Encouraging financial innovation

Reading Luis Garicano and Lucrezia Reichlin's argument for the creation of a synthetic safe eurobond through which the ECB can conduct QE, an old question arose: why do we see so much bad financial innovation and so little good?

I say this is an old question because it is now over 20 years since Robert Shiller wrote Macro Markets, in which he proposed the creation of financial products to manage macroeconomic risks, and yet we've seen little progress on this front. What we have seen, though, is the creation of mortgage derivatives which contributed to the crash.

This illustrates a point made by Thorsten Beck and colleagues - that there are both “bright” and “dark” sides to financial innovation:

Financial innovation appears to encourage banks to take on more risks, which helps provide valuable credit and risk diversification services to firms and households, which in turn enhances capital allocation efficiency and the overall economic growth. On the downside, the “dark” side of greater risk taking is that it significantly increases the bank profit volatility and their losses during a banking crisis.

So, why do we get so much "dark" innovation and so little "bright"? Banks are guilty not just of sins of commission - mis-selling and rigging markets - but of sins of omission, not developing good products sufficiently.

The answer lies in the basic economics of innovation - that the social benefits (or costs!) of it often differ from the private benefits. (There is, of course, nothing unusual about financial innovation in this regard.) The type of innovation that occurs will depend not upon its social utility, but upon whether its proceeds can be appropriated privately. And this incentivizes dark innovation. "Crap" and "shitty" CDOs which can be sold to fools - sometimes in a different division of the same bank - will be produced, whereas products with big external social benefits need not be. It might be no accident that a big chunk of the good innovation we've had in recent decades - such as index funds or venture capital trusts - has received nice tax breaks.

Herein, I suspect, lies an under-rated argument for intelligent state control (or even ownership) of banks*. Such control might be necessary to rejig incentives towards bright innovation and away from dark. Mariana Mazzucato's argument (pdf) that the state can be entrepreneurial might be especially valid for the financial sector.

There's one argument against this that is plain wrong - that the state is usually bad at coming up with new ideas. This is irrelevant because in finance we already have the ideas for products we (might?) need, thanks to the work of Shiller and the theory of complete contingent markets. The challenge is to implement them.

And the payoff to doing so could be big. The economy is a complex emergent process in which recessions are unpredictable; we didn't need the 2008 crisis to learn this because, as Prakash Loungani showed, recessions before then weren't predicted either. This implies that recessions might not be preventable by macroeconomic policy. Instead, the best we can do is develop ways of insuring against them. And this requires financial innovation of a sort which the private sector has proved itself incapable of providing.

* Mere passive ownership, of the sort we have of Lloyds and RBS, is not enough.

Comments

[Stevenclarkesblog.wordpress.com]

@Chris

I have 'The New Financial Order' on my 'To Read' pile. I believe it will cover some of the material in 'Macro Markets', but should I read that first?

When you talk about social benefits diverging from private ones, we are in the realm of positive externalities - which introductory economics talks about and suggests as a legitimate role of government.

I've recently been reading Mancur Olson. In 'The Logic of Collective Action' he shows how hard it is for groups to provide public goods without some selective incentives or State compulsion of some kind.

In 'The Rise and Decline of Nations' he shows that groups can more easily form distributional coalitions which distribute resources their way at social cost. Perhaps the financial services sector is one of these coalitions - ripping off others at a huge cost to others (i.e. recessions.)

In that book though, he does suggest that some instability is good for weeding out these coalitions. In exposing the bad behaviour of banks, and perhaps in spurring corrective responses, some good may have come out of the crisis.

[Icarus Green]

I guess libertarians would argue that since the financial sector is basically socialised from a risk point of view there's no incentive for useful innovation, just more rent seeking behaviour masquerading as competition.

One of the papers they passed around in work recently makes the cogent point that most financial engineering is actually legal engineering.

Whole swathes of the industry creating structured products and derivatives to clients looking to avoid taxation and of course, the creative accountancy of audit firms and the routing of cashflows through various shell companies and jurisdictions. It makes sense, you often get superior returns from minimising tax than investment decisions or taking on more risk.

Another factor is of course, the concentration in the industry and complete lack of competition.

It makes me laugh when bankers say they're the fighter pilots of capitalism when actually they're closer to civil servants than a market stall trader. Expecting innovation from these people is expecting too much.

If we're looking for genuinely useful innovation in the financial sector, it'll probably come from outside the decrepit industry in the technology sector. Volcker was dead right when he said the ATM was the best thing finance has done in the past few decades.

[PS]

Many financial innovations are dark because they are invented to circumvent sensible regulations.