Shiller: Has Financial Innovation Been Discredited?

Robert Shiller says we shouldn't try to limit financial market innovation, we might need it to prevent another crisis:

Has Financial Innovation Been Discredited?, by Robert J. Shiller, Project Syndicate: Skeptics of financial liberalization and innovation have been emboldened by the crisis in the world’s credit markets... Are these skeptics right? Should we halt financial liberalization and innovation in order to prevent crises like the sub-prime disaster from recurring? ...

[W]hile it does sometimes appear that the current crisis is due, at least in part, to financial innovation, financial-market liberalization has been shown to be a good thing overall. ...

Of course, while complicated financial arrangements allow us to move forward economically, they also can create hazards. Think of the scaffolding and equipment around construction sites. Sometimes people trip over the equipment, or a piece of scaffolding falls, with disastrous consequences.

Any time you build something, there is always a chance of a setback. But, with every setback, we learn. Governments and insurance companies implement better safety requirements in response to construction accidents. The same is true, over time, with financial disasters.

The US is one of the world’s most financially liberal countries. Its financial markets’ high quality must be an important reason for America’s relatively strong economic growth. ...

The reason is simple. Individual firms might have splendid investment opportunities ... but might be deterred by cash shortages or perceived macroeconomic risks. Effective financial markets enable them to pursue such opportunities despite these constraints...

There has been a longstanding discussion about whether new derivative markets, which provide such financial hedging, tend to increase preexisting financial markets’ volatility. The consensus is that they do not. ...

The effect on underlying financial markets’ volatility may not even be the right question to consider in deciding whether to permit new derivative products. The right question is whether these products are conducive to economic success and growth.

Here, ... new derivative markets clearly increase the liquidity and quality of information in existing financial markets. And it is this liquidity and quality of information that ultimately propels economic growth.

The sub-prime crisis has exposed serious problems that we must address. For example, we need stronger consumer protection for retail financial products, stricter disclosure requirements for new securities, and better-designed vehicles for hedging risks.

Some of the innovations associated with the sub-prime crisis – notably option-ARM’s, when extended to borrowers who couldn’t handle them – seem to have little redeeming value. But others – those involved with the securitization of mortgages – were clearly important long-run innovations, because they can help spread risks better around the world.

So, we should not slow down financial innovation in general. On the contrary, some of the fixes that result from the sub-prime crisis will probably take the form of still more innovation, further increasing the sophistication of our financial markets.

Update: I probably should have noted Dani Rodik's "Why Did Financial Globalization not Deliver the Goods?.

Comments

[dd]

No problem with innovation; but like new pharma there is a need for controlled trials to gain knowledge about outcomes. There is an easy control in the financial sphere and that is margin or reserves so that losses from innovative products are not borne by others when counter-parties fail.

[zapradon]

Ah..high quality? Isn't "quality" the reason the financial markets have locked up solid? No one buying because no one trusts the "quality"?

[ken melvin]

Other many more problems, what is it that they have given us that we didn't have before?

[zinc]

"new derivative markets clearly increase the liquidity and quality of information in existing financial markets. And it is this liquidity and quality of information that ultimately propels economic growth"

The credit markets are frozen because of the opacity of their derivative holdings.

The highest market volatility since 1938

The worst financial crisis since the great depression

Fed bailout necessary because of concentrated counter party risk

Housing bubble collapse

Zero personal savings rate

I'm running out of superlatives .......

[James Killus]

I believe that Mr. Shiller fails to recognize the difference between financial innovation and fraud.

Let me attempt a bit of an explanation. The invention of the convertable bond was a worth bit of financial innovation (which, nevertheless, proved to have some difficulties that subsequently led to problems). The use of email to push a zillion "Spanish Prisoner" spams from Nigeria was an innovation for fraud.

The creation of fraudulent mortages that were then diced into opaque securities whose ratings were approved by agencies substantially captive to the purveyors of those securities is much closer to the latter than the former.

I will also note that derivatives markets have managed to produce at least three financial panics in the past 25 years. This is not the same thing as "increasing volatility." It is, in fact, much worse.

[Bruce Wilder]

As a generalization, it is certainly true that any system of regulatory control imposes a conceptual system of categories and types, and, therefore, innovation that invents no categories and types requires the overthrow of the previous regulatory regime.

There's an ideological argument, motivated by the self-interest of the players, in favor of the self-regulatory power of the market. Libertarian economics is a kind of standard offer to make that argument for the market's self-regulatory power. The harder, but more important job is regulatory innovation that secures the efficiency gains of innovation.

The financial markets are an economic engine of great power, but an engine that can no more be expected to operate safely without regulatory systems than the engine in your car can operate safely or effectively without its various governors.

Some of the financial innovation of the last 30 years has aimed squarely at harvesting larger and larger sums from the poor and middle classes, first by eliminating whole classes of financial institutions, which had been put into place to crowd out the kind of loan sharking and usury, which are now standard practice. The destruction of the Savings and Loans by Jake Garn and the Reagan-Bush folks was only a first round in a campaign of corruption and destruction, which has also included the reduction of the mutual form in insurance as well as banking.

A focus on the arcane jargon of "securitization" and derivatives should not be allowed to distract attention from the extent to which the present crisis has its foundation built on nothing more than an elaborate gambit to steal from and defraud home owners and would-be home buyers.

I am no expert, and would be hesitant to opine broadly on the merits of various features of securitization, as financial "innovation". But, I am also skeptical enough to believe that we ought to be offered actual evidence that, for example, SIVs had some efficiency property to recommend them, other than their dubious merits as a way to circumvent financial reporting rules and bank capital requirements.

As for the "complex derivatives" which even Alan Blinder admits he doesn't understand, I cannot offer much. But, I know enough to know that any reform, which doesn't include as its central feature some kind of registry/clearinghouse, observable by the central bank, ought to be a non-starter.

Hand-waving proposals to extend the Federal Reserve's regulatory reach to include the "shadow banking sectors" don't have enough real content to merit much attention. Given the need for expertise in working out the details, though, maybe there is merit in committing in advance to acceptance by industry of an extended scope of regulation, even before work on the details begins. Demands, particularly from the Right, for a "single" "unified" regulatory authority, however, look suspicious to me -- an opportunistic attempt to eliminate the shells of regulatory authority, even as the predation of the current system is maintained and extended.

[Bruce Wilder]

innovation that invents new,categories

(There's always one more. I so need an editor.)

[gordon]

Wow, I had no idea there were so many people still waiting for the Titanic to arrive. Shall we tell them, or would that be cruel?

[Robinia]

Innovation-- particularly innovation that creates new categories or workforce skill requirements-- comes about because it answers a problem. It does something better than the way we used to do it. Lately, the role of users, along with R&D and capital, has captured the attention of some who study where our society gets innovation from (http://web.mit.edu/evhippel/www/cvframe.htm).

Leadership in shaping industrial innovation has come from government in many instances in the past. Not just wine and films in France, but the nuclear industry and the internet in the US. The government's role in helping to fund R&D through the education system is well-known. For financial and economic systems, however, acknowldeging a hand not invisible is verboten, although it is there. Networked communication systems enable the effective and rapid user feedback that could allow for more capture and implementation of product user innovation, which would lead to more sustainable economic structures, as well as more rapid innovation.

However, the innovation you get follows the problem you set out to solve. If the problem is "How do we best get lower-income first-time homebuyers into a mortgage that lets them afford a home, while making lending profitable?" the vehicle designed is one thing... If the problem is "How do we get unreasonable rates of annual return, or unreasonable rates of capital gain on stock?" the financial vehicle designed might be entirely something else. One thinks of Andy Fastow's creative financial vehicle names-- Predator and Death Star and so on.

Balancing the direction of financial product and process innovation to address directly the problems users of the financial system face can and should be a governmental function. To posit that it is fine for the government to shape and nurture an industry that smashes atoms, but any government planning in the design of the financial system is unthinkable... well, only ideology can explain that contradiction.

But, ideology we have, and a government that is for sale to high rollers.

So, we are left with a 100% reactive Fed, that acts as clean-up crew, rather than an agency of the people that works together with financial system users and capital to innovate workable designs for new financial products and processes that meet our society's real needs.

[reason]

The problem is not with financial innovation per se. The problem is that there is not controlled testing environment, and no inherent systemic stability check. Lots of limited liability, leveraged players with huge debts is dangerous. If they were required to place a proportion of their assets in lower earning safety deposits (as banks used to be) it wouldn't worry me so much.

[hari]

@ Robinia -

I think the thrust of your pungent argument is that Money is a commodity which can only be regulated by state authority, in order to balance the good from the evil doers inside the financial system. Moreover, in matters dealing with money, self-regulation is a non-starter without a legislative legal framework of oversight and even control - when required. Financial engineering/innovation is NOT problem; critical issue is its utility and transparency.

[dd]

One problem with financial "innovation" is the drain from the hard sciences and the hard work of reality based innovation. Theoretical mathematicians, physicists, systems engineers, mechanical engineers, chemical engineers and computer specialists of every stripe; an entire generation that might be working on the planet's most pressing problems are instead developing complex correlation models to squeeze pennies from arbitraged trading or designing derivatives trades that create/shift risk for profit. It is a logical choice when money is the only metric; but that does not make the "resource allocation" rational.

[hari]

I know you're speaking about the Hedge Funds and how they make those small margins to count ...with large volume transactions.

Thanks a lot for your pieces on Greenspan's Fed. I suspect AG still believes strongly in the market and allowing the market marker to risk his/her money. Deregulation was his mantra.

[dd]

hari, you're welcome. Yes, deregulation was (and still is) Greenspan's mantra and he bears much responsibility for the current crisis. There is no doubt that this crisis will lead to more deregulation under the guise of regulation. The financial industry will save itself and the cost will be borne by everyday citizens and perhaps a few of the very wealthy caught in the larger cross-streams. Enron is the model and investment banks did quite well with very little fall out. The key is finding a distraction. Both Paulson and Cox have targeted credit ratings agencies; but that strategy is losing steam. Interesting times ahead.

[op]

shiller engages in a might be fantasy

instead of posing
the synthetic security as innovation
against
its potential for hazardous exploitation
by the endemic workings
of the real world's hi fi system

all that multipule gearing
fraudulent rating
pass the stinker
till it reaches some giff
without a nose or a clue

these are not innovations
these are business as usual
pouncing on a new con

they are the systemic exploitation
of a novelty
the fomentaion of a fad wave
fired ultimately not by the spirit of progress thru invention
but by a never fully acknowledged
even self acknowledged
fantasy quest for
a secret insider
perpetual rent rip system

as satan discoverd
all hot set ups
must end in brimstone

[op]

"The destruction of the Savings and Loans by Jake Garn and the Reagan-Bush folks was only a first round in a campaign of corruption and destruction, which has also included the reduction of the mutual form in insurance as well as banking"

i take it
that institutional destruction was not creative ???

to me it was

after all it wiped out
a piss poor fuss budgety
labor intensive
miss peach set up

now any rube can get a line without
farting around hat in hand
for several hours
across from some
super annuated sanctimonious
tie and coat dork
sitting behind
an open office side desk
who thinks saying "no"
to some stiff lookin to buy a hen coop
is like
praising our lord and maker

viva the new and dangerous
robo-credit system

[op]

the bruce be wild i love most

"A focus on the arcane jargon of "securitization" and derivatives should not be allowed to distract attention from the extent to which the present crisis has its foundation built on nothing more than an elaborate gambit to steal from and defraud home owners and would-be home buyers"

[op]

any reform, which doesn't include as its central feature some kind of registry/clearinghouse, observable by the central bank, ought to be a non-starter.
couldn't agree more

but it is the incentive to steal that both innovates these products
and craves ...the darkness

lucifer oh lucifer
what have you rought
you rogue you

but err
the chracoaled steak was great
and
my hands and feet sure like
the perpetual heat

[op]

"Given the need for expertise"

that right there spans the gap between us bruce

i'm a red guard in these matters

[op]

robinia

balance is not the word
for what a people's uncle
would be up to

he'd have 13000 armed masked agents
raiding 100 trans nat hi fi's head quarters
each week

with plenty of

"we'll be back" 's

[dd]

How's this for more financial innovation?
Goldman Writes Out 'Blank Check'
excerpt:
Goldman Sachs Group Inc. filed plans for its first "blank check" IPO, outlining a deal that will raise $350 million and make significant changes to the typical structure of such offerings.
As the only major U.S. investment bank that hasn't underwritten a blank-check initial public offering in the past three years, Goldman Sachs's entry into the segment adds legitimacy to a structure that was considered suspect by much of Wall Street until about 2005.
Goldman's plans, outlined in a Securities and Exchange Commission filing for a company called Liberty Lane Acquisition Corp., also tinkers with the format that these deals normally take.
Blank-check companies, also known as special-purpose acquisition companies, or SPACs, begin life as empty shells, raise money through an IPO, and strive to acquire an operating business. Liberty Lane's offering, which has not set a launch date or ticker symbol yet, puts a deadline of two years for its management to complete an acquisition, a typical time frame built into most SPACs."
http://online.wsj.com/article/SB120649149546564151.html?mod=googlenews_wsj

Nope, that gambling innovation is still thriving. In the bad old days of regulation the SEC would have thwarted such innovation but hey Goldman needs the fees.

[baileyman]

Financial innovation should be a good thing. But the prime directive for people in the biz is to "get mine first". Any innovation offers new ways to do that. Does anyone know how to write regulations simultaneous with innovation that close down the fraud opportunities?

[SGC]

Like most of you, I think Shiller sets up a straw man here. Nobody's against financial innovation.

There was clearly a market failure, or the investment banks would have set up a clearinghouse themselves for things like credit default swaps. What they would have had to give up however was private information about prices. Is there any doubt that they're profiting off of their private information? The evidence shows that financial markets are inherently oligopolistic and that the members of the oligopoly spend a lot of their energy protecting anti-competitive practices. See for example http://www.ft.com/cms/s/92d94ba6-24e4-11d8-81c6-08209b00dd01,id=071119000008

What we need is principles based regulation of financial innovation. As soon as a market gets big, it must move onto an clearinghouse/exchange.

Furthermore, given modern computing power, I don't see why the government can't simply require that all transaction prices in excess of, say, $100 be part of the public record (definitely including transfer prices within firms). The data won't be that useful at first as extraordinary efforts are made to make what is being traded confusing, but I think these problems can be worked out over time. We'll probably end up having to put bar codes on CDOs, but it would sure advance the cause of competitive markets.

says...

"What they would have had to give up however was private information"

and ain't that built right in to
lots of "insider opportunity only" scams

[paine]

sgc

i like the train track you're on

[SGC]

I just noticed that the link in the post above was bad:

http://www.ft.com/cms/s/92d94ba6-24e4-11d8-81c6-08209b00dd01,id=071119000008.html

[Anthony (Tony) Wikrent]

It's really pretty simple: once the financial system is beaten over the head into submission and becomes subservient to the real economy, financial innovation will be good.

Think of it this way: a financial system does not an economy make. A financial system is supposed to serve an economy, not dominate it.