James Kwak, discussing a recent Bernanke speech defending financial innovation and a Ryan Avent post parsing it, underscored Avent’s observation that Bernanke had trouble coming up with an example of the sort that the financial services had in mind these days (ie, novel products making use of derivatives and other risk slicing, dicing, and distribution tools). His examples were pedestrian but important consumer products like credit cards and well seasoned advances, like securitization (dating from the 1970s).
The lone relatively current example? Subprime lending. Bill Black (via e-mail) has trouble seeing that as virtuous, at least in combination with securitization (which presumably was the innovative bit):
The very last thing any sentient being should want to do is restore a secondary market in nonprime loans.
Kwak made a useful distinction that innovation that is serves to increase access to credit may not necessarily be a good thing. Note that this runs contrary to the pre-bust mantra, that more credit availability was a virtue:
Where I come from (career-wise at least), innovation meant that you invented something that people wanted, or you figured out a cheaper way to make something that people wanted, or you figured out a way to improve something that people wanted….
Financial innovation, however, comes in two forms. There are financial innovations that make our lives easier. One is the automated teller machine (ATM)…
The other kind of financial innovation has to do with extending access to credit. Here I think it’s less clear that innovation is unequivocally good.
It is certainly possible for a society to be below the optimal level of access to credit. Consider the idyllic banking paradise that gets mentioned a lot these days, in which people deposited their savings with local banks which, in turn, lent money out to trustworthy local homebuyers and held onto those mortgages to maturity. The good thing about this model is it encouraged responsible underwriting. The bad thing is that it isn’t very good at moving capital (money) from one part of the country to the other. Imagine in Iowa no one needs a mortgage, so the banks have no place to lend and can only pay their depositors 0.1% interest. In Florida lots of people need mortgages, so the banks offer 4% on savings accounts, but they still can’t attract enough cash and people who would buy houses can’t. (Or, alternatively, people who would take out loans to expand their businesses can’t.)
Yves here. Matching deposits with loans demand across regions has been a non-trivial and sometimes contentious problem in American history. The impetus for the old state banking restrictions was the emergence of national banks that hoovered up enough local deposits in some areas as to be perceived to be depriving businesses (then usually farms) of needed credit. Back to Kwak:
The effect of securitization should be to moderate differences in interest rates – mortgage rates can come down as money moves into Florida, but they may go up as money leaves Iowa – and perhaps to lower them overall by making more money available to the market as a whole. If we were in a situation where too few people were getting mortgages, this is a good thing. But it is also possible for too many people to be getting mortgages, as we now know. Something similar happened with venture capital and startups over the last fifteen years. After the IPO rush of the late 1990s, billions of dollars of new money piled into the VC industry; that money flowed to thousands of companies that should never have gotten funded, resulting in lost money for investors and lost time and effort for thousands of generally bright and well-meaning entrepreneurs…
In short, financial innovations whose sole function is to increase access to credit do not in and of themselves make the world a better place.
While this is a useful distinction, and helps advance the discussion, I think we can go a good deal further.
One of the reasons economics have been lulled into viewing the widespread proliferation of new derivatives and risk transfer products is that it helps advance a fantasy put forth in a seminal paper 1954 paper by Nobel prize winners Kenneth Arrow and Gerard Debreu. The paper gave a rigorous proof (at an economist wet dream level of elegance) of the existence of a multimarket equilibrium in a decentralized economy. However, the model assumed that there were forward markets not simply for every commodity but also for all conceivable contingencies and that no one holds money for longer than a single time period.
This paper shifted attention in the discipline away from how economies and competition actually works, that is, the processes by which prices are set and adjusted, a dynamic process, to proving that a specified set of prices could clear all markets simultaneously.
It also had the effect of dignifying the development of more risk transfer products as “completing the markets”, when markets as complete as Arrow and Debreu envisioned could never be obtained. Individuals can’t anticipate how reality will unfold far out enough to ever specify the needed contingencies (say hedging the risk that you might be ten minutes late to a client meeting could cause you to fail to win a possible piece of business). As economic historian Mark Blaug put it:
Following the methodological standard learned sitting at the feet of Arrow and Debreu, a modem economist would rather say little precisely than much vaguely. If there is such a thing as “original sin” in economic methodology, it is the worship of the idol of the mathematical rigor more or less invented by Arrow and Debreu in 1954 and then canonized by Debreu in his Theory of Value five years later, probably the most arid and pointless book in the entire literature of economics.
Note how a prototypical discussion of the merits of financial innovation, from a speech by Timothy Geithner in March 2007, assumes the virtue of more advanced hedging tools:
One of the widely presumed benefits of the last go-round of what passed for innovation in the money world was that it allowed for more sophisticated hedging and risk sharing.
Over a long period we have seen innovations ranging from the syndication of bank loans and the direct provision of credit through the capital markets, to the spread of asset-backed securities and products that separate different parts of the payments stream and different dimensions of the risk in a credit obligation into different instruments.
These changes have contributed to a substantial reduction in the share of total credit held by banks. They have produced a greater separation or distance between the entity that first arranges a loan and those who end up holding the risk, and more intermediaries in that chain. And they have contributed to a dramatic increase in the number and diversity of creditors to any individual borrower, and a greater capacity to actively trade credit risk…
But there is a mundane and more subtle reason to be skeptical of these risk transfer arrangements. The fact that some is good does not necessarily lead to the conclusion, contrary to Arrow and Debreu, that more is better.
The first is that these new products were sufficiently complex and opaque that risks were too often dumped on the hapless who didn’t know what they were buying. We’ve seen everything from German Landesbanken, Norwegian villages, Australian pension funds, Jefferson County and a host of other municipalities buying products or entering into swaps they didn’t understand. Even the supposedly sophisticated Harvard endowment pushed way out on the risk curve with lots of illiquid investments and derivatives, to its undoing. For the first set, they were given assurances by salesmen and lacked the sophistication to make an independent assessment of the risks. In the case of Harvard and many of the other risk seeking endowments, true belief in the brave new world of finance, compounded by years of apparent success, led to overconfidence, a surprisingly naive pursuit of return with insufficient attention to the downside potential.
The less obvious concern is that the view that more hedging tools (which presupposes more hedging) is ever and always a god thing assumes the users can make smart decisions about to how to use them. The classic argument, offered by Myron Scholes among others, is that business people should worry about making their business run better and lay off the risks they can shed. The argument is that hedging is cheaper than equity.
But that presupposes a God’s eye view of when to pass those risks and how far out to hedge them along. Look at the (comparatively) simple case of airlines and fuel costs. Airlines watch the energy markets intently, yet regularly hedge (as in lock in, since my impression is that most use futures rather than the far more costly long dated options would be) fuel prices, often at the worst moment. How many panicked when oil went north of $110 a barrel?
In a competitive business, getting it wrong doesn’t merely mean a quarter or two of lower earnings than you’d have otherwise (and remember, if you muff it badly, you can show net losses). No matter whether the cash flow shortfall relative to competitors that did better is small or large, wrong footing it puts the company at a comparative disadvantage. It has less in the way of funds to invest or use as cash buffers (although with the until this year of companies running lean, many would have paid it out in some combination of dividends, share repurchases, and goodies for top management, so the competitive implications in reality were probably less than in theory).
If a company has exposures of any complexity and wants to hedge, assessing the alternatives of how to execute the hedges is not trivial, particularly one decides to manage the hedges actively. Thus the idea that you can have a tidy specialization, with businesspeople simply laying off risk onto more savvy risk management types, is spurious. To do an adequate job, you need to have at least a base level of competence. Given the propensity of financial firms to take advantage of widows and orphans, a caveat emptor posture and investment in attaining a higher level of expertise seems prudent.
When does the frictional cost of having these all these savvy and highly paid risk professionals (who may overengineer matters to justify their own existence) become counterproductive relative to the real performance gains? Funny that that the cutting edge quants haven’t turned their modeling skills loose on that question.
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What’s most interesting to me about this post is that, although I agree with it given its presuppositions, I never could find the presuppositions convincing.
To cite the Kwak quote:
It is certainly possible for a society to be below the optimal level of access to credit. Consider the idyllic banking paradise that gets mentioned a lot these days, in which people deposited their savings with local banks which, in turn, lent money out to trustworthy local homebuyers and held onto those mortgages to maturity. The good thing about this model is it encouraged responsible underwriting. The bad thing is that it isn’t very good at moving capital (money) from one part of the country to the other. Imagine in Iowa no one needs a mortgage, so the banks have no place to lend and can only pay their depositors 0.1% interest. In Florida lots of people need mortgages, so the banks offer 4% on savings accounts, but they still can’t attract enough cash and people who would buy houses can’t. (Or, alternatively, people who would take out loans to expand their businesses can’t.)Well, I guess according to this I’m an “idyllist”, but I just don’t find anything optimal in the framing of the alleged problem and the alleged solution.
Rather, existing problems are not solved while new ones are created.
In this case, the reality basis for Iowa land use is farming. it’s absurd that such a fundamental biological activity is subject to the vagaries of artificial “markets” at all.
Meanwhile, I’m not sure what’s the reality basis of Florida development, where these mortgages are allegedly so needed. This reads to me like just a scavenger hunt to prop up suburban sprawl, an absurd thing with no basis in reality.
(And if it Florida did make any sense economically, why would it have to go hunting in Iowa for capital? Shouldn’t it spontaneously generate such capital out of its own bursting market robustness?)
This reads to me like a satire on capitalism. Or rather, capitalism itself is clearly not “optimal” beyond a certain size. We see here how, once it ramifies beyond some tipping point, it requires rigging all markets and laws and bizarre capital redistributions from real activity like Iowa farming to conjure up fictional things like Florida sprawl, all the while requiring ever more risk and moral hazard, and empowering systemic swindling, as a feature, not an abuse (as Yves wrote about here).
Once again we see how size itself is the great evil.
Importantly general equilibrium theory didn’t stop in 1954. As you note, the Arrow and Debreu result has no practical relevance as markets are clearly not complete. It does not imply that moving towards complete markets is good. The result only describes the case in which there is no room for further financial innovation.
In fact, it is a well known result in the field that introducing an innovative asset can cause a Pareto worsening. This is not a knife edge result. For an open and dense set of economies, there is an open set of new instruments whose introduction makes everyone worse off (talk about that for arid).
The lesson from General Equilibrium theory is that there is almost always (generically) a restriction on financial trading which causes a Pareto improvement. (a link to a link here http://tinyurl.com/ahcge7)
Oddly, the newer results which are less totally irrelevant than the original Arrow Debreu results have been ignored. They sit there in what is now an obscure field of theory. Almost as if people only listen to econmic thoerists when those theorists tell them what they want to hear.
YS:
I have long opposed hedging. Some of it is done for accounting purposes, i.e., to make earnings look smoother. For the economic system as a whole, there can be no hedging. Yes, there are real costs to running a hedge book. If an individual wants to diversify, let him. But the companies he owns should not hedge. Warren Buffet’s insight into the costs of running the finance business applies. For society as a whole, and investors as a whole, hedging is a losing proposition.
I have said this for 33 years. Really.
I find today’s ‘link’ article from the BBC regarding the “Key role of forests may be lost” very similar in intent to this post. In both instances, too rapid technological advance has carried us into trouble, as we only later discover the unintended consequences of that ‘progress.’
In reading this post, and the post on Risk Management Sanity Check, I get the feeling of being in never-never land. I acknowledge that it has been a long time since I was a front-line manager, but the basics cannot have changed that much.
Sharing risk, or insuring against risk does not constitute managing risk. It can reduce ones’ exposure to risk, but this is far from how risk needs to be addressed.
Think of it this way – even if you have Medical Insurance, you still look for oncoming traffic before crossing the road. The risk is still there, regardless of whether or not you took out insurance. While the risk is present, it has to be managed. Managing it means monitoring it, and having he ability to deal with whatever elements of risk present themselves. If there is a car coming, you do not step off the sidewalk!
The Mortgage Securitisation fiasco has demonstrated confusion (or perhaps deliberate obfuscation?) between insurance against a risk, and managing that risk. Financial innovation can never replace first-hand risk management, and first-hand risk management is always essential.
What decent manager does not ask himself, over and over, what are my exposures, what factors can prevent my plans coming to fruition? How can I minimize those exposures, how can I control those factors? It is that “front line” management capability that distinguishes the competent from the mediocre. If our Financial Innovation attempts to obviate the need for such management, it is doing us a huge disservice.
Most international companies will hedge, especially with currencies, hedging against big losses is also an appropriate strategy for a pension fund therefore I believe hedging does have its place. What is not appropriate is hedging everything , using a lot of leverage and assuming professionals have enough capital and will hedge apropriately.
Securitisation on the other hand seems more like lazy banking. Yes you can bundle together some loans and it will enable market efficiency, but it does not change the fact that the loans are not all the same. Not all house builders are the same, yet both bankrupt and flourishing builders get virtually the same credit deals. The perception of many businesses is that banks are unfair and tend to group companies by sector rather than individual merit. Unfairness and there is a lot of it around at the moment usually prompts action, and banks would do well to get their basic banking in order.
What went wrong with the system appears to me to be that risk got concentrated in the wrong places with recipients who did not have enough capital for the risks they took on. There seems to have been a general consensus that hedges and insurance carry no risk, a fact proved wrong by the fact of the monoliners.
Really nice piece, we need a lot more of this thinking from many people.
All the financial “innovations” were basically Ponzi devices, that is they removed money from any real economic activity allowing more and more profit from a bigger and bigger bubble floating higher above the ground below.
Little Timmy has stated publicly that his job is to get the securitization market working again. That in a nut shell is why he doesn’t have a clue and he will fail, he’s trying to re-inflate the bubble.
One thing that needs to get out there more is that subprimes weren’t the bubble, the bubble is derivatives, securitizaiton, etc that is financial “innovation,” which is why we have long way down still.
Remember over the last decade how the mantra defending all this was “spreading risk.” Funny you dont hear that anymore, because they were right. We all got the risk, whether we wanted it or not.
as a very ‘lay’ observer, i cannot help but notice that financial product innovation has become financial process innovation..yet still somehow considered productive and contributing to the bottom line of ‘growth’.
also, the context, for me, of this sort of innovation is nothing more then classic obfuscation and deliberate at that…’make it complicated enough and money can be made in the shell game it has become’.
can’t regulation be as simple as…’if its too big to fail its too big to exist’ and if its too complicated to understand its too complicated to exist’??
what sort of general principles shall we put in place to guide us towards common sense regulations that don’t require a team of lawyers to parse.
paraphrasing Talib’s recent comments on bloomberg TV…the new models have to be so simple that even dumb regulators can understand them..and we must assume our regulators will be dumb indeed…good hearted perhaps, but dumb in the sense of being able in real time to deal with exsessive complication.
Michael
I’d never intend disrespect to Kenneth Arrow – the Impossibility Theorem is foundational to my take on reality – but to pick just ONE facet of the unreality of “Existence …”, I’ll cite Koopmans:
“The hardest part in the specification of the model is to make sure that each consumer can both survive and participate in the market, without anticipating in the postulates what specific prices will prevail in an equilibrium. … [T]he authors assume first of all the aggregate supply set contains a point which supplies just a little more of every commodity than is necessary … for every consumer to survive. Secondly, they assume that each consumer can, if necessary, survive on the basis of the resources he holds and the direct use of his own labor, without engaging in exchange, and still have something to spare of some type of labor which is sure to meet with a postive price in any equilibrum. [This assumes] that each of the types of labor in question … has a postivie marginal productivy with regard to at least one out of a certain class of commodities [which] still add to the satisfaction of every consumer.” (Koopmans “The Allocation of Resources and the Price System”, p.59 of Three Essays …)
Then after considering the Arrow-Debreau model as “stationary”, Koopmans summarizes:
“[In] an alternative interpretation .. time is broken up into successive periods… In this case a choice by a consumer is in fact a plan for future consumption extending over all periods considered. … Likewise, each producer chooses a production plan….
… Consumers choose a plan for their lifetime, in full present knowledge of their future preferences, of their time of death, and of the place occupied in their structure by the resources handed on at death to their heirs. Producers are fully informed about the nature and timing of future improvements in technology relevant to their operations …”(p. 61)
After further discussion that introduces “income transfers” as a possible means to assuring “survival”, the killer point comes to this:
“It has been pointed out to me orally by Debreau that the treatment of time adopted by Arrow and Debreau … permits a more subtle version … of the ‘hard boiled’ interpretation of the model in regard to the survival problem. The plan formed by each consumer in response to the price system includes a specification of the length of life compatible with his present resources, his ability to do remunerative work or shift for himself, and other aspects of his life plan. All that is to be assured by the postulates is survival of every consumer at least in to the first period. The amount and initial distribution of resources and skills in the population determine the pace and extent, if any, of starvation.
Granted the inadequacies of any model unable to recognize the element of uncertainty in individual survival, this interpretation has an appeal of descriptive accuracy with regard to societies or phases of development in which incomes transfers are quantitatively unimportant. (pp. 62-63)
Well, then …..
I would say that Paul Samuelson, not Debreu, is primarily responsible for the introduction of “mathematical rigor” into economics — for which he gets my vote as the worst economist of the 20th century (or at least the most pernicious).
Of course, we have to consider that the reason that these assets were so misused is because they were subsidized by poor regulation. The Basel accords, among other things (I think capital definitions had some bad incentives, haven’t studied it much), encouraged rising complexity by requiring lower capital charges on certain assets. Under properly functioning regulation, there wouldn’t have been the regulatory arbitrage that pushed people into assets that were very difficult to understand.
Anyways, if we acknowledge that a lot of financial innovation wasn’t very productive, we also have to acknowledge why it was being produced in the first place. And if it’s being encouraged by regulation, then the answer isn’t to kill these complex instruments, it’s to cut off their feeding tube and watch them die. People should generally take into account the costs of understanding a financial instrument, and the risks posed by not doing so.
Which isn’t to say that there’s no scope for market failure in finance. There’s plenty of that. I just thought I’d mention it’s important not to prescribe the wrong solution here, and I think that cracking down on specific areas of finance would be useless gesture if you leave fundamentally flawed regulation like Basel in place.
Luke, early neoclassicals such as Edgeworth and to some extent Marshall may be more responsible as they apparently felt the need to garb theory in the ‘armour of mathematics’.
Independent Accountant,
You’re ignoring the fact that hedging can and does create value. Indeed, it should be done only when the economic benefit of the hedge exceeds the economic costs you cite.
When done properly, hedging is not about fudging earnings; it is about real economic benefits like preserving growth options or reducing risk of bankruptcy. I think the classic example is of a R&D-intensive pharma company with revenues primarily in a foreign currency. If they don't hedge the exchange risk, there's a possibility of not having enough money available to fund continued product development.
I think this post is quite on point in its buyer beware approach to financial products. Many— though almost certainly not all—have some legitimate purpose, but the potential for abuse is quite high.
I think it's about time we started thinking of the more complex derivatives as the financial equivalent of medical marijuana.
Jacob, what may be worthwhile even necessary at one level, that of the particular firm, is not – as we’ve been seeing – necessarily so when done by the many.
Juan, do you have in mind a counterexample where hedging creates value for each firm but destroys value in the aggregate? There are all kinds of situations where hedging is foolish or done improperly (e.g. airlines should have been using deep OTM options on oil, as Yves has suggested). The key value in hedging is from firms (and entire industries) maintaining optionality that they would otherwise lose. It should be thought of as insurance against catastrophic losses, which have real social costs.
Jacob,
Nothing in the sphere of circulation ever directly creates any value whatsoever, the most that can be said is a facilitation of value creation that in numerous cases has promoted greater real economy over-accumulation than would otherwise have been the case. IOW, I take exception to the entire notion of say, the financial, being directly productive no matter how necessary it might be to the capital system’s functioning.
My earlier point, though, had to do with _contradiction_ between levels or that the practice of hedging makes sense at one level but – as we once again see – the displacing of risk does not make it disappear [even if some/many individual participants imagine so] but takes on a cumulative character which leads right into its socialization and attendant costs.
‘Counterexample’? Well, we are living in one and I’d also note that from the perspective of intl liquidity and fictitious capital, it was understood to be in development at least so early as 1998. Others wrote of it even during the 1980s.
Hedging practices and instruments assisted in generating financial hypertrophy and uncontrollability.
more simply, the well known fallacy of composition that, imo, is a ‘feature’ of modern econ.