Comments on Rick Bookstaber: Does Financial Innovation promote Economic Growth?...

On the opening the casino example, are we also not...

2010-10-12T16:31:12.911-04:00

On the opening the casino example, are we also not increasing welfare (expected returns) for a select set; and, hence won't risk-return be intrinsically connected.

If in finance we are always talking about risk-adjusted returns then should we also not talk about financial risk (always in connection with economic development...since finance plays a role in developing the real economy).

Finance (with or without innovation) is likely to play havoc - Surmise based on assessing previous credit crises- when Finance instead of playing "finance" and facilitator, becomes an industry as an end in itself and hence "real" to that extent.

Interesting how the Pro side switched to rhetorica...

2010-04-28T14:44:35.717-04:00

Interesting how the Pro side switched to rhetorical tricks mid-debate and we're more physically "forward" in body language. Assume they were feeling erosion of their case.

Just a couple of very rich Type-A sales guys, doing what they do best.

Second Law of Thermodynamics!? Have to remember to bring that up in future sales presentations.

The point does seem academic. If these instruments can find a willing (eager) buyer....

My understanding is that Madoff simply gave his clients what they demanded. One of his biggest clients did this at first.

As marketers, while we understand the quick appeal of "bad actor" explanations - each transaction has a "pitcher" and a "catcher."

Of course, these are mainly sales strategies and solutions, designed to maximize the profit of each transaction - immediately.

I think you have made implicitly a convincing case...

2009-11-09T15:18:16.649-05:00

I think you have made implicitly a convincing case to tax financial transactions, financial innovation and all trades which have no added value to the economy. If then negative externalities are created instead, there is a cogent case to tax financial products and innovation heavily. If you tax beer and bread, incomes and labour, why would not we tax financial products?

"I could just say you know them when you see ...

2009-11-05T10:51:37.792-05:00

"I could just say you know them when you see them."

Well that's the rub, isn't it? So much of what is innovative or dangerous is in the eye of the beholder, and the complex/customized/opaque system of categorization doesn't do much to remedy this.

The earliest financial innovation I can think of was a credit derivative; I am referring, of course, to money. Is money opaque? Certainly - millenia after its introduction, most people still do not grasp that the value of money is derived from credit, rather than either a physical substance such as gold or cowrie shells or else the evil machinations of a government conspiracy.

Is it complex? Highly. Many historical periods have supported a bewildering array of systems - bimetallic in various weights and degrees of fineness, all requiring interconvertability. Even today our money markets cannot be said to be truly simple.

Is it customized? That depends. International trade has always required some conventional settlement unit, such as a standard weight of gold. But minting was a royal prerogative because it was a profit center - it allowed sovereigns to control the timing and extent of devaluations and revaluations and trade on this inside information. Consequently, every sovereign had a powerful incentive to customize his domestic currency.

So a hunter-gatherer would be quite justified in looking askance at your new-fangled "money". But few of us would want to live without it.

Your final remarks about standard alternatives, economic purpose, and externalities are well-taken. But these questions cannot be resolved without skill and judgment - "knowing it when you see it."

My last comment was referring to fisherking66, the...

2009-11-04T16:22:41.864-05:00

My last comment was referring to fisherking66, the comment above the most recent one.

On the Arrow-Debreu point: What I meant was a world with the assumptions of the Arrow-Debreu formulation but without yet having a full set of spanning securities. So in that formulation, adding new securities that get closer to allowing one to create, indirectly, all the required primitive securities will make the markets more complete.

On the second point above: Making an analogy betwe...

2009-11-04T16:18:36.791-05:00

On the second point above: Making an analogy between conservation of mass and conservation of risk is appealing, but I don't think it is a good one. A zero sum game does not imply zero risk. If you open up a gambling casino, you have created risk for the gamers where no risk existed before. Each person, who before might have had zero uncertainty around their annual income (if they had stable jobs), will now have uncertainty.

A second point on this topic, even if risk is in some sense unchanged in aggregate, shoving more onto the extreme tails creates more material risk.

Sorry to nitpick, but in an Arrow Debreu world, fi...

2009-11-04T16:07:16.166-05:00

Sorry to nitpick, but in an Arrow Debreu world, financial innovation cannot increase efficiency, because markets are already complete and there's no room for valuable innovation. In a world with incomplete markets, it's my impression that the literature does not support the conclusion that incremental increases in spanning the market necessarily lead to improved efficiency. Precisely, because markets are incomplete -- and there is room for beneficial financial innovation -- it is also the case that we cannot conclude that innovation is necessarily beneficial. (See: http://users.iems.northwestern.edu/~staum/IncompleteMarkets.pdf Appendix B.2)

(This is an error analagous to the leveraged investor assuming that because he is 100% certain that the dollar will go down over the next year, he is sure to make money trading currency futures. i.e. nonlinearities are ubiquitous in economic theory.)

If the view you express is actually common amongst economists at financial firms, I'd be curious as to any thoughts you might have about the foundations of this view.

Nick, While I broadly agree with your general obse...

2009-11-04T15:41:13.125-05:00

Nick,
While I broadly agree with your general observations let me add:
1) Obfuscation is triggered by accounting not by financial innovation per se, although it is true that new products may be devised to work around or even exploit rules and regulations. Sadly, the obsessive need for consistency at all costs amongst accountants and regulators often results in one-size-fits-all rules and accounting treatment that are just an invite on a silver plate to clever structuring. Richard Thaler, the U of Chicago Professor who studied extensively mental accounting in the context of hedonic framing and Behavioral Finance issues, presciently stated that, since individuals want the pleasure of gains soon and the pain of losses as late as possible, accounting tricks will be implemented accordingly. An eminent example was provided by the US Congress last March, when FASB was essentially threatened to have mark-to-model implemented ex-lege if the accounting body would not relax mark-to-market rules. Fighting obfuscation is definitely a must but recent actions by policymakers are hardly encouraging.
2) As in the world of physics, risk is not created or destroyed, just transferred. It may become more concentrated or have a somewhat different shape but it takes two to dance! Thus, I violently disagree that innovation results in greater risk. In the witch hunt against stock index futures that followed the 1987 Crash, empirical evidence denied the hypothesis that futures increase volatility.
3) Finally, from a macro/systemic point of view, having bank and credit institutions move back to a lend-and-hold business model means that the turnover of that institution's risk inventory will drop enormously, creating therefore a capacity constraint for new loans. In turn, this may make the system less leveraged (which is desirable), but what about the growth/jobs side of the equation? It is irresponsible that many of the same policymakers who were just talking about growth (and omitting to mention risk) until 2006 have now flipped the tune to the "no risk" mantra (and conveniently avoid talking about the growth constraint that tighter credit may originate). I acknowledge, however, that there are merits in Volcker's preference for separating credit/lending from trading. But the question of the optimal risk/growth balance remains painfully unanswered.

Rick, I did like your 3-d model of innovations ...

2009-11-04T11:37:52.611-05:00

Rick,

I did like your 3-d model of innovations in a state space. I think a basic venn diagram could do a lot of justice to your model, of course you can't haul that into a debate. Just curious about your view on the dropping of Glass Steagall. In my mind Glass Steagall was an innovation that de-risked the system by sacrificing operational & capital efficiency for de-linked systemic stability and sub-optimal efficiences of scale.

it seems like innovation in finance is a big label...

2009-11-04T11:25:45.944-05:00

it seems like innovation in finance is a big label. Ideally financial innovation would have been articulated into groups (risk management: consumer: industrial: regulatory). The innovation could be highlighted relative to the expected pros and cons vs. the acknowledged pros and cons. I agree with your main thesis innovation that creates obfuscation that is bad. I am against innovation which creates too much consensus or belief. Ie. if everyone believes in VaR, big banks, a new asset class etc. by definition a bubble in that asset or a behaviour bubble will ensue.