Is financial innovation good?

by on July 20, 2009 at 5:13 am in Economics, History | Permalink

Felix Salmon, for one, writes:

Net-net, financial innovation is a bad thing: the downside, during
times of crisis, is higher than the upside in more normal years.

Maybe I am taking Felix and others too literally but I am genuinely puzzled by this attitude.  I can understand that particular financial innovations might be bad, but financial innovation overall?  Surely this claim was false in years 1200, 1900, and also 1950.  (Of course you’ll find very harmful financial explosions between those years and the current day but still on net you’ll take the progress.)  If the U.S. economy resumes growing at an average rate of about two percent a year, eventually our economy will look very, very different than it does today.  It’s hard for me to see running the economy of 2100 with the banking system of…what is the nostalgic year?  1992?  1957? 

We’ll need more than better ATMs, which is not to say we need approve of every step along the way.

marcus July 20, 2009 at 7:55 am

Yes, and the internet is a “bad thing” because it led to the dot com crash.

josh July 20, 2009 at 8:27 am

Perhaps we need to first ask: “Would this innovation exist in a hard currency world?”

David July 20, 2009 at 9:24 am

How about, “Net-net, 40:1 leverage is a bad thing…”

Reed July 20, 2009 at 9:43 am

Is behavioral economics, in its policy applications, not a form of financial innovation? Or should we just ignore this reality and assume everyone can live with the banking system of 2002…

David July 20, 2009 at 10:17 am

I’ll try again. Option-ARM mortgages aren’t bad; 100% financed homes are bad. Credit-default swaps aren’t bad; owning CDS 10 or 100 or 1,000 times in excess of your counterparties’ equity is bad. Derivatives aren’t bad; levering your entire firm 80:1 with them is bad.

MW July 20, 2009 at 10:47 am

I think securitization could still play a role in a 1950′s “boring” banking system. Some investors have higher risk tolerances than others. Like interest rate swaps, securitization could ideally align risk tolerances with risks for different types of assets. The investor who only wanted safety was limited to treasuries and other AAA rated paper, while securitization allows access to lower-grade paper.

The system just needs to become much more transparent and less complex. Investment Banks were allowed by AAA ratings to intentionally obfuscate the underlying worth of subprime-backed securities, or their lack of worth. Once securities became securities of securities, then there was truly no hope. The ratings agencies also need to do more work than simply looking at CDS prices. They look at underlying balance sheets in rating companies and they need to do the same for mortgage-backed securities.

Howard Clark July 20, 2009 at 12:18 pm

Financial innovation can be good if it is aligned to purpose and what matters.

It is when you get bonuses and other extrinsic incentives that you get warped systems.

It happened in the UK. Millions of pounds of bonuses meant that they kept on digging when sane people would have stopped.

The bonuses made them blind. It would have been better to pay them well.

See the Systems Thinking Review for examples of systems thinking in the public sector to get a clearer view.

Also visit ITunes and search for the podcast on systems thinking in service organisations.

http://www.thesystemsthinkingreview.co.uk/

babar July 20, 2009 at 1:11 pm

@a — why pick fixed rate mortgages? there are probably safer kinds of mortgages.

Billy July 20, 2009 at 1:59 pm

Paul Krugman basically said the same thing in his New York Times op-ed “The Joy of Sachs” on Friday. I don’t understand how they can automatically dismiss the entire history of financial innovation because of one bad event. Maybe this means I could take Krugman to one poorly performing Canadian hospital and get him to renounce his allegiance to nationalized health care.

Nik Kondratieff July 20, 2009 at 10:50 pm

Plreader is correct, imho. It’s not financial innovation writ large that is bad, it’s specific applications of finnov that can be put to use with disastrous consequences by profit maximizing individuals with no ethical compass or compunction. Gee, I don’t think free market capitalism has a point of view on compunction, so no wonder that doesn’t work.

Financial innovation, net net, is bad because the raison d’etre of innovations in risk management, arbitrage, and asset allocation is to “beat the system” of regulators and competition. Why do you think GS spends millions on program trading algorithms? The ugly truth is that pure capitalistic instinct abhors perfect information and perfect competition, and in seeking to dominate profits, firms will go to unbelievable lengths to introduce innovative products and services. It is endemic to everything in the financial world…not just the things you see and interact with every day, but the entire underpinning of the financial services world is predicated on financial innovation and what we’re experiencing today are the disastrous results of that force run rampant with a complicit Fed and an emasculated regulatory infrastructure.

Nik

Jay Kumar July 21, 2009 at 3:15 am

Relatively simple derivative products provide ample capacity for risk transfer. However, increasingly opaque products of rare expertise continue to proliferate. It seems their purpose is only to evade capital restrictions, capital rules, and securities and tax legislation.

Speculation has become a dominant function of credit default swaps, evident in the fact that volumes in the CDS market were approximately four times outstanding underlying bonds and loans.

ogmb July 21, 2009 at 6:10 am

“Efficient organization entails the establishment of institutional arrangements and property rights that create an incentive to channel individual economic effort into activities that bring the private rate of return close to the social rate of return. [Footnote:] The private rate of return is the sum of the net receipts which the economic unit receives from undertaking an activity. The social rate of return is the total net benefit (positive or negative) that society gains from the same activity. It is the private rate of return plus the net effect of the activity on everybody else in the society.” — The Rise of the Western World, by Douglass C. North, Robert Paul Thomas

Fiddler July 22, 2009 at 1:42 pm

Suggested new headline: “Felix Salmon Becomes Amish”

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