05 abril, 2013

Financial Innovation — Illusory and Real

Some ‘innovations’ are merely new names for ways of lowering credit standards, running up leverage, and increasing risk. How do we know what’s real and what’s not?
In the 1990s, James Grant, that incisive and acerbic chronicler of the adventures and foibles of financial markets, wrote about the 1980s that science and engineering were progressive, but finance cyclical. He went on to say:
"In technology, therefore, banking has almost never looked back. On the other hand, this progress has paid scant dividends in judgment. Surrounded by computer terminals, bankers in the 1980s committed some of the greatest howlers in American financial history."

And what about the bankers and other financial actors of the twenty-first century? Surrounded by exponentially more computer power, supplied with reams of data, and informed by Nobel Prize–winning financial theories, they made even more egregious mistakes, creating, as we all know so well, an amazing bubble, an international panic, and a massively costly bust.
A while ago, the Financial Times had a contest to come up with the best word to describe the opposite of a “bubble.” My entry was a “shrivel,” which did not win. The winning entry was a “bunge.” This was drawn from “bungee cord,” the idea being that you experience a terrifying free-fall, but do in the end reach bottom and bounce back up. But we are speaking here of eternal financial patterns, not innovations.
The Kauffman Foundation’s Bob Litan has presented a highly interesting list of “good” and “bad” financial innovations. But as skeptical Greek sophists pointed out long ago, the same thing can be both good and bad. (Fire can warm you and cook your dinner, but it can also burn down your house or your neighbor’s barn.) So I propose a different distinction: that between illusory and real financial innovations.
In every boom, we hear about “creative” new financial products. For example, the Clinton administration’s home-ownership strategy in the 1990s called for “creative mortgages.” An extreme example of this sort of “creativity” was the “Option ARM” mortgage, where borrowers did not even pay all the interest due, thus in effect borrowing more each month — with this additional borrowing being booked as income by the lender.
All these ways of increasing old risks by new names bring the same old, inevitable, sad end.
These are not real innovations. They are merely ways of lowering credit standards, running up leverage, and increasing risk, by new names.
In the same fashion, “Collateralized Debt Obligations-squared” and “Structured Investment Vehicles” were new names for lending long and borrowing short, as the “government-sponsored enterprise” structures of Fannie Mae and Freddie Mac were for running at extreme leverage. All these ways of increasing old risks by new names bring the same old, inevitable, sad end.
They are all illusory financial innovations.
But real financial innovations do exist. They are much less frequent, of course, because it is hard to do something truly new.
Here are some real innovations from fairly recent financial experience:
    • Interest rate swaps
    • Treasury Inflation-Protected Securities, or “TIPS” (which make it harder for the government to cheat savers by inflation, a worthy achievement)
    • Senior-subordinated securitizations
    • Money-market mutual funds
    • ATMs
    • General purpose charge and debit cards
    • The 30-year fixed-rate mortgage
From further back in financial history, we have:
    • Mutual funds
    • Deposit insurance
    • Futures exchanges
    • Stock exchanges
    • Central banks
(Speaking of central banks, when the Federal Reserve was organized in 1914, the then-comptroller of the currency enthusiastically wrote that now “financial panics seem to be mathematically impossible.” Well, even true innovations may not live up to what their proponents promise.)
Still further back, we have negotiable instruments and paper money.
All of these are true creations of interacting human minds as they move through history. Such innovations turn ideas into institutions, which shape and constrain, but cannot prevent, the next new ideas — and so on, forever.
The fact of real financial innovation recalls Schumpeter’s celebrated phrase “creative destruction.”
As Frank Knight famously taught, uncertainty, as opposed to ‘risk,’ means that we do not even know the odds of future economic and financial events, and moreover we cannot know the odds.
Real innovation, in finance as elsewhere, produces uncertainty. Uncertainty means not only that we do not know the future, but that we cannot know the future. As Frank Knight famously taught, uncertainty, as opposed to “risk,” means that we do not know the odds of future economic and financial events, and moreover we cannot know the odds. That we are therefore frequently surprised by the results of innovation in financial markets is not a surprise.
Related to this, here is another great thought from Schumpeter: “The capitalist process progressively raises the standard of life of the masses.” “Masses” is an old-fashioned term — instead, let us say, “The capitalist process progressively raises the standard of life of ordinary people.” Schumpeter goes on: “It does this through a series of vicissitudes.”
Why the vicissitudes — the booms and busts? Because the effects of innovation are uncertain.
For example, the 1920s experienced innovation and change, with corporate profits increasing 75 percent between 1922 and 1927. This was the “Coolidge prosperity,” as the “new economy” of automobiles, radio, electricity, and consumer appliances grew rapidly. All were real technical and economic advances, but were still followed by the infamous crash.
“History, which has a painful way of repeating itself, has taught us that speculative overexpansion invariably ends in over-contraction and distress,” financier Paul Warburg wrote in 1929. But somehow we never learn.
Or as George Kaufman put it:
Everybody knows Santayana’s famous maxim that those who fail to study history are condemned to repeat it. When it comes to financial history, however, those who do study it are condemned to recognize the patterns they see developing, and then to repeat them anyway!
Why is this? Let us return to James Grant’s distinction between science and finance. In science, the great physicist Max Planck observed, “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.”
But in finance, new generations grow up to repeat the errors of previous ones.
Thus, real innovations, including financial ones, create growth and improve the standard of living of ordinary people. Both true and illusory innovations create uncertainty, and uncertainty insures mistakes, booms and busts, and transitions.
We are now in a period of transition, living in the wake of the twenty-first century bubble. So you may be interested in the definition of “a period of transition.” According to the noted economist Jacob Viner, “A period of transition is a period between two periods of transition.”
Likewise, we often hear about uncertainty these days. My corollary to Viner’s definition is: “A period of uncertainty is a period between two periods of uncertainty.” This is assured by ongoing innovation, both real and illusory.
To let Schumpeter have the last word: “Capitalism not only never does, but never can, stand still.” And a good thing it is, too — it’s how we grow richer and better off, with vicissitudes along the way, to be sure.
Alex J. Pollock is a resident fellow at the American Enterprise Institute. From 1991 to 2004, he was president and CEO of the Federal Home Loan Bank of Chicago. This article is adapted from remarks at the Loyola University of Chicago symposium on financial innovation.

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