One of the most remarkable aspects of the success of Wall Street in subordinating the real economy to its wishes and needs is the con job implicit in the application of the word “innovation” to what might more accurately be described as tax evasion, regulatory arbitrage, and chicanery. Martin Mayer once described innovation as “using new technology to do that which was forbidden under the old technology.”
Rob Johnson, former economist to the Senate Banking Committee, has a new article that parses how the financial services industry has managed to wrap itself in the mantle of progress, when if anything its new products have been a force for destruction rather than creation. We had a wave of new OTC derivative products sold, starting in the early 1990s, whose high profits for the most part depended on the fact that they allowed investors to game ratings or mask the economic substance of transactions or fob risk off on to people who really did not understand it. The industry managed to co-opt SEC chairman Arthur Levittt and fight a delaying action until the media got bored and went on to other matters, A collateralized debt obligation market blew up in the late 1990s only to be reborn in the new millennium in only slightly modified form to wreak havoc on a much greater scale. Abuses of off-balance-sheet vehicles by Enron did not lead to reforms that affected the financial services industry much, since huge carve outs were made so as to keep mortgage securitization alive. And I will admit to having been unable to keep up on the news as fully as I once did, but I don’t recall any of the proposed fixes for the securitization market calling for changes in deal structures and servicer contracts so as to make mortgage mods easier and more attractive.
From Johnson:
Innovation. It is a lovely word that teases the mind with the notion of expansive possibilities… A win-win game. Just as Americans once expanded westward to relieve social tensions, we are now exhorted to have a rather imprecise faith in the notion of technological change to deliver us from our current troubles. Embracing that starship to unlimited possibility and deliverance requires a faith that cannot be easily refuted: Who, after all, is against progress?
David Noble, who has written so powerfully about this in his series of books including America by Design, Religion of Technology and Beyond the Promised Land, has explored this mythology of redemption and salvation through changes in technique and deference to undefined dreams of “possibility.” It is time to apply his perspective to the religion of financial innovation.
We have seen the financial sector, with its massive resources and access to the best minds of public relations, work to create what Stuart Ewen calls “spin.” ….we have been ever-so-persistently encouraged to draw the comparison between developments in financial products and the great leap forward in social uses of computers and the Internet, or advances in biomedical research. Former mathematicians, physicists, and computer scientists redirected their energies and Ph.D. tenacity to the domain of finance. Financial innovation was presented to us in a way that suggested that great things were happening for mankind. The presentations were usually vague. To understand them, we had only the power of our own imaginations, or perhaps, failing that, our awe in the face of this powerful expertise, confidently propelling us to a greater future.
Skeptical questioning–”Where are the benefits to be found?”–was frowned upon or ignored. ”Just doesn’t get it,” the whisperers would say. The skeptic was discredited with the insinuation that he or she was either 1) jealous of those who were making money and progress at the same time, or 2) had fallen down like a tired horse and just could not keep up with the new breed of thoroughbreds on Wall Street. After all, what kind of human spirit would get in the way of progress?
The reason I bring forward the notion of “spin” is that I sense that the great benefits of financial innovation were not self-evident, and that some form of intimidation or coercion was needed to keep the genie of doubt in its bottle. If a great Wall Street luminary were actually forcefully questioned, could he really convince grandma and you and me that he was making the world a better place? The point of the exercise, the spin, was to create deference to this process, to deter questioning and create social license, to make what those rocket scientists were doing appear as though their work was not merely profitable but something that would benefit us all. It was presented like a free option to the public: Wall Street pays these guys and “shazam!” They do things that make us all better off. No reason to get in the way of that, or even suggest that your Congressman or friendly bank regulator keep an eye on the proceedings. The subtle message was, “Get out of the way.” Such was the Kool-Aid poured into our glass by the financial press and pundits. That capital avoidance and tax avoidance and regulatory evasion were involved in offshore and off- balance-sheet methods was rarely emphasized, as the notion of innovation was paraded like a badge of valor.
Then we had the crisis. The side effects and spillovers and bailouts reminded us that what we had allowed to unfold was not a free option on progress but something that had a downside, too. It’s funny how a crisis changes your perceptions….
Despite these recent protestations, I am witnessing the lingering hangover of deference to so-called “innovation.” It permeates the debate on regulation. We hear that getting in the way of new technique may cause more problems than it solves. Or that the innovators can always outrun the regulators. Or, and this is my favorite, that nothing you do to stifle these new derivative products like credit default swaps will (ominous music in the background) lead to “systemic risk.” Systemic risk is the new stun-gun phrase to impart dread to those who would tamper with this delicate machine.
Malarky. This is all code for defer to the wishes of those who make money from these techniques.
Financial engineers on Wall Street are employed to make money for Wall Street firms and themselves. There is no hidden code that says they will design their products to align private and social benefits and costs. That is precisely where a healthy role for regulation and laws and enforcement can be envisioned. At the same time, it is important not to be romantic about that vision, though. Regulatory policy often does not live up to the romantic appeal, as theories of collective action and regulatory capture have illuminated.
My takeaway is distinctly unromantic. It is that, devoid of these religious-like connotations, innovation simply implies the use of a new method or technique. It can be harmful or it can be helpful. Let’s keep score. It can benefit us both, or it can harm us both, or it can make you better off and me worse off, or vice versa. That sober reality, and the notion that we are a society, sets the stage for critical thinking about these methods. If credit default swaps serve a purpose and are economically viable when proper capital and margin requirements are in place, then let the proponents bear the burden of proof in convincing us of the benefits to society according to some real social goals, rather than the vague myth of intangible progress. Protecting the profit margins of large investment firms is not a social goal.
We have a serious and real problem right now as a society that employs complex technique. Experts in the financial, nutrition, energy, and health realms have been found wanting when the curtain is pulled back and their behavior examined. Trust, particularly in financial expertise, has been shattered. Early in the 20th century, the so-called Progressive Era was an attempt to bridge the gap between the oligarchs of industry and the populists. Deference to expertise was said to be in the interest of all. Delay gratification and let the experts allocate capital so that in the future we would all be better off was the mantra. It had a religious-like psychic resonance. Experts on economics and social planning were custodians of our future, not unlike the role that priests played in earlier times. Restrain yourself now to achieve the promise of the afterlife. The linchpin was the experts vision and integrity. They were trusted to make sure we all got to economic heaven together.
We just got handed a big bill and the perpetrators that led to the bailouts are back getting large bonuses. If experts cannot be trusted and governments are unwilling to change the rules, then we will once again be heading toward popular reaction. The cooperative game is breaking down. The population showed us a hint of that over the AIG bonuses. A volcano that is still today may yet explode tomorrow.As I watch the stories of this newest revelation on the wonders of financial innovation, so-called high frequency trading (HFT), I scratch my head and wonder how we got to this place: That most profound mystical deity which we are asked to worship, “the market,” can now be rigged so that a few get to see orders beforehand. As Charles Duhigg wrote last week in the New York Times, “While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee.”
This “innovation”–employing monster computing power and the apparent ability to buy your way to the front of the line–looks like old fashioned front-running to me. How can that contribute to the integrity of our marketplace? Bob Kuttner has written an illuminating piece on this subject. For my part, I just hope that our society can demystify (unspin?) this process. It is time to build a financial system that serves the real economy for the next generation. To do so, we may need to sweep aside some of the so-called innovations in financial practice that were born of this foolish era of market fundamentalism and its supervisory and enforcement laxity. Surely there are techniques that we should adopt. Yet in the aftermath of the crisis the burden of proof is on those who advocate them. Where are the benefits to society? What are the costs? To answer those questions, we must come out from the well spun power cloud of Wall Street and ask real questions. Regarding financial innovation, I am fond of the lyrics of Michael Stipe. It is time we start losing our religion.
18 comments
Comments are closed.
From the Wall Street Journal:
Several dark-pool executives told Dow Jones Newswires that Mr. Greifeld's far-reaching proposal would have calamitous effects for retail and institutional traders.
"Undisplayed liquidity adds to execution quality," said Bob Gasser, chief executive of Investment Technology Group Inc., which is credited with creating the first of the modern-day dark pools roughly 20 years ago. "You can come up with all kinds of anecdotes, but the simple fact is, on behalf of all investors, dark liquidity adds to execution."
War is Peace
Freedom is Slavery
Ignorance is Strength
Dark Pools are your Friend
The facts here are very simple.
There is only one measure of the health of an economy: how many fulfilling, living-wage jobs are created or destroyed. (All other factors can be distilled to this.)
We're now approaching 40 years of financialization and globalization. That's far more than enough time to render judgement.
What has happened to real wages? They've steadily declined since 1973.
What has happened to real jobs? They've been destroyed by outsourcing, offshoring, and technologizing/deskilling.
The financial sector presided over this massacre.
(That's dispositive right there. But we can also add the extreme burgeoning of wealth unequality. And we can add the sickening volatility and moral degradation of a boom-bust binge-purge exponential debt crisis socioeconomy, which is the only kind of socioeconomy globalization can generate. The "Great Moderation" is for the hall of fame of Orwellian totalitarian terminology. The banks facilitated all of this.)
So the verdict is in. The financial sector adds no socioeconomic value, only destroys it.
It should be completely dismantled.
YS:
Bravo. The financial alchemists are exposed.
@Yves,
The plea bargain mentality of Wall St. must end, fear full out comes if not compliant.
How many of us must suffer too empower a dream of the few and for their entitled vision of the world we share.
Skippy…my heart is a bit lighter for your thoughts tonight, fair lady.
PS. I second Independent Accountants proclamation, Bravo!
Wall Street is a place were 'everything old is (perenially) new again'. Since the time when bankers were relieved of personal liability, there has been no incentive to be legal, moral and ethical. For those who would want to bring morality and ethical conduct to the market, they should first look at who benefits from such dodges as term-auction securities, the grandest fee scam I have noted in 50 years. Similarly, few, if any, sellers of CDS have the balance sheet to support the volume of contracts they have written. What should have occurred is that we should have had the castrophe. Perhaps then, all that theater in the congressional hearings would reduce to something meaningful.
Today we see a stock market intent on advancing in the face of incredibly poor economic reports which while better than earlier data nonetheless stink. Employment is still shrinking and until we see real job growth and some statistical artifice our econnomy will not be very comforting. Bill Dudley says that the ability of the Fed to pay interest on excess reserves will thwart the onset of inflation. We will get to see if that is a lovely set of emperors new clothes in the coming months. Look for interest rates to creep up as well as the costs of staples at the supermarket where the 'real' economy shops. What we are ling thru is the grandest economic experiment ever conducted. For now I do not believe that it has a good outcome.
A 2:45 AM post! And a really good one.
Can anyone explain what is so potentially dangerous about high-freq trading? I understand it's prob unfair, but is it material to the small investor?
The entire idea of finance was turned on its head. Instead of making steady profit providing funding to fuel economic growth, it became about making money by making money. Any time the economy becomes more about the money than about what is done with the money, this is going to happen. Until we all realize that money in and of itself is not important, it is what we do with it that matters, we will be screwed up.
well said, kudos to Johnson;
As an economist I give a break to those, especially Greenspan and Summers, who in the 1990s spread the word of the benefits in efficient capital allocation enabled by these new instruments. Without digging into and understanding the details we could glimpse the potential, and after all, the Wall Street geniuses surely new how to hedge and diversify. Not!
But now that they have blown up on all of us, its high time to put the burden of proof on those who resist regulation.
Making "money" through leverage.
If GNP = money supply X money velocity, and counterfeting money supply is a criminal offense (Isaac Newton took glee in hanging counterfeiters when he ran the British Mint), then the counterfeiting of good credit that boosts money velocity is algebraically equivalent to counterfeiting currency.
And the call it "innovation". Ha ha ha ahhahah hahah hgahah ROTFLMAO
And yet the counterfeiters get our tax dollars for their bonuses, even AFTER the counterfeit credit implodes like wooden nickels.
Admittedly, that is pretty innovative.
Rob Johnson is basically describing the elements of a con. Play upon the ego, greed, and fears of the mark.
You're a smart guy. You can understand how modern day gimfazzlery works. The returns are amazing but I got to have an answer now because I have 5 other guys wanting in on the deal.
The simplest test of whether financial innovation has benefited society is this:
Can you name a project that was able to be funded because of Wall Street innovation, that would not otherwise have been funded, and thereby produced something profoundly beneficial?
I can't see a case where that's happened. So, it's most likely been all a crock.
Silas,
"Can you name a project that was able to be funded because of Wall Street innovation, that would not otherwise have been funded"
Therein lies the rub.
You see, it is not America that has been conned by Wall Street. It is the rest of the world (to America's benefit).
America now has a huge supply of housing for all of its citizens, that had it not been for this "innovation", would not have existed. Not to mention all the commercial buildings and the road infrastructure put in place to commute to these new developments.
All the paper wealth that has been created over the last 30 years was just one large Ponzi scheme. The paper wealth will be destroyed, but the real assets constructed will remain.
Had it not been for this innovation, people would still be broke today, but we would not have the housing.
This to me seems like the best wealth redistribution plan that could possibly have been implemented in a capitalistic, dog-eat-dog society that America has become. When the poor pick up debts they can never realistically hope to pay, they will eventually default, and therefore will be no worse off. But a house will have been built that they will eventually be able to reside in, at a rent they can afford to pay, based on their minimal income. This will bring down the value of the home, which will now become an investment property. But the loser in all this is the person who had the savings in the first place to lend the money to have this home built.
Therefore, by greed, wealth is eventually redistributed. When the poor can borrow no more, the economy collapses and debt destruction through bankruptcy takes hold. But one man's debt is another man's wealth, so this is destruction of debt is also a destruction of wealth. This is capitalism's reset button.
Sukh
In regards to how the US benefited on the backs of other nations:
I forgot to mention all the oil and manufactured goods that have been sent our way in exchange for worthless IOU's.
How's this for innovation:
Import manufactured goods and oil in exhcange for US dollars. Then, borrow those dollars back to build houses you cannot afford.
Then, default on your housing debts.
In the end, you have consumed oil and manufactured goods provided by others, and have built homes for your citizens that they could not afford.
In the end, Americans get oil, manufactured goods, and homes, and those that sent you the oil and the manufactured goods get stiffed.
Also getting stiffed in this process will be anyone who thought they accumulated wealth by being a middle man in the process, as they will see their wealth destroyed as their investments drop in value (as companies will eventually go broke and shareholders will be wiped out – once a large enough company in any industry (ie GM) reorganizes itself by going through the bankruptcy process, do all its competitors not have to evenually follow suit, as the company has a competitive advantage once it comes out of bankruptcy?. This also means that the life savings and pensions of the middle-class are also going to be wiped out.
Only those with so much wealth that they can afford to not chase returns by buying equities (are content with the meager return they get on US Treasuries) will be able to save any semblance (sp??) of their wealth.
You cannot create inflation when debt is being destroyed. Unless you are willing to go Zimbabwe's route and just print money and hand it out. This can only happen if the government decides to do away with double-sided accounting and decides that Plan B is to just actually print US dollars and give its citizens enough of them to wipe out their debts.
One more loophole masquerading as Fin innovation in the news lately is flash trading.
David Shillman, an associate director at the Commission's Division of Trading and Markets, said at the SIFMA conference that flash orders lasting less than 500 milliseconds fall within an exception to the Quote Rule, or Rule 602, in Regulation NMS. The Quote Rule requires all market centers to publicly disseminate their best bids and offers through the securities information processors. The exception is for orders that are immediately executed or canceled.
All the exchanges (even those that protest flash trading) are ready to jump in if the loophole stays. If it's banned the playing field would be leveled for all players, if its not closed the playing field will be leveled when the remaining holdouts jump in.
DRX, to answer your question see Nina Mehta at Trader magazine here
http://www.tradersmagazine.com/news/pipeline-blocks-high-frequency-trading-al-berkeley-104059-1.html?pg=5.
Actually, all her stuff is terrific.
@Anon 5:36.
Thank you so very much, as some one who plays around with algos/physics engines and hardware this makes soooo much sense. I would give half my SSDs to see their rigs and a peek at the algo streams, especially if they are working with real time or historical 3D graphic representations.
Skippy…lol flash trading…nothing more than an exploit in price discovery…ROFL Wall St is nuthin more than a Gaming platform HL2DM style and the Regulators are server admins allowing GS/AIG etc to get away with grifting/exploits. Mother of us all, were playing an Internet video game with our very lives/futures.
Interesting article, but the overpraising of financial innovation by financial experts is just a part of finance's tendency to excessively praise innovation.
Taking the nation as a whole, there is a certain rate of building new equipment and of scrapping the old that will give us the largest possible amount of useful products for our labor. If over a long period we modernize either faster or slower than the best rate, we shall necessarily reduce the returns. If we put in the new inventions too fast, the plant will always be in the pink of efficiency, but the scrapping costs will make us poor—too much work going into putting up and taking down machinery. If we put in the new inventions too slowly, the losses on our investments will be small, but we shall suffer from inefficient plant—too much work going into using obsolete machines.
The financial experts still think that no matter how fast we save and invest we can never save and invest too rapidly. They are mistaken. We might go too fast.
This is the fundamental "oversaving theory," regarded with scorn by most of the experts….–David Cushman Coyle, Brass Tacks, 1935.
To me the main fault of Economics (as it was taught to me using a standard textbook) is its failure to deal appropriately with the tendency for investment to get overheated. One sees it most obviously in the retail sector. E.g., a town might be able to support one cafeteria. If a new cafeteria is built that is just slightly nicer or better located than the old quite adequate cafeteria, the old cafeteria is probably doomed. The people building the new cafeteria don't care they've just rendered another building practically useless because it is not their building. True, they might take into account that later someone will perhaps play the same trick on them, but clearly they won't fear this sufficiently (enough for the economy to avoid inefficient excess modernization), because if they did, everyone else would fear sufficiently also, and so there would be no tricks played on them to fear. Efficiency demands some sort of taxation, etc., to keep investment and modernization from becoming excessive. Imho, the basic concepts such as aggregate demand, aggregate supply and opportunity cost have a vagueness about them that allows sloppy arguments that make for error. There is a lack of subtlety here notwithstanding mostly economics is pretty logical and reasonable (especially for a social science); it's too subtle for me to be clear precisely how the basic definitions need to be changed or clarified. It's a kind of opposite phenomenon from the monopoly situation of not enough competition. Of the theories concerning monopolies economists perhaps have made too much of an idol, thereby blinding themselves. And I don't know what economists if any nowadays think carefully about these things.
The difference between now and 1935 is that the excess investment in manufacturing is worst overseas in places like China. Here in U.S. we have mainly excess investment in housing and commercial buildings. But financial people have always apparently mostly found overheated investment no problem, making money off investment and lending as they do. Wouldn't surprise me if they were behind Economics' tendency to believe firms don't tend to be too cutthroat in modernizing.
As for calling the problem as I see it oversaving, as Coyle does the problem as he sees it, I'd really say it is more fundamental than that or even overinvesting (which only has to be mostly the same thing as oversaving if banks are rightly required to keep high reserves); maybe excess cutthroatness even encourages overproduction at times.
But they give out Nobel Prizes for it, so it must be creative.
That was well argued, and supported. Much better than: "C'mon, can't you see that financial innovation is for suckers?"