Financial Innovation

Felix Salmon has a silly post arguing that financial innovation is a net waste to society. One problem with his argument is that his view of financial innovation is too narrow.

if you look at how fast the US economy managed to grow in the 50s and 60s without the benefit of Black-Scholes or the Gaussian copula function — or, for that matter, how fast the Chinese economy has grown of late with very strict fetters on financial activities — it looks very much as though most of the financial innovation in recent decades constitutes a history of increasingly-desperate attempts to eke out returns in the context of a naturally-slowing economy. And that history, I think, is doomed to failure.

There are two problems here. First, he simply ignores many innovations that are of recent vintage. In the period he castigates as net loser, we had such innovations as:

*money market investment funds
*NOW accounts
*municipal bond mutual funds
*IRA accounts
*Universal Life insurance policies
*ATM’s
*financial transactions by personal computer
*electronic funds transfer

and many others. For more see Van Horne's Presidential Address to the AFA in 1985. He discusses many financial innovations and possible excesses. At least the issue is taken seriously there.

The second problem, which is perhaps more significant, is that he only thinks about the impact of financial innovation on growth. But many financial innovations are ways to share risks. They may increase welfare without increasing growth. Think of any insurance. Without fire insurance I have to save more to cope with the state where my house burns down. My consumption is lower but my savings is higher. Growth might even be higher without the insurance because of higher savings. But welfare is lower because the goal of an economy is to allow people to consume.

Arrow on the Crisis

It is always important to listen to Kenneth Arrow on any topic. Here he talks about the financial crisis. Important passage:

the root is this conflict between the genuine social value of increased variety and spread of risk-bearing securities and the limits imposed by the growing difficulty of understanding the underlying risks imposed by growing complexity.

Financial Crashes and Incentives

Joseph Stiglitz, Nobel Prize winning economist, has an article in the New Republic on excessive risk taking and our financial crisis. He writes:

In recent years, financial markets created a giant rich man's casino, in which well-off players could take trillion dollar bets against each other. I am among those who believe that consenting adults should be allowed great freedom in what they do--as long as they don't harm others. But there's the rub. These high-rollers weren't just gambling their own money. They were gambling other people's money. They were putting at risk the entire financial system--indeed, our entire economic system. And now we are all paying the price.

Stiglitz discusses the incentives to take excessive risks, not surprising for someone who earned his Nobel Prize for information economics.

I think that this is the right focus, but I think the discussion could be sharpened by asking why hedge funds have incentive schemes that reward managers for excessive risk taking. Specifically, why has the system of "2 and 20" (two percent management fee and 20% of profits) survived. This system rewards excessive risk taking since in any good year the manager will earn large profits but the losses go to the shareholders. Other financial institutions face regulations to prevent excessive risk-taking but hedge funds keep their strategies as proprietary secrets -- after all, it is their trading strategies that is the only source of their rents. But why would rich people invest in funds with such incentive schemes? That is the question. We know why managers love it. This is the puzzle we need to solve.