I sing the praises of financial innovation

A few weeks ago, Dani Rodrik issued a challenge:

[A]dvocates [of financial innovation] owe us a bit more detail about the demonstrable benefits of financial innovation. What I would love to hear are some examples such financial innovation—not of any kind, but of the kind that has left a large enough footprint over some kind of economic outcomes we really care about. What are some of the ways in which financial innovation has made our lives measurably and unambiguously better?

If I had asked this question a little over a year ago, I suppose I would have been hearing a lot about how collateralized debt obligations and structured finance have allowed millions of people to purchase homes that they would not have been able to afford otherwise. Sorry, but you will have to come up with some other examples now.

I will give Dr. Rodrik some of what he wants, that is, examples. But first, I have a nit to pick. In citing last year’s would-have-beens, Rodrik has offered up the textbook marker of an anti-innovation.

…have allowed millions of people to purchase homes that they would not have been able to afford otherwise.

Any claim that a financial innovation has achieved a concrete, positive end is a sure sign of disaster, or (in the unfortunate lingo of economics) a distortion. The purpose of a financial system is to solve a collective optimization problem whose solution we cannot guess a priori. If we are very sure that welfare is maximized by vastly expanding the housing stock and making homeowners of people who otherwise might not buy, then the government should just tax to build McMansions, and auction off the oversupply. More generally, one cannot judge a financial system by any particular outcome, because all financial systems make mistakes, and the mistakes always look good while they last. We judge financial systems by the performance of the economies they guide over time.

Rodrik has asked for examples of good innovations. Here are a few on my list:

  • Exchange-traded funds
  • The growth of venture capital and angel investing
  • The democratization of access to financial information (e.g. Yahoo! finance)
  • The democratization of participation in financial markets (e.g. the growth of internet and discount brokerages that offer easy access to a wide variety of stocks, bonds, and exchange-traded derivatives, both domestic and international).

No list of good innovations is complete without a list of bad innovations. Obviously at the top of the list go CDOs, CPDOs, OTC credit-default swaps, the general alphabet soup of the structured finance revolution. (I would not, however, put all mortgage or asset-backed securities on the list. Well-constructed asset-backed securities, those that are transparent and not overdiversified, are very much like ETFs, and if they were more widely accessible I’d place them directly in the “good” column.) But there are many, many more bad innovations that we have yet to come to terms with:

  • 401-K plans with limited investment menus
  • The conventional wisdom that long-term savings ought by default be placed in passive stock funds
  • The conflation of ordinary saving and financial return seeking
  • The tolerance, advocacy, and subsidy of financial leverage throughout the economy
  • The move towards large-scale, delegated, and professionalized of money management
  • The growth of investment vehicles accessible primarily or solely to professional and institutional investors

How do I distinguish the good innovations from the bad? I cannot do what Dani Rodrik asks, and point to concrete good outcomes, and I have no studies to show that economies with tools I prefer outperform those without. In engineering fields, one develops and chooses innovations not by virtue of historical experience, but by application of a theoretical toolkit that prescribes what would work if it were tried. Of course, eventually historical experience either vindicates or discredits the theory, but I have a theoretical view, and I claim that it has not been discredited. Here are a few principles:

  1. Financial systems are means of aggregating diverse, decentralized information into patterns of capital creation in the real world. Financial innovation ought to be judged by how capably they facilitate this information transmission. By this criteria, “opaque” financial instruments — these include everything from complex tranches of CDOs to certificates of deposit at your local bank — are presumptively bad. If an investor does not know and actively choose to bear the risk of the real projects she is investing in, then she is introducing noise into the allocation decision. On a sufficiently large-scale, this noise will lead to allocative errors and widespread catastrophe with probability one.

    Good innovations:

    • Are transparent, investors can understand what they are investing in.
    • Are expressive, that is they increase the range of widely dispersed information that investors can impound into an investment decision.
    • Are compartmentalized, the parties upon whom the costs and benefits of the investment decision fall are well-defined, and these parties accept and are capable of bearing the risks they have chosen without external support.
  2. Savers should not be investors, that is they should not be underwriting the execution of projects about which they have no opinion and whose risks they are unwilling to bear. Savers’ sole legitimate goal is to transmit their current wealth into the future with the minimum loss possible. (Savers who want to earn a real return must become investors, that is they must perform informational work and bear risk.) Our current system does not serve savers well, because our markets offer inadequate ways of purchasing claims on future consumption (as opposed to claims on future production). This is a tragedy both for savers (baby-boomers who are losing their retirements ought to have been able to “buy forward” their housing, food, transportation, etc. years ago), and for the economy as a whole, because information about future consumption is lost, and we have no reason to believe that the salesmen who pawn off “savings products” are qualified to make outsized contributions to the allocation decision.

  3. A primary goal of a financial system is to allocate and minimize the burden of economic risk. That has two implications:

    • To the maximum degree possible, the financial system ought not introduce risks that are not inherent to the real projects it is underwriting. In particular, financial systems should be designed to minimize what I’ll call “secondary counterparty risk” — the risk that an intermediary will fail to pay a claim that is not made explicitly contingent by the terms of the investment contract. Secondary counterparty risk is tacit, it is opaque (since human enterprises are never perfectly transparent and inter-relationships are complicated, we can never know a counterparty’s capacity to pay), and the informational problem of evaluating and quantifying it grows exponentially with the size and complexity of financial intermediation. So, financial intermediation ought be kept as “thin” and simple as possible. Having vast numbers of intermediaries bound into unstructured and unknowable networks by virtue of idiosyncratic bilateral claims is obviously dumb.

    • The risks inherent to real economic projects, which include ordinary investment risk and “primary” counterparty risk (you lend to an enterprise that fails, as opposed to the failure of a financial intermediary), should be very clearly allocated, and financial markets should not make it easy for risk-bearers to escape the consequences of their risks by ex post transfers in overly “liquid” markets. As much as possible, investors should be able to choose the level of risk they bear, and should plan to reap the fruit or accept the costs those choices in a very straightforward manner.

Some miscellaneous comments:

  • Complexity is much more often a marker of snake-oil than of quality in a financial instrument. “Sophisticated” investors are almost always predators or fools. The real-world informational problems investors face — what is it that should be done? how ought our resources be deployed? — are challenging enough. Creating structures that cannot be understood except by applying complex models that may or may not adequately capture the behavior of the instrument is just idiocy, a mish-mash of quant hubris and pseudoscientific salesmanship.

  • There is no inherent tension between financial innovation and regulation in designing a financial system. Some regulation compels and encourages useful innovation. For example, if as an outcome of the current crisis, banks find their leverage tightly constrained, it may be necessary for a new ecosystem of investment funds to arise to meet the needs of investors who otherwise would have lent to banks and enterprises that previously relied on bank financing. That is, a “local venture capital” boom might arise as a direct consequence of bank regulation. Further, much good regulation is itself a form of financial innovation. Centrally-cleared, collateralized derivatives exchanges are incredibly clever devices, whose function and regulation are intimately intertwined. Good regulation does not take the form of minions of the state saying “no! non! nyet!” to hearty capitalists. Good regulation involves the clever definition of market structures to which participants are naturally drawn because they function well. Regulation itself can be a form of financial innovation, as in “cap-and-trade” pollution control schemes, Warren Buffet’s import-certificate proposal, or congestion-pricing of trades in financial markets.

So, this has been a sprawling brain-dump, rather than a clear-headed vindication of the proposition “financial innovation can be good”. Despite the deficiencies of the essay, I strongly believe that transitioning from our current, very broken, financial system to something better will require a great deal of innovation, along with regulation. We should think of the financial system as an integrated system, and work creatively to improve both its private-sector and public-sector components. We should be humble, and careful, and introduce big changes incrementally where possible. We should try to bear in mind the social purpose of a financial system, and use that as a yardstick against which to evaluate new ideas. But we must make big changes, and it will not be enough to tell people what they cannot do. We want a financial system that is safe and simple, but also expressive and dynamic and capable of taking large, well-considered risks. We will have to invent to get what we want. The stakes could not be higher.

 
 

19 Responses to “I sing the praises of financial innovation”

  1. talboito writes:

    “This is a tragedy both for savers (baby-boomers who are losing their retirements ought to have been able to “buy forward” their housing, food, transportation, etc. years ago),”

    How is that different from your bog standard annuity?

  2. Gu Si Fang writes:

    Great article! The way I interpret your words is that money is the archtype of hayekian spontaneous order.

  3. Right on Steve! I have been critical of “financial engineering” for years. Until the Fed is killed, savers will be exploited for the benefit of Wall Street and Washington, DC.

  4. RueTheDay writes:

    Great post Steve. Unfortunately, I think your list of “positive financial innovations” needs paring down.

    WRT VC and angel investors, I’m going to have to agree with Yves at Nakedcapitalism – these are more the result of greater and greater wealth concentration than of any tangible innovation.

    WRT the democratization of financial information, this is the result of technological innovation, not financial innovation. It is merely one class of information, of many, that have been made more readily available due to the rise of the Internet.

    WRT democratization of financial market participation through the rise of discount and internet brokerages, discount brokerages have existed since 1971 when Charles Schwab set up shop, and Internet brokerages are a function of the technological advances mentioned above. Not financial innovation per se.

    That leaves us with Exchange Traded Funds. I agree that these are in fact a positive innovation. However, given how long we’ve had stock exchanges, indexes, and mutual funds, it’s kind of sad commentary that it’s taken this long to come up with the idea of putting together a fund that buys the components of the index and trading the fund on an exchange as if it were an ordinary stock.

  5. Gabriel writes:

    I’m not sure I understand your #2… future production is inherently risky and if you want future consumption of most people to be deterministic then someone should be willing to fully insure everyone else. Who?

  6. wh writes:

    Weather derivatives are possibly a beneficial example of financial innovation (if you’re willing to call them innovation). Hard to say if they count.

    Speaking of weather derivatives (or currency swaps, etc.):

    These are financial instruments typically praised (at least in introductory textbooks) as tools that allow an organization to dampen the impact of external volatility (eg: weather, or exchange rate fluctuations) and thereby smooth out its finances…in exchange for fees (or other forms of “cost”) that also constrain the range of possibilities for the absolute return.

    One issue I’ve never seen explicitly raised is whether the widespread use of such “smoothing” tools has the systemic result of excessive rigidity, perhaps to the point of (systemic) rigor mortis.

    Let me proffer a parable.

    Say that Widgets, Inc., is a midsize european company (ie: large enough to take advantage of “smoothers”) that mainly supplies capital equipment to USA-based manufacturers of food equipment used in outdoor amusement parks.

    Widgets potentially suffers large amounts of weather and exchange-rate risk:

    - if the previous year’s weather was particularly unfriendly, widgets’ customers’ customers are going to have less money to spend on new equipment; they’ll try and make do with what they already have

    - if the Euro is too pricey, Widgets’ goods are uncompetitive; if the Euro is too cheap, Widgets’ goods may sell for less than desired

    Widgets’ CFO can certainly ameliorate those risks with a well-chosen basket of weather derivatives and currency swaps. The protection comes at a cost — possibly some mix of upfront cash outlay and diminished absolute profitability — but for Widgets, getting those risks nearly-neutralized is clearly a big win: the company can focus on its core competency (making widgets) without too much intrusion from important — but not really “relevant” — outside forces.

    At an individual level this is a tradeoff most responsible entities would make: sacrificing some higher-risk, higher-payoff opportunities in exchange for a higher expected outcome is almost the definition of prudence.

    At a systemic level, though, I wonder: if everyone and their brother is locking-in a few years’ worth of outcomes, how much does that slow down the process of creative destruction?

    Does the ability to lock in (at a cost) a future you can foresee today leave you:

    (a) unable to pursue a better option you discover tomorrow, b/c you’ve spent money upfront ensuring an outcome (and thus have inadequate money leftover, or just the cost of modifying your previous arrangement shifts the cost/benefit ratio of the new, better option enough to make it unpalatable)?

    (b) unmotivated to seek out better options, b/c “eh, I’ve got my results locked-in already”?

    Would Widgets have been better-off investing its funds in r-and-d, business development, and other, similar, opportunities? Possibly.

    Systemically, would the system be net better off if more firms spent more on r-and-d, business development, etc., and less on “smoothing” (even if it meant that some firms got clobbered by “preventable” volatility)? Within certain parameters, I’d find it hard to believe that isn’t the case.

  7. wh writes:

    Gabriel: if I may speak for our host, the point is this:

    if you are planning to retire in N years for a period of time of M years, the goal you are attempting to hit is: having food, shelter, medical care, etc., starting in N years and continuing for the next M years.

    The current retirement “system” is: during your working life, accumulate financial resources and use said resources to procure those needed items during your retirement years.

    This approach is something that is not intrinsically impossible, but it has several moving pieces:

    - it’s pretty much impossible for the vast majority to save enough money in “savings” (eg: cds) over a life to provide for retirement (wages are too low; inflation-vis-a-vis interest rates too high)

    - ergo, one has to “invest” one’s “savings” in a variety of financial instruments with higher expected returns and the correspondingly higher risk profile

    - and, even then, assuming you get your expected return, there’s no guarantee that, when you do hit retirement, the amount you forecasted as being sufficient will actually be sufficient: prices can change

    A really valuable financial innovation would be something like:

    - a standardized futures product for a one-person year of some standardized basket of “food staples”, or “medical coverage”

    …which would let you lock in a year’s (basic) food supply or medical coverage N years out at a known current price.

    We don’t see that financial innovation, but it would be beneficial if it existed.

  8. rortybomb writes:

    “The conventional wisdom that long-term savings ought by default be placed in passive stock funds”

    Expand?

  9. Felix writes:

    Steve, I’d move CDS from you list of bad innovations to the list of good ones, noting that they fulfill all your criteria for what a good innvoation is. (And also.)

    I’d also be interested in where you think long-term savings should be kept. FDIC-insured CDs? TIPS?

  10. talboito — Annuites (as investment products) typically hedge the risk of running out of money before you die, which is an important risk to hedge. But they don’t hedge the risk that adverse price changes leave you unable to afford to consume what you had expected to consume in retirement. So annuities (of the simple sort, the complicated ones tend to be schemes for ripping off old people, I think) are a useful savings product, but not a sufficient hedge against a hard retirement.

    RTD — Re VC, perhaps they are the result of wealth concentration, but they do permit a wider range of entrepreneurs to get somewhat discriminating financing. I would like to see something like micro-vc, things like prosper.com that raised funds for new ventures in crowdsourced small increments. But for now I’ll take what I can get. I think the availability of VC financing outside of friends-and-family based connections is an important and good thing.

    I’d agree many of the positive innovations are pretty braindead application of technological change to the financial sphere, but they still count as far as I’m concerned. The financial sphere is enormously resistant to positive technological change — there’s a lot more brainless automation and disintermediation that could occur than has occurred, and I say bring it on. In a good world, much of the process of “going public”, from accounting and disclosure requirements to underwriting in a community of investor capable of supporting small ventures, would be as automated and simple as the process of incorporation has now become.

    Gabriel — wh has it. In my view, saving is about hedging future consumption requirements. You are right that this is impossible to do perfectly, the future is inherently risky, if a comet hits the earth, promised future housing will not be provided. But financial markets offer a wide range of insurance products whereby for a price, a third party assumes the risk of fixed performance. Those obviously need to be carefully designed and regulated, and are. Insurance in general is subject to catastrophic, systemic breakdown, but with the exception of regulatory wormholing AIG, it has proven to be a tractable kind of product. There is no reason why, in theory, I should not be able to contract forward for housing in Florida beginning 20 years hence, or purchase a certain level of food service. It’d require a lot of work to define far-future services generally enough to capture inevitable social and technological change, but specifically enough that people on both sides of the contract can understand and fulfill their roles. But I think it could be done, and if it could, it would represent an incredibly useful innovation. Savers could endow themselves with a basic, predictable and near-certain future living standard (and then take on investment risk as they see fit). A lot more information about future consumption plans would be revealed to the market, leading to more productive patterns of real investment. (Yes, from demographics we can predict a lot about future consumption. But not everything — people’s preferences about location, tradeoffs between consumption in housing vs food vs travel etc — are not so predictable, but could be expressed in these markets.)

    wh — You can speak for me anytime. The issue re rigidity is interesting, but production hedges can be and usually are purchased over time frames “short” relative to social/technological change, but long relative to a business planning cycle. For example, Southwest hedges (at least until recently!) fuel costs, I’m guessing up to about a year forward. That won’t prevent SW from having to adapt to a world with higher fuel prices (if that’s what’s coming), but it does let SW plan for the next 6 months in an environment of reasonable certainty. In a way, this is a rigidity, since in a perfectly dynamic world, all prices and expectations would update instantaneously. But in reality, that’s implausible, business plans have to have a certain degree of rigidity, as do consumer expectations, the real world is sticky. So long as the time-scale of production cost hedges roughly corresponds to the “natural” stickiness if the business planning process (defined by informational limitations, menu costs, hard-to-change expectations, etc.), it seems to me that little is lost and much is gained by permit such hedging. It’s certainly imaginable that hedges could be taken to extreme, and permit well-hedged wagon-wheel manufacturers to thrive a century too late, but in practice, I don’t see that as likely. Neither producers nor their counterparties are eager to go very far into the future. Developing workable far-future hedges, as we see in the savings case, is hard to do, and firms tends to plan over few-year horizons at most. It could become a problem, that firms become so far-sighted that they lose all dynamism. But so far, we have the opposite problem.

    rortybomb — Stock is a risky business, however many times you read “Stocks for the Long Run”. Sure most cohorts would have succeeded very well, had they with perfect efficiency ploughed mindlessly into equities, reinvested all dividends, and never lost their nerve or suffered a financial crisis at the same time as stocks were down. In real life, stock market downturns correlate with human crises, people reinvest and dollar-cost average imperfectly, they experience fees, and risks associated with the institutional structure of investing (over much of that “long run”, investors weren’t protected from broker failure, for example). Further, the practice of mindless passive equity buying itself harms the efficiency with which stock markets perform — I claim that the hegemony of this idea and the overall volatility we’ve seen since the mid-nineties are not unrelated. Mindless equity investing makes stock overvalued, and overvalued markets eventually fall. In general any strategy that becomes the widespread conventional wisdom is vulnerable, as financial markets are places where civilize people try to take one another’s money, and to the degree a large group of people share very similar portfolios and behavioral characteristics, someone will figure out a way to shake the crowd’s faith for fun and profit. Individually and in aggregate, safety in markets comes through diversity, and if everyone’s in the S&P 500 index fund, that doesn’t count as diverse.

    BTW, I’ve nothing against index fund investing. But people should understand it is risky business, they are investing, they are subjecting themselves to very dangerous games of which it is hubris to believe one is totally immune, and they should have strategies for dealing with that. (And if your strategy is the same as everyone else’s — “stomach of steel!” — you should ask yourself why your steel stomach should be stronger than everyone else’s.) I invest in passive, broad equity funds. But I time, I go short as well as long, and I think I’m not doing what I’m doing just when everyone else is.

    Felix — I think your attempt to rehabilitate CDS is a bit disingenuous. Not because you are very wrong now — you may well be right that at this point, the CDS market is nearly universally well collateralized and marked-to-market. But the OTC CDS market was poorly designed from the outset, and at best it has slowly and clunkily evolved from being nightmarishly stupid to almost decent. CDS contracts were designed like insurance contracts for holders of the underlying — remember, initially they were almost never cash-settled — but traded like bets that needed no relationship to the underlying. The ad-hoc cash settlements beginning with Delphi and various IDSA evolutions since have helped, but the recovery on a CDS remains a subject of grave and stupid uncertainty until the day ISDA conducts its auctions. If these were insurance contracts, they should have been sold only to those with insurable interest, and regulated like insurance contracts. If they were general instruments for speculating and hedging on credit risk, great!, I have no pr
    oblem with such instruments, but they should have been designed to behave in a predictable manner.

    You also give the CDS market far too easy a pass re credit risk. Yes, at this moment, after Bear and Lehman and a zillion hedge fund implosions, the sprawling network of CDS contracts outstanding may in large be carefully managed to mitifgate counterparty risk. But even now we have no way to know that, other than to take peoples’ word, and I would bet you that two years ago, when the only significant default had been Delphi and the Great Moderation was humming along, that was not the case. If Lehman turns out to have been a non-event, it’s because a lot of trauma occurred prior to a very major default. If the default had been a sudden storm, if it had been Act I rather than Act III of the crisis, do you think the ripples would have been so placidly absorbed? I don’t. Now it is probably right to say AIG is the exception that proves the rule, but two years ago, the exceptions may well have ruled.

    Even if I’m wrong, the opacity leaves open the possibility that I’m right, and that creates terrible and unnecessary uncertainty. Do you think Bear would have had to be saved without the CDS market? There is no good reason why we should not know that credit derivatives are well-collateralized with losses fully taken daily.

    I do think credit derivatives could belong to the “good innovations” column. But until counterparty risk, and uncertainty about counterparty risk are managed, and until the cashflows associated with the contracts are better defined ex ante, CDS will remain in my “bad” column. I hope we do see better credit derivatives going forward.

    Re: long-term savings, the main thing is that there is no right answer. If everyone is doing the same thing, no one can ever be safe. Ideally we would have such a diverse array of personalizable savings instruments (claims in housing in every city, on a wide variety of food contracts, etc) that people would make diverse choices suitable to their preferences. But we don’t live in that world yet, so savers who do not want to be investors have to do the best they can. TIPS are a decent option, though they involve the risk that ones own consumption and published CPI don’t correlate well over time. Treasuries (or FDIC-insured CDs) are decent, but involve price-stability risk. Indexed equities offer higher expected return, thereby hedging some price stability risk, but a lot of volatility risk, and volatility risk that is likely to be timed against large retirement demographics. Annuities hedge the risk of outliving ones wealth. Long-term care insurance hedges the risk of poverty during chronic illness. All of these are savings vehicles that hedge some risks but leave one exposed to others. Savers should try to define portfolios based not upon expectations about the future market, but based on evaluations of their own risks and how best those risks might be hedges. We collectively should make it easier for people to do this by, yes, innovating. But given the array of savings products that already exists, there are many better, safer, and less predictable strategies than just going all-in with equities and hoping for the best.

    Beyond a certain level of wealth, I think it is foolish not to become an investor. That is, I think even modestly wealthy people should develop opinions and bear risk by say, timed purchases and sales of equity. But if what you are doing is saving, if you want to take your current wealth forward while minimizing risk as best you can, investing in equities regardless of their price is simply not a reasonable vehicle. At best, you are gambling on the luck of your cohort. Personally, you are taking on risks that are easily underestimated. Collectively, you are contributing to the mispricing of capital and harming the broad economy.

  11. groucho writes:

    “Our current system does not serve savers well, because our markets offer inadequate ways of purchasing claims on future consumption (as opposed to claims on future production). This is a tragedy both for savers (baby-boomers who are losing their retirements ought to have been able to “buy forward” their housing, food, transportation, etc. years ago), and for the economy as a whole, because information about future consumption is lost”

    Steve, you’re getting to the core of today and (even more so)tomorrows’ social problem(s).

    The only way society can increase its (all inclusive) standard of living is by amortizing lifetime consumption over shorter time periods. This clearly has not been done. In fact Govt in Cahoots with Hi-Fi has run the system in reverse; amortizing consumption over much longer time horizons on a per capita basis.

    This is NEGATIVE Real Wealth.

    The kernel that drove this process was the money illusion and the elimination of private COLA(US).

    If workers can offset the inflation tax(which they still can in EU)than Govt loses its seigniorage “exorbitant privilege”.

    CB’s like some inflation because they want to avoid any appearance of powerlessness during so called “liquidity traps”. Hence Bernanke’s making sure it doesn’t happen here (look mom we blew up the system) speech. (Ironic that we have both Bernanke, the monetary instigator and Paulson, the mortgage CRAP instigator in charge of FIXING the system!)The historians will have fun with that!

    With the loss of COLA, workers bought into both wall st schemes. First equities and than RE. They are now the bagholders.

    Could things have been different?

    Absolutely YES! For the Anglo countries, with production moving to asia, CPI should have been allowed to find its natural level. Instead of a negative exogenous shock this would have been a virtuous Real wealth cycle development. A positive savings cycle would have ensued and the rest as they say would have been history………..But Nooooooooooo, Greenspan would have non of it. Why should the citizen be allowed a Free ride like the govt and finance? They would get spoiled maybe fat and lazy. That is why COSUMPTION Credit had to be unleashed with a vengeance.

    Wall st(with the direct effort of yours truly King Tut Paulson) was trying to scheme their way into the chinese banking system and was very willing to hand over indebted citizens to china Inc if that would help in this endeavor.(didn’t work, but the US citizen just guaranteed trillions in bad agency debt: what a country!)

    The debt deflation we are now in should be allowed to run its course as quickly as possible. Today’s private workers have few real claims to pay for “retirement”. Consumption(esp including shelter)claims(through the default process) need to reduced significantly for many to have any standard of living at all in the very near future.

    If the govt cranks up the printing press, the US will end up like Russia or Agentina.

  12. John writes:

    One problem I see with future-consumption financial products is that they can hardly be less risky than private defined-benefit pension plans, which many workers (often via their union contracts) invested in and are now finding to be under-funded and unable to pay the benefits promised. Some of these plans in fact had a “future consumption” health=care component, which is of course now being eviscerated. I think that even before we try to figure out how to build innovative future-consumption financial products we have to analyze what went wrong with the private defined benefit pension plans we already have, and fix that.

  13. Rowan writes:

    wh, I used to work for a UK-based software company that had about 98% of its revenues in USD and about the same proportion of its costs in pounds. Being able to lock in an exchange rate for future payments was vital, because it reduced the risk of a short term cash flow crisis to nearly zero. That enabled us to take more risk on products and compete with US firms, which would have _increased_ the speed of creative destruction, not lower it through rigidity. On an economy wide level, I would think that wide use of currency forwards should push the current value of the exchange rate toward a stable long term value by facilitating competition.

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  15. Per Kurowski writes:

    The financial engineering bubble!

    Give home buyer Joe a 300.000 dollar mortgage at 11 percent for 30 years.

    Place that mortgage with other similar in a structured security able to argue itself to a triple-A rating.

    Convince investor Fred that the security that includes the mortgage to Joe, as it has a triple-A rating, is at a rate of only 6 percent, a good financial investment.

    And then you can sell Fred the 300.00 dollar mortgage to Joe for 510.000 dollars

    As you see, after all is sliced and diced, the 210.000 dollar profit had little to do with easy money or a house bubble, and all to do with the wizardry of financial engineering bubble based on the venom of ratings.

    And now we have Joe, with a real liability of a mortgage of 300.000 dollar guaranteed with a house that might o might not be worth it, and Fred, with a 510.000 dollar investment in the willingness of Joe to service his original mortgage at 11 percent for 30 year.

    How do we sort this one out?

    Cheers

    http://www.subprimeregulations.blogspot.com/

  16. Daniel Clarke writes:

    “Our current system does not serve savers well, because our markets offer inadequate ways of purchasing claims on future consumption”

    Something to add to your list of good innovations: Indexed linked bonds (see http://en.wikipedia.org/wiki/Inflation-indexed_bond). Coupon and capital payments are linked to a price inflation index, allowing pension funds (and hence individuals) to effectively hedge indexed-linked liabilities. Without such instruments it is very difficult for financial institutions to offer inflation-linked products (as opposed to production-linked products).

  17. “The democratization of participation in financial markets (e.g. the growth of internet and discount brokerages that offer easy access to a wide variety of stocks, bonds, and exchange-traded derivatives, both domestic and international).”

    This is a tough one, although you have to be careful in how much and how you regulate it. The vast majority of people don’t have the expertise to buy single stocks, let alone derivatives, and instead should only be buying stocks in very well diversified funds like the Wilshire 5000. Or a nice and simple plan for laypeople is 30% Buffet/70% Wilshire 5000 or equivalent.

    Laypeople can get in so much trouble buying “Pep Boys because they have great service”, or “Nanotech stocks because that’s the industry of the future”

  18. This is the best thing I’ve read on the financial crisis so far. Simple, obvious.

  19. Terry writes:

    Great post!

    One concern: You mention ETFs as a “good” innovation and, for the most part, I agree. Yet, just today I read elsewhere about new/growing triple-leveraged “short” ETFs. I note your lack of enthusiasm for leveraged investment, but it appears that the managers of these ETFs have learned NOTHING about leverage from their financial sector brethern. How will they pay off their clients when the market actually turns up and people start selling those ETFs?

    It seems we are doomed to continue acting like avaracious idiots in perpetuity.