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IS FINANCIAL INNOVATION A GOOD THING?
Felix Salmon has an (unsurprisingly) sharp post on regulating financial markets that includes this observation:
If the purpose of regulation is to avoid market failures, we cannot use, as the instruments of financial regulation, risk-models that rely on market prices, or any other instrument derived from market prices such as mark-to-market accounting. Market prices cannot save us from market failures. Yet, this is the thrust of modern financial regulation, which calls for more transparency on prices, more price-sensitive risk models and more price-sensitive prudential controls. These tools are like seat belts that stop working whenever you press hard on the accelerator."The best way to go," continues Felix, "is to set some very clear and simple rules, much as the Spanish central bank did, and refuse to allow banks to build enormous businesses doing things that the regulators don’t understand. "
There's a word that's gotten thrown around a lot during the financial crisis: "Innovation." That's the term we've settled on for the financial system's tendency to concoct new ways to package risk and channel money. It is, in American capitalism, a pretty storied term. It's what gave us personal computers and iPods and air conditioners and an economy in a nearly constant state of expansion. In this telling, Collateralized Debt Obligations are just one more innovation. Maybe good, maybe bad, but still a part of America's broadly admirable tendency towards entrepreneurship.
The next step -- the regulatory step -- is going to have a lot to do with that judgment. Everyone agrees that no one should be allowed to do this thing again. But no one will. The question is how far you go in constraining the behavior that leads to things like this one. How far you go, in other words, in constraining financial innovation. Salmon is willing to go pretty far: Don't allow banks to build businesses on innovations that regulators don't understand. Conversely, some observers, like this anonymous Economist blogger, argue that "I'm inclined to believe that whatever innovation our kinetic and energetic innovators come up with is, until proven otherwise, welfare enhancing."
That will be the divide. Do you give financial innovation the benefit of the doubt and maybe amp up the government's capacity to "prove otherwise?" Or do you put the burden on Wall Street and force them to prove worth before they can unleash their creations into the wild? That wouldn't be an unknown strategy: It's how the pharmaceutical market currently operates. But it would be a serious change.
By the way: Congratulations go to Felix Salmon, who's taken up shop at Reuters, and the excellent, train-obsessed, Ryan Avent, who will be replacing him at Portfolio.
COMMENTS (17)
Salmon is willing to go pretty far: Don't allow banks to build businesses on innovations that regulators don't understand.
This doesn't sound that far. I mean, sure, as written it's way too broad to be applicable as a regulation, but the spirit of the statement doesn't seem to strong. Regulators aren't stupid. If reasonably well-educated professionals up-to-date on the industry can't figure out what a certain innovation is supposed to do or how it works or what its likely short-term side effects are, then it's probably constructed incompetently and/or with intent to fool someone. And correct me if I'm wrong, but I think innovations that don't meet conditions - understandable method, intent or side effects - are common.
Posted by: Cyrus | April 14, 2009 3:56 PM
Huh. Hastily written. Forgive the grammar mistakes.
Posted by: Cyrus | April 14, 2009 3:57 PM
A lot of these innovations were devised to increase profits while contributing nothing to the basic economic function of financial institutions: safeguarding savings and providing credit in a rational way. Why should they exist?
Posted by: SqueakyRat | April 14, 2009 10:40 PM
Let's go further. Why should banks exists?
I like Felix Salmon's points, as far as they go, but he doesn't say or seem to know exactly how to regulate these institutions. Maybe that's because he's not going deep enough to cut out the cancer.
The more reliable solutions may lie in the fundamental area of asking: what, exactly, do we need banks for anymore? Are they really that good at moving money around? Couldn't we do it better, at far less cost?
The money power is everywhere a sovereign power, and sovereignty in the U.S. means us the people. We, through the Fed, create (and destroy) money, but it goes first to the banks, who make a percentage on it before it even trickles down to us, discounted in value by the mildly inflationary activity of the banks before us.
The banks also make a percentage on our deposits in checking accounts, while all we need is a trustworthy storehouse of stable currency to draw on for spending purposes.
The modern system of adjusting the money supply through interest-dependent banks is an inheritance from the centuries during which the only thing that could move money around was interest, and banks were the vaults that handled the stores of excess liquidity, paying less interest than they earned, and making their profits in the difference.
The banks still enjoy this legacy position as a supposedly necessary part of the economic matrix. But are they?
Right now a vast amount of our sovereign credit and good faith is going down the drain to make whole a class of people who have violated their obligation to manage their own economic affairs prudently, as good stewards of trust, as the privileged intermediary between the Federal Reserve System's money creation and the markets.
The only thing that has made our economy stable throughout our history has been Federal intervention as the guarantor of last resort. The government, and thus the American people, have taken up the fiduciary responsibility laid down by the banks. Our latest crisis is little different from all the other panics we've had to endure because nobody could come up with a better system of financing the productive economy.
The answers to the failures of finance don't need to be looked for in a narrow view of what was missing this time around in terms of regulation. The answers need to be sought from the long history of bank and market failures, and in our willingness to take a fresh look at the mechanics of the financial sector. We should be asking, how we can actually create an economy that behaves in a manner as stable as the sovereign guarantee which is the only thing that makes it all possible in the first place?
It's time to get rid of the whole idea of banks, and time for us to start managing our own money ourselves, using the computers that made the Internet, and our own crowdsourcing, and transparently numerated money and instruments of money.
If finance today is unintelligible to almost all people, that doesn't mean we can't design perfectly understandable methods of loan and repayment, and risk and reward, and stable money measures, and have all of this be subject to the rule of law and sovereign political accountability.
Posted by: Ross Hunter | April 15, 2009 12:48 AM
Financial Innovation
is finagled, gamer-schemer-scammer market manipulation...
It is NOT, NOT, NOT a product.
An iPod or a toaster or a PC
or a new way to build a bridge...
IS.
To equate these things is existentially specious and possibly malevolent.
Posted by: Anonymous | April 15, 2009 2:21 PM
Whoops...
v.s. = Me.
Posted by: has_te | April 15, 2009 2:26 PM
Thanks for the link! If I may, though, could I ask you to link to my Reuters blog at http://reuters.com/felix rather than reprints at Portfolio?
xxf
Posted by: Felix Salmon | April 15, 2009 3:07 PM
Oh, you're ahead of me, sorry, missed the update...
Posted by: Felix Salmon | April 15, 2009 3:08 PM
Very good "watershed" to evaluate regulation plans.
Posted by: racetoinfinity | April 16, 2009 4:35 AM
Innovation is what gave us "personal computers and iPods and air conditioners".
But the key issue is that these innovations are based in the physical sciences. And the problem with financial innovation is that all too often we stubbornly try to apply mathematical forms of reasoning that work well in the physical sciences, but are simply inadequate to capture market dynamics, which as many other forms of social phenomena, are of a degree of complexity that goes beyond mathematical treatment.
Felix Salmon also wrote a brilliant article on the flaws of David X Li’s Gaussian copula function that gave triple-A ratings to CDO's, and Jerry Z. Muller just wrote an essay on "pseudo-objectivity", the ideology that leads us to beleve that attaching a number to information makes it more solid than is actually the case.
I comment both pieces and several other related ideas in my last blog post:
http://alanfurth.com/a-whole-new-mind-for-finance
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