A Perspective on Financial Innovation

Simon and I have a new article, “Finance: Before the Next Meltdown,” in the Fall issue of Democracy: A Journal of Ideas on one of our favorite topics, financial innovation. (It’s part of a larger Democracy symposium on innovation in general, available online and on sale on September 15.) Instead of just sniping at specific innovations gone awry, we try to lay out a systemic explanation of why financial innovation is different from other forms of innovation, and how it should be evaluated. In particular, we argue that even though some financial innovation is good, more is not necessarily better.

Financial innovation has also been on the minds of the Planet Money crew recently. Their first episode was a little over the top, basically ascribing all of the benefits of capitalism to financial innovation (I guess this is technically true, since money is a financial innovation, but they make it sound like the joint-stock corporation was a necessary ingredient for all economic progress). But last week they had a panel with prominent bloggers Felix Salmon, Tyler Cowen, and our friend Mike Konczal. Obviously I agree most with Salmon, but I thought Cowen’s position as the “defender” of financial innovation was interesting. Basically he agreed that financial innovation can cause problems, but he first argued that the innovation in question (synthetic CDOs) was a response to bad regulation, and then argued that regulation was likely to cause more problems than it solved, and therefore our best bet is to let the free market sort it out and hope for the best.

By James Kwak

33 thoughts on “A Perspective on Financial Innovation

  1. And here I thought prudential regulation was a necessary component of a genuinely free market.

    If questionable “innovations” are the response to bad regulation, perhaps the solution is good regulation rather than no regulation?

  2. “In particular, we argue that even though some financial innovation is good, more is not necessarily better.”

    Actually, that is true of most innovation. It’s a jungle out there. ;)

    “Financial innovation has also been on the minds of the Planet Money crew recently. Their first episode was a little over the top, basically ascribing all of the benefits of capitalism to financial innovation (I guess this is technically true, since money is a financial innovation, but they make it sound like the joint-stock corporation was a necessary ingredient for all economic progress).”

    And here I have been wondering if it was the equivalent of Original Sin. ;) (The granting of rights with limited liability and responsibility, I mean.)

    “I thought Cowen’s position as the “defender” of financial innovation was interesting. Basically he agreed that financial innovation can cause problems, but he first argued that the innovation in question (synthetic CDOs) was a response to bad regulation, and then argued that regulation was likely to cause more problems than it solved, and therefore our best bet is to let the free market sort it out and hope for the best.”

    O ye of little faith! Err, … I guess that’s me of little faith. ;)

  3. Financial Innovation is important, but so is Legal Innovation. A corporation’s shareholders are shielded from legal liability beyond the money they invested. Without that legal protection, few would buy stocks. Let’s give credit where credit is due: Capitalism requires the innovations in law as much as the innovations in finance.

  4. What a good article! It is so rare to hear or read about the subjects of finance and democracy being linked together – even though they are inextricably so in reality.

    Economists have become expert at avoiding any mention of the “D” word… How messy!

    Allowing the abuse of people through the sale of “innovative” financial products – is not creative. (It does not even meet the 19th century standards of Utilitarianism but rather goes to less civilized 16th century Machiavellian methodology of conquer and control). Whereas the sciences (such as medicine, physics etc) are finally initiating the use of knowledge translation to ensure that people (including their own colleagues!) can understand new discoveries, economists and financiers have used linguistics to hide the fact that there are no discoveries – that is, no innovation.

    Hope that democracy and economics continue to be brought together…

  5. I could handle it either way: 1) no regulation, let the market kill ’em all and God can sort them out, or 2) regulate both for financial stability and consumer protection.

    What I can’t handle, but have gotten anyway for the last 30 years, is disappearing regulation while my hard-earned taxpayer money bails out the losers in the Wild Wild West market free-for-all. I’m mad as hell, and I’m not going to take it any more.

  6. I am a huge Mike Konczal fan and consume anything he writes or says like a southern redneck eats pork grinds after a week long fast. But I have to say the 2 young people on Planet Money who did that interview with Konczal, Cowen, and Salmon did the sloppiest, most unprofessional interview I have heard in YEARS. They rambled on sloppily like 2 young students having a half-drunk conversation in a dorm room, and at one point that felt like 10 minutes of giggling small talk, Cowen had to interrupt them to ask if he could say something.

    I am a fan of the 3 interviewees and was enthused to listen, only to hear the interviewers ramble on and giggle with each other. If you want to see a much BETTER interview with Mike Konczal, check out this link. http://bloggingheads.tv/diavlogs/22026

  7. “some financial innovation is good, more is not necessarily better.”

    This is obviously true for most technology. For example do we really want human cloning? Do we really need more advance nuclear weapons? Is MS Office bloatware really net positive to the end users? Is a debate really necessary?

    The hard part isn’t taking the general view of the above. The hard part is how to differentiate the good vs. the bad and limit the bad .

    A brain dead approach is to generally nab financial innovations in the bud .

    A better approach may be to copy the pharmaceutical industry. Drug companies are encourage to innovate. However, drugs are only introduced into the general public after carefully vetting. This doesn’t completely eliminate the possibility of a bad drug but it is a fair trade off for the potential benefit of innovative new drugs .

  8. Financial innovation? Usury is not new. Well, it is new in the sense that its repeal for the benefit of the banking industry is roughly thirty years old. By institutionalizing usury we have allowed JPM and GE to replace Tony Suprano, which of course reduces the number of broken legs, and by securitizing consumer and mortgage debt we have allowed the profits to be glommed by con men and the default risk to be passed to those institutions conveniently managed by the greediest and most obtuse idiots managing to gain control of other people’s money, but since those institutions are all too big to fail, the consumers laboring under this legalized usury, who pay all the taxes already, must also be mulcted periodically to bail out the idiot managed institutions, and to pay interest on that, as if they weren’t already reeling like Sissyfus under the burden of Nineteenth Century Imperialism Redux, and all but flattened for the benefit of Big Oil and its Arab pals, and bleeding from a thousand cuts imposed by our Fortunate 500 monopolists and oligopolists, and poisoned by our industrial agriculture, and driven cuckoo by the prattling of monopoly media, but at least we still have public television pretending to provide responsible commentary about all this while giving equal time to liberal hogwash and wing nut hysteria.

    FA Hayek, the poet laureate of free markets, correctly pointed out that freedom does not imply either the absence of rules nor a tolerance for monopoly. It is too bad those constantly quoting him never bother to read what he actually said, which would have warned us specifically about the very evils we now face.

  9. Picked up this in that Democracy article, “Economist Robert Shiller has proposed government-subsidized financial advice …”

    Forget any government helping out. But it ought to be easy given the talent attracted to this place. Coincidentally, I ‘sold’ the idea to Dr Jarrell, another follower of this Blog and the result is here:http://learningfromdogs.com/2009/08/22/economics-inflation1/
    Feedback on the value of this attempt, other topics to come and how it should be more widely promulgated really welcomed.

  10. You miss the point: The adjective “bad” is redundant since all regulation is bad! But the point has to be driven home for those of us too slow to grasp the obvious.

    What I find interesting is that we once had unregulated free markets. In the golden age of free markets, apparently no innovation was necessary! And of course there were never any problems.

  11. “If innovation must be good, then financial innovation should be good, too. ” This sentence is a logical fallacy. Just because innovation (in general) maybe good (whatever that means), that doesn’t mean that all types of innovation are good or even equally good. Such simplistic thinking is likely the locus of our current crisis.

  12. I thought Cowen got the better of Salmon in that particular podcast, but I am not yet convinced he is right.

    Cowen came across as if he thought financial innovation could never be a bad thing, that it was always a positive. Though he didn’t say this in so many words.

    This can’t be his position can it?

  13. You say “If finance is the lifeblood of our economy, then figuring out new ways to pump blood through the economy should foster investment, entrepreneurialism, and progress. Right?”

    Absolutely right! And so why did you never say anything when with regulatory innovations they tried to block the flow of funds to areas that could be perceived as “risky” but that still conforms vital musculature, like to entrepreneurs without credit ratings, and promote the financial flows to areas that might only contain fatty tissue, like houses in a house boom, just because these could easier hustle up some AAA.

    The fundamental piece of the current financial regulations is utterly wrong, and inhuman… for the very simple reason that a world that taxes risk-taking and subsidizes risk adverseness, is a world that seems to want to lie down and die

    Repeatedly you mention some “tricking investors into making investments they would not otherwise have made”…. Forget it! Those who have done the worst of the tricking are the financial regulators… trying to live out their boudoir fantasies of a world without bank failures.

    Think of it, if a bank lends to a normal unrated citizen then he can only leverage 12 to 1 but if he lends to someone who a human fallible credit rating agencies has rated AAA then he can go to 62 to 1… crazy!

  14. “Financial innovation” that increases debt on the lower and middle class is BAD!

    For other financial innovations, it depends.

  15. “However, drugs are only introduced into the general public after carefully vetting.”

    great idea, but wouldn’t it outlaw piracy???

    and that certainly must be bad, pirates being probably the closest to the perfect free marketeers (disregarding little bits of cat-o’-nine-tails aboard ship of course)

    how apt of Wikipedia to picture the thing together with a dollar bill http://en.wikipedia.org/wiki/Cat_o'_nine_tails

  16. when way way back they innovated in finance they did it to help traders so they could travel without cash which would have attracted robbers.

    I guess somewhere along the way they invented methods to distribute the risk for starting businesses also, the same way they had come to share the risk of sending a ship out to trade by pooling their money

    now they seem about to work on an innovation that adapts real big stake poker to Wall Street pure and simple and collects the necessary money pools not from the daring merchants of old but from people eager to get out of it all as early as possible

  17. Let the players pick whether they want regulation or no regulation. But if they pick no regulation, then they have to forego all regulation, including enforcement of contracts and protection of private property.

  18. If I recollect, Schumpeter defined innovation as ‘new combinations'(of labour, capital, etc) and this had no imputation as to being either ‘good’ or ‘bad’. Rather, entrepreneurs sought advantage and hence,created the dynamic of creative destruction he saw as a core feature of capitalist economies. Later, in capitalism, socialism and democracy, he foresaw an evolution towards ‘socialism’ probably along the lines of German “social market” capitalism. As it is always and everywhere that states vouchsafe markets, there is an inherent interest in regulating what may be socially destructive ‘new combinations’. Much of the ‘financial innovation’ of the last 20 years hinged on the slight of hand (and intellectually dishonest) assertion that uncertainty had been converted into calculable risk, about as creditable as claiming that one can turn straw into gold. For those who hark back to a (make believe) era of ‘free markets’, one might note that the latter were merely elites occupying the state to their own advantage (e.g. the Corn laws in Britain or the legislation that outlawed worker ‘combinations’). So the state has a legitimate interest in orderly, transparent markets and that includes the regulation of risk.

    A note on medieval/early modern history. The innovation of the 12-13th centuries (in Italy) was the concept of limiting liability to the capital invested. Trans-Mediterranean trade had operated on the basis of letters of credit since at least, the 12th century (v. S.D. Goitain) and within Europe, the church was the central transmitter of letters of credit. Trust between co-religionists was also critical to the flow of trade and contracts where transactions might take several years to complete. Markets are never ‘free’ in the sense that the Friedmans and Greenspans claim, they are always culturally constructed and enacted, and thus constrained.

  19. Perhaps part of the problem of innovation is a consequence of the overproduction and overefficiency issues that are a consequence of capitalism. Agriculture, for example. Many improvements and efficiency gains over the past 100 years plus. Farmers can now easily grow far more crops than the system can consume. For this and other reasons, although agriculture is still obviously of the highest importance in our culture, it’s probably impossible for an individual farmer to make much if any profit by being better than the farmer next door. The solutions to this problem are having farmers cyclically going out of business to be replaced by other farmers, a Wal-Mart of farming that makes its money through immense pressure on other players in the economy, or the current subsidized system. The subsidies create problems of their own, but at some point it’s the lesser of multiple evils.

    I’m no bank sympathizer, but I’m guessing it’s impossible for banks to make money anymore at a large number of the things they do, like account servicing or interest rates. So they seek other ways to make money.

  20. I suggest that financial institutions have a choice: either accept regulation of innovations, or post a bond for innovations. Given the size of the problems caused by innovation, a bond of 15% of GDP (e.g. about $2 trillion today) would be appropriate.

  21. Should they also have to forgo protection from vigilantes who come looking for them after their externalities ruin other people’s lives.

  22. Whether or not financial innovation is good or bad is not the question to be asking today.

    The question to be asking is: how can financial innovation be used to enhance the economy – not just maximize the bank accounts of investment bankers?

    The truth is – financial innovation over the centuries has been beneficial.

    However, the financial innovation we’ve seen in the last decade has been a disaster. Or if I’m wrong on that, please educate me as to the value we’ve seen from recent financial innovations like CDOs and the like.

    And the brave, new financial innovators should be prepared for the consequences of their actions – either massive profits if successful or failure unsupported by government if their bid doesn’t pan out.

    The socialization of loss resulting from the aftereffects of financial innovation gone awry is not a good business model at all for the nation to continue to follow.

  23. In regards to the evolution of markets, perhaps Carl Sagan said it best: “extinction is the rule, survival is the exception”. The trick, I suppose, is to foster innovation while allowing the necessary extinction of ideas doesn’t work and simultaneously minimizing collateral damage. Sort of like patting your head and rubbing your stomach.

  24. Ok, ok, you did it. You posted so much about innovation that few will be likely to want to bring it up themselves again.

    You hit “innovation” head-on with these posts, and “engineered crisis” with the post that follows this one. The public will now consider these issues “talked out” and you will be able to return to your regularly scheduled broadcasts.

    Now, where did RortyBomb’s Mike Konczal go to school? Where is he currently employed (is he being compensated for doing the RortyBomb blog?)

  25. I’m going to take an extreme stance here–and I’m not sure I really believe this, but I think there is a grain of truth in it.

    I challenge the notion that even traditional financial innovations such as mortgages are a good thing. Why, after all, is it necessary for people to save for decades to buy a house. In part, at least, it is because the availability of mortgages causes people to bid up the price of houses. I once lived in a cooperative apartment building that, initially, did not allow mortgages. The prices for those apartments were far below (about 50%) the prices for comparable apartments in other buildings nearby. When the coop board decided to allow mortgages (but with a 60% down payment required) prices rose, so that they were no only about 25% below comparable ones in conventional mortgage buildings. Finally, the policy was changed to allow mortgaging up to 80% of the purchase–and prices then came into line with the rest of the neighborhood. Nice windfall for those who already owned: but clearly the purchasers with mortgages paid far more than they would have had to otherwise. And that’s without even counting the fact that on top of an inflated price they have to pay interest to the bank! It’s my view that mortgages make housing more expensive and that housing would be far more affordable if mortgages did not exist.

    There is another aspect to the adverse effects of mortgages. They probably suppress innovation in construction. In the absence of mortgages, the need to save for a house would have reduced demand for housing, and builders would have had an incentive to find cheaper ways to build good quality homes. But with mortgages pumping money into the housing market and making people willing to pay more than they should for a house, builders have no reason to try to find more efficient approaches to construction.

    Contrast that with food. There are no wholesale loans available for the purchase of food; and the “retail” loans carry huge interest rates, so people try to avoid using them for the purpose. While one can argue (and I do) that the quality of the food produced is seriously inferior to what was around 50 years ago, you cannot deny that the quantity produced is grown enormously and the price has fallen dramatically. Food producers had the incentive to do that. If we had “food mortgages,” I would bet that food would be unaffordable for the typical person today and we would have periodic bubbles in the food markets.

    Higher education is another area where I think credit has ruined things. Fifty years ago education was, in real terms, much cheaper than it is today. There were essentially no education loans back then. Students didn’t go into hock to get an education: their parents typically could afford to pay for it, and schools provided financial aid for most of those who could not. Then we injected credit into that market and prices have exploded. Now few parents can pay for their children’s college, and the kids graduate already deeply in debt. Those that go on to graduate or professional school are pretty much indentured servants by the time they’re done. Has the education product improved as a result of all this extra money? The basic product is the same, slightly updated. What we’ve gotten is more frills in the student life area, more expensive school athletics, and other additions that are peripheral to the actual educational goals.

    Now, I’m no economist, and perhaps there are better explanations for what I’ve observed. But I can’t think of any markets (for consumers, that is) where the introduction of large-scale credit has done more good than harm.

  26. “Now, I’m no economist, and perhaps there are better explanations for what I’ve observed. But I can’t think of any markets (for consumers, that is) where the introduction of large-scale credit has done more good than harm.”
    What an interesting point of view. Is there not an argument that increased consumption, much of it funded by credit, has resulted in more and better innovation (think of electronics, for example), more employment, better education, better health, and so on. Turning the clock back would not be the answer?

  27. It would be very innovative to erect a private toll booth on a public interstate. It’s never been done before.

    For instance, head to Kearney, Nebraska and plop one right in the middle of Interstate 80, the major US East/West Interstate.

    Like financial innovation, there may initially be some dispersed sqwuaking about the new hassle and fee. But, once in place the new toll booth innovator would simply remind people of the massive value it provides-by opening its gates, it facilitates the countless masses that want to egress from Colorado to do so, and inversely, it facilitates those that want to ingress to Colorado to do so. For a mere $9.95 (each way of course).

    Pretty soon, private toll booths start showing up everywhere. And with them come jobs. And taxes. And political contributions. And, McDonalds. And, Super 8s. And T-Ball team sponsorships and shirts. Blighted communities want to partner with US Toll Corp. for economic development, and craft proposals with tax abatements and other concessions to attract a US Toll Corp. toll booth to come to their communities.

    Naysayers who question the intrinsic value of private toll booths, and who remember when it was possible to blow through Kearney at 85 mph without stopping, and without paying $5.00, are quickly shouted down and reminded of the stable and good paying jobs and benefits offered local Kearney employees at US Toll Corp. toll booths, US Toll Corp’s altruistic sponsorship of the annual Kearney Days celebration, and that in the worst recession since the depression, the last thing we want to do is eliminate the private U.S. Toll Corp. toll booths, and their attendant jobs….

    The first one is the toughest. So how does an innovator pull off erecting the first private toll booth on a public interstate in Kearney? One of three ways:

    1) Leverage one’s contacts and influence with the local, state, and national governments, and enter into a partnership with them to kick back a modest amount of revenue to their respective cash strapped treasury coffers, with attendant and obligatory contributions to campaigns of innovation supporting politicians.

    2) Or, leverage one’s contacts and influence with the local, state, and national governments, and have legal and regulatory impediments removed to allow for this activity.

    3) Or, a hybrid combination of #1 and #2.

    This analogy may seem strange. But, I submit that it is exactly on point. We have been allowing private toll booths to be erected on our public financial interstates for years.

    And many of us have forgotten that you used to be able to call your credit card company and make a phone payment to them without the hassle, and without a fee. Some laggards like myself question the real value this fee based service facilitates. Like the toll booth company opening its gate, the credit card company answers its phone, thereby removing an impediment it created to facilitate your ability to do what you were going to do.

    And, all those fees support all those call centers, and pay all those wages, and buy all those T-shirts…..

  28. It’s true that housing prices depend on mortgages, or more specifically on the monthly payments to service the mortgage, which need to be in line with local wages for most housing.

    However, builders are always substituting lower cost materials. These materials are not healthy, and will off gas toxic chemicals like formaldehyde for years. Natural alternatives exist, but the “cookie cutter” approach to saving money while building houses insures they will never be used. Likewise, any gains in the food production have been at the expense of the environment, and are actually heavily subsidized. Arguably, our current swine flu epidemic has resulted from these innovations.

  29. Actually, this is exactly what governments of every level are proposing to do with roads, except it won’t be U.S. Toll Corp. it will be foreign toll corp. And toll booth operatos will buy the roads, so there will be no going back. Get ready for our wonderful new toll booth economy.

  30. to the best of my memory the sewage treatment facilities and the like of middle to big German cities were bought by American investors and if I may trust the not aiming for too much precision radio reports I heard, one can only want to escape into space in despair.

    Doorstoppers of contracts were signed by Germans without ever requesting a translation all they saw was the immediate cash-flow. On top of that the buyers didn’t have the money in their coffers but took out loans with high interests to finance the deal.

    If that thing should blow up the minimum consequence will be that it will keep lawyers well provided for for quite a long time the maximum consequence will be that the cities will have lost ownership of their sewage system and other stuff while having increased their debts at the same time. Maybe the US has bailed out these companies via AIG also …

    If half-cooked schemes like that blow up things tend to be a lot worse than they would have been had one stuck to the traditional method.

    Therefore I have a consolation for you, it does not matter who will operate your toll booths and own the roads, it can be somebody from Mars the outlook is always equally sinister

  31. Wish I could find the paper that came out back at the beginning of our predicament (approx. 3-4 yrs ago?) that spoke of the wondrous and profitable psychology of toll booths. It spoke in glowing terms, IIRC, about the frog that doesn’t mind being boiled slooooooowly.

  32. FLIMFLAMATION = The combined result of “Financial Innovation” by many players, interlocked and overleveraged.

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