Encouraging Financial Innovation


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Encouraging Financial Innovation

12/12/2014 | Chris Dillow – Stumbling and Mumbling

Reading Luis Garicano and Lucrezia Reichlin´s argument for the creation of a synthetic safe eurobond through which the ECB can conduct QE, an old question arose: why do we see so much bad financial innovation and so little good?
I say this is an old question because it is now over 20 years since Robert Shiller wrote Macro Markets, in which he proposed the creation of financial products to manage macroeconomic risks, and yet we´ve seen little progress on this front. What we have seen, though, is the creation of mortgage derivatives which contributed to the crash.
This illustrates a point made by Thorsten Beck and colleagues – that there are both “bright” and “dark” sides to financial innovation:
Financial innovation appears to encourage banks to take on more risks, which helps provide valuable credit and risk diversification services to firms and households, which in turn enhances capital allocation efficiency and the overall economic growth. On the downside, the “dark” side of greater risk taking is that it significantly increases the bank profit volatility and their losses during a banking crisis.
So, why do we get so much «dark» innovation and so little «bright»? Banks are guilty not just of sins of commission – mis-selling and rigging markets – but of sins of omission, not developing good products sufficiently.
The answer lies in the basic economics of innovation – that the social benefits (or costs!) of it often differ from the private benefits. (There is, of course, nothing unusual about financial innovation in this regard.) The type of innovation that occurs will depend not upon its social utility, but upon whether its proceeds can be appropriated privately. And this incentivizes dark innovation. «Crap» and «shitty» CDOs which can be sold to fools – sometimes in a different division of the same bank – will be produced, whereas products with big external social benefits need not be. It might be no accident that a big chunk of the good innovation we´ve had in recent decades – such as index funds or venture capital trusts – has received nice tax breaks.
Herein, I suspect, lies an under-rated argument for intelligent state control (or even ownership) of banks*. Such control might be necessary to rejig incentives towards bright innovation and away from dark. Mariana Mazzucato´s argument that the state can be entrepreneurial might be especially valid for the financial sector.
There´s one argument against this that is plain wrong – that the state is usually bad at coming up with new ideas. This is irrelevant because in finance we already have the ideas for products we (might?) need, thanks to the work of Shiller and the theory of complete contingent markets. The challenge is to implement them.
And the payoff to doing so could be big. The economy is a complex emergent process in which recessions are unpredictable; we didn´t need the 2008 crisis to learn this because, as Prakash Loungani showed, recessions before then weren´t predicted either. This implies that recessions might not be preventable by macroeconomic policy. Instead, the best we can do is develop ways of insuring against them. And this requires financial innovation of a sort which the private sector has proved itself incapable of providing.
* Mere passive ownership, of the sort we have of Lloyds and RBS, is not enough.
This editorial comes from Stumbling and Mumbling (Creative Commons). You can find it here.

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