’s comment (without having read the book) is this:

    1. Financial development helps channeling funds from savers to investors with high return projects. That is why countries with high financial development have higher income per capita.

    2. There is a lot that can be done yet to channel those savings to the highest return projects.

    3. This crisis (and previous ones) shows, in fact, that we are far from that optimum, given the fact that a lot of savings were going to low return projects (although they looked high a priori).

  15. Therefore, rhetorical questions for financial innovation:

    More is better? or More is less?

    “More is less” captures the driving aesthetics in Modern architecture. Mixed reviews on modern architecture. Which lead us to Post-Modern architecture and Deconstruction. Mixed reviews on Post-modern architecture and Deconstruction. The prevailing style now being “Green” architecture.

    But still: ‘More is less” may be a theory financial engineers could consider in their evolution.

  16. Have you read Enough by John Bogle (founder of Vanguard)? If not, I think you’d really like it…

  17. More is less, seems to me much better, at this point in time. Rhetorical questions: Have financial engineers been designing junk? (Jury in on this question.) Are financial engineers able to do better by designing products that have real social value?

  18. Carson Gross

    Oh, because the “experts” have been doing such a bang up job, right?

    I don’t think that expertise that can exist at the micro-level in a given profession, such as engineering, mathematics or medicine, can exist in the same way at a macroscopic level. That is why I don’t think professional politicians are a good thing, that’s why I think macroeconomics has failed so spectacularly and that’s why all those statistical computer models of the mortgage market have proved worthless. What is skill at a micro-level just strikes me as hubris at the macro-level.

    Common sense and even a bit of stupidity is what is necessary for designing the sort of legal and economic system I’m interested in living in. Look at the Bill of Rights. Beautiful.

    OTOH, I’m not a political/economic theorist. So I suppose I should defer to my intellectual betters on these matters.

    Cheers,
    Carson

  19. There is a cost to unfettered innovation on top of the basic R&D and launch figures. Within a single mfg. company unfettered innovation can cause detrimental impacts to infrastructure, quality control and customer comprehension. Within finance it appears that the cost of launching a new product is so low and the benefit of consumer confusion so high that rabid innovation may always be the result without some kind of controls in place. Lord, did I just say that? I thought I was for free markets… arghhh.

  20. Thanks Anne, I’ll check it out.

  21. It’s kind of like “water” – everyone needs water to live, but “better water”? Not so clear.

  22. The analogies in this post make no sense at all. First, the world economy is not a single consumer. Second, the question with financial innovation isn’t more of something, it is more types of things. Third, the real challenge isn’t whether there is a use for new types of financial products, it is preventing them from growing beyond those uses.

    Finance has always been plagued by fads that make the new and the exotic far more prevelant than makes sense. The question for regulation, therefore, is whether the upside of innovation is worth the downside of overuse. That’s a much harder question.

  23. ” But you can’t infer that more financial market “development” is always better. ”

    This is easier to see if your main field of study is Political Economy, within which economics and finance play important, but not exclusive, roles. Ethics and Politics figure in as well, for example.

    For that reason, the idea that Narrow Banking can’t be a solution because it’s a product of an earlier and simpler age doesn’t work. There’s no end to the question of determining who we want to be, and who we’d like to become.

  24. This is a video of Shiller debating Taleb:

    http://www.newyorker.com/online/blogs/newsdesk/2009/05/new-yorker-summit-video-nassim-n-taleb-and-robert-shiller.html

    In fact, it was not supposed to be a debate. Taleb and Shiller were supposed to be on the same side. In the end, it did turn into a debate with Taleb eviscerating “experts” and Shiller defending them.

    Form a theoretical point of view, we cannot a priori rule out the possibility that there may be some financial invention that will make the flow of money more productive for society as a whole. From a pragmatic point of view, how many instances of such inventions can we point to? Paper money, bonds, credit cards?

    I’ve always wondered about the guys working at Goldman Sachs. They are presumably intelligent reasonable folks. How do they view the value of their work? Are they cynics who know it’s ultimately worthless to society but don’t care as long as it brings them money? Or do they delude themselves into thinking like Shiller that financial engineering is valuable to society?

  25. “From a pragmatic point of view, how many instances of such inventions can we point to? Paper money, bonds, credit cards?”

    If you asked someone from Goldman (or elsewhere in the industry), I’m sure they could give you a long list. The fact that the list lay people come up with is short is misleading.

    But I will give you one more: the vanilla mortgage backed security. Expanding the secondary market for traditional mortgages brought down interest rates and increased home ownership substantially long before things spun out of control (and got more exotic).

  26. It is said “But you can’t infer that more financial market ‘development’ is always better”

    Oh yes you can! What you cannot do though is believe that all growth in the financial market is development.

    For instance the use of non-transparent credit scores as an excuse to give loans to some who should not have received loans but that end up being profitable because others are willing to pay for their non-payments should not by any means classify as financial market development… it is going in the opposite direction!

  27. Tippy Golden: “Are financial engineers able to do better by designing products that have real social value?”

    Yes, but they are biased towards other financial professionals with whom they share a world view. Like lenders. For instance, I would have thought that trickle down economics would be passe by now, having been discredited for a long time before our current crisis. However, the U. S. Treasury Department still seems to hold that view, as evidenced by whom it has been handing out money to.

  28. Shiller: “Finance is a huge net positive for the economy. The countries that have better-developed financial markets really do better.”

    I have been told — and do believe –, that Shiller is very smart. I do wish that he would make better arguments, however. You do not have to resort to argument by association to show that finance is a good thing. Much of the difference between Medieval Europe and Modern Europe has to do with finance. Futures markets benefit farmers, food markets, and consumers, as a simple example.

    But haven’t we reached the point in finance that the law of diminishing returns has kicked in? While there is room for improvement in financial instruments, other kinds of innovation may be more valuable.

    And, as for social value, is there not a tendency for creative financing to benefit financiers over consumers and taxpayers? (After all, who is doing the creating?) In discussions on this blog, how often have knowledgeable people pointed out how finance professionals could — and would –, game a proposed reform?

  29. awww, beat me to the punch. I continue to marvel at the number of times each day that supposedly ‘smart’ people use on cum hoc, ergo propter hoc to support their POV. Where do these yo-ho’s come from??

  30. Black Swan … I finally got to googling what Black Swan meant, having noticed your evocative moniker (and noticing the phrase mentioned a few times on this blog) a reference to something I did not know … and so I’m learning a fascinating topic.

  31. Absolutely agree, the law of diminishing returns has kicked in.

  32. Quite right. Gillian Tett’s new(ish) book covers this point very well, if a bit indirectly.

  33. Design by committee. Hah!

  34. Min, what financial products do you consider would be of real social value?

  35. Carson Gross

    Can you explain how making more credit available for a good makes that good cheaper? I can understand how better building techniques and cheaper labor could do so, but just more widely available credit?

    It seems more plausible to me that it simply increases demand by allowing people to forward shift income, bidding up existing prices. This is effectively a transfer of wealth from the non-home owners to home owners and banks (in interest.)

    Of course, things are reflexive, and as demand goes up, so will production (but one must always bear in mind the ‘why sell when it’s going up’ psychological economist argument as well.)

    It seems to me that in the early days of securitization we were living off the moral habits of underwriters from the bad old days. Once those moral habits collapsed… Catastrophe.

    Cheers,
    Carson

  36. What financial products have real social value?

    Futures contracts, letters of credit, mortgages, stocks, bonds, insurance, etc., etc.

  37. What new financial products might have real social value?

    I am not a financial engineer, but here is a thought: mortgages with payments that are a percentage of the borrower’s income. Obviously, that idea has to be fleshed out to cover things like extended unemployment, but it addresses the problem of income fluctuations in a flexible manner. Default becomes less likely than with a mortgage with fixed payments, regardless of the fortunes of the borrower.

    IMO, one of the social negatives of financial instruments is the severing or attenuation of relationships. If a person or institution reduces or eliminates their responsibility by transferring their risk to some other person or institution who does not take on the responsibility, that can be a social negative. This kind of mortgage actually tightens the relationship between borrower and lender. I think that that would be a social positive. :)

  38. Alan McConnell

    I don’t know if this is the right place to ask this
    question, or even if, in the welter of posts, this
    question will get noticed, but I’ll try anyway.

    We are now told, by many but by no means all, that
    although we are in a Recession at the moment, we
    are well poised to emerge from it Real Soon Now, and
    we should all consider how lucky we are to have
    dodged the bullet of a Complete Financial Meltdown.

    So I’d like to ask any and all experts: what would
    have happened if we hadn’t hit the Panic Button
    last September? if we(i.e. the gov’t) had simply
    let everything fail that was going to fail, had
    put banks and other financial institutions that
    failed into receivership, taking over important
    assets like e.g. insurance contracts for people’s
    homes, businesses, etc. and letting the rest
    go belly-up.

    And eventually owning bunches of stuff which would
    be reorganized and eventually the functioning
    parts would be sold back to the private sector.

    What would be “worse” about that? Would it have
    hurt the U.S. economy more than it has already
    been hurt? and what about outside the U.S. in
    particular the effects on developing nations?

    TIA for any and all responses.

    (Technical complaint: I get in my INBOX a
    daily post from a sender called “The Baseline
    Scenario”. And the Subject is also, and always,
    “The Baseline Scenario”. Could not the Subject
    be made more informative?)

    Best wishes,

    Alan McConnell in Silver Spring

  39. Carson “It seems to me that in the early days of securitization we were living off the moral habits of underwriters from the bad old days. Once those moral habits collapsed… Catastrophe.”

    From what I have been able to gather the above contains a lot of truth though it does not explain all of it. The tremendous profit opportunities that were presented by being able to sell off as an AAA something risky proved to tempting for some mortgage originators underwriters to resist.

    The financial engineering bubble!

    If you have been able to convince Joe to take a 300.000 dollar mortgage at 11 percent for 30 years and if then, with a little help from the credit rating agencies, you can convince Fred that the risk structure of this mortgage is such that it merits an investment at a rate of only six percent, then you can sell him the mortgage for 510.000 dollar, and pocket a tidy profit of 210.000 dollar.

    We then have Joe, with a real liability of a mortgage of 300.000 dollar guaranteed with a house that might o might not be worth it, and Fred, with a 510.000 dollar investment in the willingness of Joe to service his original mortgage at 11 percent for 30 year.

    Where do you go from there?

  40. “Can you explain how making more credit available for a good makes that good cheaper?”

    I don’t think anyone has argued that houses got cheaper. But credit did.

  41. Thanks Min,

    I agree, the severing of relationships in financial agreements is at the core of why things went wrong. Re-establishing the relationship returns accountability.

    It seems to me the underlying issue in the financial crisis is a moral one. Individual and systemic. Morality can be flawed and onerous. But still morality is the touch stone for civic life and, ideally, one for constant engagement.

    PS: I gave you the first quote in the story “The Rat Casino” on my blog. I used a bit of artistic licence by saying you “growled”. I had to ask myself if this was fair? I opted for artistic licence. :-) Using an edgier verb. I hope you dont’ mind. Min you don’t growl. Rather I find your comments wise and thoughtful.

  42. Tippy Golden: “PS: I gave you the first quote in the story “The Rat Casino” on my blog. I used a bit of artistic licence by saying you “growled”. I had to ask myself if this was fair? I opted for artistic licence. :-) Using an edgier verb. I hope you dont’ mind. Min you don’t growl. Rather I find your comments wise and thoughtful.”

    Why. thank you, Tippy, I am honored. :)

    At least it wasn’t the quote about killing all the economists. ;)

  43. Alan McConnell: “So I’d like to ask any and all experts: what would
    have happened if we hadn’t hit the Panic Button
    last September? if we(i.e. the gov’t) had simply
    let everything fail that was going to fail, had
    put banks and other financial institutions that
    failed into receivership, taking over important
    assets like e.g. insurance contracts for people’s
    homes, businesses, etc. and letting the rest
    go belly-up.”

    i am no expert, and so cannot make any detailed educated guesses. However, I do not think that the specter of another worldwide depression was overblown. One concern was that the U. S. would experience something like Japan’s Lost Decade, and I think that that is still a likely scenario.

    I have read two good books that talk about such things: “Extraordinary Delusions and the Madness of Crowds” by MacKay, which you can read online at http://www.econlib.org/library/Mackay/macEx.html
    and “Manias, Panics, and Crashes: A History of Financial Crises” by Kindleberger, which you can get at Amazon ( http://www.amazon.com/Manias-Panics-Crashes-Financial-Investment/dp/0471389455 ). Tulip mania crippled the Dutch economy for years. It and the bubbles of the 18th century scared the bejeezus out of people. They give a good picture of how bad things might have been, multiplied by our modern globalized financial system.

  44. For one thing we might have been able to reach faster that bottom we need to reach in order to start growing again on firmer ground. There is nothing like being able to go out and sing “Oh what a wonderful morning” being sure you have reached bottom… as is we are still prepared to fall further

  45. Alan McConnell

    Hey, someone paid attention to my question.
    Thanks, Min.

    To comment on your answer: you seem to imply that
    if we’d let the firms tumble, we might have got
    mired in a world-wide depression. I would comment:
    a) we may already be in one, and do you or does
    anyone have evidence that the rest of the world
    was that heavily invested in e.g. AIG?
    b) if we had just let the firms go that were
    going to go, and not spent billions on the TARP
    and other programs to restore eonomic health to
    Greenwich CT, we would have had money to do something
    about e.g. Flint MI, where according to Michael
    Moore every other house is empty. Of course,
    bankers are much more important than auto workers,
    but are they _that_ much more important?
    c) Instead of a frenzy of TARPism, suppose the
    Congress, even the new Congress, could have
    been persuaded to let bankruptcy courts “cram
    down”, i.e. make the banks accept lower payments
    from the delinquent, or about to become delinquent.
    d) It has been known for over 60 years how to
    break out of a depression: to Give a WAR. I and
    others are advocating, give another WAR, but this
    time without deleterious side effects. Let’s
    bend every effort to have masses of not-necessarily-
    skilled labor installing solar panels on roofs
    everywhere, putting methane cookers everywhere
    where there is organic garbage, designing and
    producing super-Twingos, possibly electric powered
    or hydrogen or methane powered, . . . Etc etc etc

    I see the problems as very simple, in theory. But
    of course I don’t have the ear of Obama, as do
    Rubin/Summers/Geithner et al.

    Best wishes,

    Alan

  46. “I do not think that the specter of another worldwide depression was overblown. One concern was that the U. S. would experience something like Japan’s Lost Decade, and I think that that is still a likely scenario.”

    I’m not sure whether you meant these as separate things, but they are generally viewed as such. A “lost decade” with no economic growth, was not what government invention in the financial markets was meant to avoid. The fears were far more grim.

    As to Alan’s innitial question, I’m not clear on which alternate scenario he is asking about because letting everyone fail and putting everyone into receivership are not the same thing. A literally laissez fair let everyone fail approach would likely have resulted in bankruptcies for several additional large financial systems, potentially wiping out all of Wall Street and leaving the rest of the economy without any access to credit, or even to basic financial services (like processing payments). The fear was a complete collapse of the infrastructure that makes economic activity.

    Putting everyone into receivorship of some sort (perhaps along the lines the FDIC uses for banks) raises a different set of objections. Typically, it requires government funding to support it, and the objections usually come from the right, who think it is akin to socialism. There is also a question of whether the government has the authority to take this approach to non-banks (like AIG). But it generally works well for banks, and it is what James, Simon and many others advocated. Regardless, the objections here aren’t about potentially dire consequences.

  47. There is a clear difference between innovation, development, and growth. What we have seen in the financial sector is growth without development, spurred by innovation.

    Cancers grow but do us no good.

    The derivatives markets have grown to around $700 trillion and it appears the most they offer is oversized commissions and bonuses. The CDS market has not prevented risk but rather incentivized risk and failure; insurance for a portfolio became insurance for bull and bear markets.

    The financial sector has grown to more than 40% of the economy and like a cancer it has begun to consume its host.

    Innovation is needed to spur development not growth. Development in the financial sector will not be achieved through size but in utility to strengthen other sectors. A smaller financial sector may prove better, more efficient and more innovative.

    The purpose of banks and markets is not their ability to add more to the abundance of those who have much but whether they have willing hands of practical purpose.

  48. bank-o-meter “Cancers grow but do us no good”

    That is a good line indeed!

  49. Per Kurowski: “or one thing we might have been able to reach faster that bottom we need to reach in order to start growing again on firmer ground. There is nothing like being able to go out and sing “Oh what a wonderful morning” being sure you have reached bottom… as is we are still prepared to fall further”

    As my high school physics teacher used to say, “It’s not the fall that kills, it’s the sudden stop.”

    I know that you are really an expert, but do you seriously think that if we had reached “the bottom we need to reach” by now that we would be singing an upbeat song?

    Maybe a pandemic is our best hope, eh?

  50. Alan McConnell: “To comment on your answer: you seem to imply that if we’d let the firms tumble, we might have got
    mired in a world-wide depression. I would comment:
    a) we may already be in one, and do you or does
    anyone have evidence that the rest of the world
    was that heavily invested in e.g. AIG?”

    My opinion does not mean much. I am not an expert. But I will respond to your comment. :)

    Per Kurowski seems to think that we may have further to fall. I think so, too.

    “b) if we had just let the firms go that were
    going to go, and not spent billions on the TARP
    and other programs to restore eonomic health to
    Greenwich CT, we would have had money to do something
    about e.g. Flint MI, where according to Michael
    Moore every other house is empty. Of course,
    bankers are much more important than auto workers,
    but are they _that_ much more important?”

    I think that if we had let the firms fail that were going to go, it would have triggered further collapses, until a lot of firms that would have survived but for those collapses would also collapse. The cost of all that would have been enormous.

    “c) Instead of a frenzy of TARPism, suppose the
    Congress, even the new Congress, could have
    been persuaded to let bankruptcy courts “cram
    down”, i.e. make the banks accept lower payments
    from the delinquent, or about to become delinquent.”

    The Republicans are afraid of socialism.

    “d) It has been known for over 60 years how to
    break out of a depression: to Give a WAR.”

    We already have two wars. How many do we need?

    “I and others are advocating, give another WAR, but this
    time without deleterious side effects. Let’s
    bend every effort to have masses of not-necessarily-
    skilled labor installing solar panels on roofs
    everywhere, putting methane cookers everywhere
    where there is organic garbage, designing and
    producing super-Twingos, possibly electric powered
    or hydrogen or methane powered, . . . Etc etc etc”

    The Republicans are afraid of socialism.

  51. markets.aurelius

    Spot on. Well said. Hayek made the point differently but arrived at the same conclusion: you need institutions that are not corrupt, chiefly courts that will enforce contractual rights and obligations among strangers in a disinterested fashion. Only then can society move forward. Corruption destroys that primary requirement for efficient markets. That’s why the current morass in which we find ourselves is so potentially dangerous: well-heeled vested interests are taking over the institutions — chiefly regulatory functions and law-enforcement functions — that safeguard Rule of Law. These are strange and perilous times.

  52. markets.aurelius

    @ Alan McConnell:

    Here’s your War:

  53. Min “I know that you are really an expert, but do you seriously think that if we had reached “the bottom we need to reach” by now that we would be singing an upbeat song?”

    NO! No one is an expert on this one. And I am not at all sure “if we reached had reached “the bottom we need to reach” by now that we would be singing an upbeat song?” but perhaps our children or grandchildren would have had a chance to sing a happier song than what they will have to sing if they get stuck with the public debt bill of us the baby-boomers.

  54. Max Hyperbole

    For advocates of regulatory freedom to pursue “financial sector innovation,” the onus is on them to demonstrate in advance that any given new financial product/service satisfies two basic requirements: First, it must NOT be so opaque or transparency-reducing as to eliminate the possibility of effective counterparty scrutinty (ala CDO and/or CDS). Second, it must NOT, through omission or commission, create any new/additional perverse incentives or mechanisms that permit/encourage financial institutions to collude to generate unbounded speculative profits (ala the combination of CDO and CDS).

    Inevitably, whenever changes in technology, or regulations, or business practices conspire to provide some industry with what seems like their own magic perpetual revenue-generating machine — and this is the second time (at least) that this has happened in just the last decade — we should not be surprised when the sheer joy of possessing such a machine again eclipses all other considerations among those lucky enough to be in the know. Potential collateral effects and risks of operating such a machine at full speed 24×7 are just too easy to minimize or justify by their owner-operators. Rationality, to the extent that it exists at any point in time, takes an extended holiday. When that happens, the only thing that can save the industry (and every other economic sector, employee, beneficiary, consumer, et al. that it supports) is the existence of *enough* transparency so that those who aren’t direct beneficiaries have some reasonable chance of figuring out what’s going on, and initiating the appropriate market or nonmarket responses (outing, shorting, etc.) before the system again blows up.

    To the extent that it’s not possible for advocates of financial innovation to clearly satisfy these requirements a priori for all real and potential financial sector innovations, the rest of the economy will be at perpetual risk of severe collateral damage every time that the machine-fueled “irrationality” becomes so exuberant that it can only be checked by blunt force trauma. IMO, radical transparency represents the only conceivable means for squaring the general preference for openness to financial innovation with the proven risks of active collusion and/or passive self-delusion. But with technology and regulation and business practices becoming ever more complex and specialized, and changes in all three coming with ever greater frequency, even preserving current (and apparently, woefully inadequate) transparency levels will require a constant increase in time and effort on the part of both potential counterparties and the broader population of uncompensated risk bearers — i.e., those who hope to avoid becoming one of the next wave of unintended civilian casualties when the next financial WMD goes off.

  55. Max Hyperbole

    (i.e., yes)

  56. Max Hyperbole: “NOT be so opaque or transparency-reducing as to eliminate the possibility of effective counterparty scrutiny…”

    Nothing opaque will find a market without “endorsing agents” such as credit rating agencies and anyone endorsing an instrument proclaiming he has reviewed it so much that he can assign an AAA to it should be legally responsible. The whole idea of empowering credit rating agency opinions but at the same time not holding the credit rating agencies accountable for what they opine is nothing but a perfect mechanism for fraud to prosper. Get rid of any official endorsement of any credit rating agency!

    Max Hyperbole: “NOT, through omission or commission, create any new/additional perverse incentives or mechanisms that permit/encourage financial institutions to collude to generate unbounded speculative profits (ala the combination of CDO and CDS).

    I am not against unbounded speculative profits but what I oppose is when these profits are derived from a socially unacceptable speculation. For instance allowing speculators to have a vested interest in that as many people as possible get evicted from their homes, should not be something permitted to trade on open and formal markets or provided any type of legal protection. That does not mean I would outlaw it and if anyone wants to speculate in that informally well that is his problem, and I would not waste one dime in going after him, especially since that could create an additional growth opportunity for the illicit markets.

  57. Max Hyperbole

    I think you might want to think this through a little more carefully… First off, what justification can you offer for advocating full liability and other punitive restrictions on “ratings agency innovation” at the same time that you claim a right to limited liability and unrestricted innovation in other parts of the financial sector? If your wish were fulfilled, the ratings would simply disappear, and you’d still be facing the same problem.

    If that seems hyperbolic, then perhaps you’re actually agreeing with me in a slightly oblique manner. I believe that the ratings agencies themselves were supposed to act as a kind of proxy for exactly the “radical transparency” that I’m suggesting, albeit one that preserves some level of confidentiality for sensitive corporate information. So you want *them* to possess the power of radical transparency (if not omniscience), and you want *them* to be held responsible whenever their findings are not borne out by the subsequent performance of the rated entities? But without possessing that x-ray vision yourself, how are you (or anybody else) going to distinguish between instances of (a) ratings agency misfeasance/malfeasance, (b) rated entity deception, (c) collusion, and (d) unfortunate but totally unrelated/exogenous developments?

    But even if the rating mechanism could be fixed somehow without recourse to a more generalized transparency, the problem would not be solved. If financial institutions were truly capable of generating “unbounded speculative profits” (i.e., profits that have no foundation in non-financial sector production or capital formation), then everybody would want one — hell, I’d want two, and I’d probably already be working on my “Max Hyperbole’s You Can Be A Banker Too!” infomercial and instructional DVD. The only way to avoid the equally unbounded inflationary consequences would be for someone (guess who?) to establish and strictly enforce steep market entry requirements for would-be financial sector new entrants — and given the allure of an input-free perpetual profit machine, that gatekeeper would definitely need to possess that radical transparency power — so once again all you’re doing is diverting the locus of regulation and/or the requirement for radical transparency from bank operations to bank establishment.

    Of course, for that to make any real difference, incumbent financial institutions would need to be re-certified on the new rules too…

    Abundance — i.e., infinite or near-infinite supply with marginal production costs approaching zero — is not like any other economic phenomenon that we’ve ever had to deal with to date. And, as technology advances, it is likely to be coming to more and more industries. Maybe time for someone to start a blank-slate, zero-base review of how economic systems work in an environment with a liberal mix of rival and nonrival factors…

  58. Alan McConnell

    Mr Kurowski write: “am not against unbounded speculative profits but what I oppose is when these profits are derived from a socially unacceptable speculation.”

    My question: Why aren’t we all opposed to unbounded
    speculative profits? I have an insight: “MONEY
    IS IMPORTANT”(TM). If this is a valid insight, then
    it should not be played with. Also: what social
    good do all these “innovative credit instruments”
    do? It is clear that GM, with all its faults, served
    us well for many decades. The claim could even be
    made that the Gatesian M$ serves a useful social
    purpose( I don’t make this claim!). The old
    folk a hundred years ago, the Wobblies, the
    Progressives, the farmers who produced things, knew
    that J.P Morgan and his ilk were dangerous. How
    come we’ve lost that insight?

    Best wishes,

    Alan

  59. Max Hyperbole “what justification can you offer for advocating full liability and other punitive restrictions on “ratings agency innovation” at the same time that you claim a right to limited liability and unrestricted innovation in other parts of the financial sector? If your wish were fulfilled, the ratings would simply disappear, and you’d still be facing the same problem.”

    I am not advocating punitive restrictions on rating agencies opinions as they used to be. But now, when the regulators have empowered them to determine with their opinions the capital requirements of the banks, effectively granting the credit rating agencies a oligopoly in credit risk surveillance that must come with some strong accountability in return. Other areas of the financial sector do not yet work in such oligopolic conditions… not yet though it sure seems we are heading there.

    Max Hyperbole “generating “unbounded speculative profits” (i.e., profits that have no foundation in non-financial sector production or capital formation)”

    If you define speculative profits in such a limited way as having no foundation in non-financial sector production or capital formation then I would agree with you… but then I would also need to ask you to give me an example of what we agree upon because as I see it sooner or later all speculation will relate to the real world, even the sale of virtual real estate on the web.