This Is the End


Markets, Risk and Human Interaction

November 4, 2009

Does Financial Innovation promote Economic Growth?

I participated in an Oxford-style debate at The Economist’s Buttonwood Gathering a couple of weeks ago. The proposition for the debate was Financial Innovation Boosts Economic Growth.
On the pro side of the proposition were Myron Scholes, the chairman of Platinum Grove and Robert Reynolds, the CEO of Putnam, and on the con side were Jeremy Grantham, the CEO of GMO and me. This was the first time I had participated in a formal debate, as I suspect it was for the others. When we came out onto the stage, I overheard one person in the audience say, with a British accent, “Well, they obviously have never been in an Oxford debate before.” I don’t know what we did wrong, but it looks like we even messed up our entrance.
The entire debate is available on the Economist site (scroll to the video "Debate on Financial Innovation") and here. It includes five-minute opening remarks by each participant – first Robert for the pro, then me for the con, then Myron and finally Jeremy. This is followed by questions from the moderator and audience and then closing one-minute Clarence Darrow-moment summations. The debate is pretty interesting, but for those who do not want to spend the time watching it, here are the main points I made.
I elected to restrict my discussion of financial innovation and economic growth in two respects.
First, I focused only on the so-called innovative products. I grant that there are some innovations in the financial markets that have been beneficial; Robert Reynolds gave a summary of many of these. I take as a given that electronic clearing, the adoption of telecommunications, the development of futures, forwards and mutual funds have all had a positive impact.
So what do I mean by innovative products? Well, I could just say you know them when you see them. But when I think about innovative products, I think about them in a three dimensional space. I look at where the product fits in the dimension of simple to complex, standard to customized, and transparent to opaque. The things I term innovative products congregate in the {complex, customized, opaque} region.
Second, I focus on the impact of financial innovation over the past ten or fifteen years. I am looking to the past rather than forecasting the future for two reasons. One is that I do not have a crystal ball, so I cannot project what innovations will occur in the future. Another is that if the future ends up looking like the past, then at least the past can provide a guide. Behavior being what it is, absent regulation to bridle our actions, this is a reasonable assumption to make.
So, defining innovative products in this way and looking over the past ten or fifteen years, let’s look at the ways financial innovation might promote economic growth.
Do innovative products promote growth by increasing market efficiency?
If we were in an Arrow-Debreu world, the answer would be yes, since these products will help span that space of the states of nature. But the incentives behind innovation move in the other direction. The objective in the design and marketing of innovative products is not market efficiency, but profitability for the banks. And market efficiency is the bane of profitability. The last thing a bank wants is a competitive, efficient market, because then it would not be able to extract economic rents. So the incentives are to create innovative products that reduce market efficiency, not enhance it.
How is this done? Well, I can quickly think of two ways. First, by creating informational asymmetries, by having products that are difficult for the users to understand and price. And, second, by designing innovative products, which, due to their non-standard nature, allow the banks to extract higher transaction costs.
Do innovative products promote growth by allowing us to manage risk better?
Hardly. They create risk, or, if you don’t want to go that far, they hide risks. They put risks off balance sheet, obfuscate them through complex schemes, create non-linearities and correlations that only become evident in times of large market changes. They also push more risk into the tails, so that in the day-to-day world things look more stable, but in an extreme event the losses are accentuated.
Earlier in the conference, Larry Summers gave an address where he remarked that since the early 1980s we have had a major financial crisis roughly every three years. Whatever financial engineering and the innovations it creates is doing for the markets, it is not tempering risk.
Do financial innovations help meet investors’ needs?
Unfortunately, the answer is yes. Well, not investor needs, but investor wants. They allow investors to lever when they aren’t supposed to lever, take exposure in markets where they are not supposed to take exposure, avoid taxes, take on side bets in markets where they have no economic interest. I go through some of the uses of derivatives for gaming and gambling in my Senate testimony from June.
Do innovative products promote capitalism?
The answer to this is yes and no. We get capitalism when things are going well, and socialism when things are going poorly. I went through this in a recent post.
Innovative products are used to create return distributions that give a high likelihood of having positive returns at the expense of having a higher risk of catastrophic returns. Strategies that lead to a ‘make a little, make a little, make a little, …, lose a lot’ pattern of returns. If things go well for a while, the ‘lose a lot’ not yet being realized, the strategy gets levered up to become ‘make a lot, make a lot, make a lot,…, lose more than everything’, and viola, at some point the taxpayer is left holding the bag.
If we were to look at the sorts of strategies employed by large investment firms and banks, my bet is we would see a bias toward short volatility, short gamma, short credit and short liquidity. All facilitated with innovative products – you can’t really do the first two without derivatives – and all leading to these sorts of return characteristics.

This was a debate, so we all took the polemic positions. I am not so extreme as to hold that all innovative products, even those that do fit in the {complex, customized, opaque} corner, are devoid of value. But just because we are able to take some cash flow and turn it into a financial instrument doesn’t mean we should. Here are three questions we can ask to determine if a new, innovative product makes sense:
  1. Is there a standard, simple instrument that could do the job – either one that already exists or one that can be created.
  2. Is the primary purpose of the new instrument to meet economic objectives (i.e. helping to get capital to the producers or helping producers layoff risks) or to meet non-economic objectives (i.e. gaming the system, making side-bets on the market).
  3. Does the instrument create negative externalities; on the margin does it increase the risk of market crisis, does it make the market more levered, complex and opaque?