Recommended Books for 2016

In contrast to previous years, I will be brief, forgoing my usual exhortation to read more books in the belief that if you’re reading this blog, you are probably doing a lot of reading anyway. And I’ll dispense with telling you how many books I’ve read this year, since doing so always triggers a flurry of email inquiring how I read so much (short answer: I’m a professor and reading a lot is part of my job.) For more suggestions, you can consult my previous recommendations or this gargantuan compilation of hundreds of other lists of recommended books.

Here are some of the best books I’ve read over the past 12 months. They deserve special attention and have my enthusiastic support.

  • Philip Tetlock and Dan Gardner, Superforecasting: The Art and Science of Prediction
    Excellent discussion of the attributes of good forecasters and why forecasting is so difficult. Valuable to all business professionals.

  • Duncan Watts, Everything is Obvious, Once You Know the Answer
    Excellent discussion of the difficulty of inferring insights from social data.

  • John Reader, Africa: A Biography of the Continent
    A comprehensive history of Africa. A foundationally important book for anyone who wants to understand how it got to where it is.

  • Robert J. Shiller, Finance and the Good Society
    Shiller argues that finance is an instrument for improving society—a welcome antidote to the political rhetoric in recent years.

  • Roger Lowenstein, America’s Bank
    An entertaining and insightful history of the Fed.

  • Jimmy Carter, Turning Point
    Carter’s memoir of his entry into politics. He fights electoral corruption in Georgia in his first campaign—and wins. It reads like a thriller.

  • Morgan Ricks, The Money Problem
    A somewhat technical book for aficionados of financial system stability. And I highly recommend it for Ricks’ erudition and wisdom.

  • David Wessel, In Fed We Trust: Ben Bernanke’s War on the Great Panic
    Perhaps the best one-volume history of the Panic of 2008.

  • Abby Smith Rumsey, When We Are No More: How Digital Memory is Shaping Our Future
    Confronts the ephemerality of digital records and the vital importance of preserving books for future generations.

And best wishes to you and your loved ones for the holidays and the New Year.

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Liveblogging the Great Depression: Comparison with the Great Recession

As I write this concluding post for the fall semester, the present context gives more meaning to our readings about the Great Depression.  Donald Trump’s startling win in the Presidential election, the buoyant estimates for infrastructure spending (maybe $1 trillion) under the new administration, and the vaulting gains in the stock market invite two questions.  First, is the new talk about higher economic growth for real?  Second, what kind of fiscal stimulus is consistent with the higher growth outlook?  This isn’t the place to try to answer those questions.  But if economic growth is the topic du jour, then our recent reading and discussion were very timely. 

 

For the fourth meeting of our seminar, Richard A. Mayo and I assigned Barry Eichengreen’s The Hall of Mirrors: The Great Depression, the Great Recession, and the Uses—and Misuses—of History.  This session afforded an economic “long view” of the entire period, afforded a comparison with the Great Recession of 2009-2015, and raised several conceptual points. 

 

The Long View: 1929-1939

 

The depths reached in the Great Depression between 1929 and 1933 were bad enough to qualify it for the record books.  But equally stunning was the duration of under-performance.  Popular thinking considers that the Depression ran until 1939.  But as Figure 1 shows, unemployment did not fall below the level of December 1929 until 1943. 

 

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Source: Author’s graph, with data from https://www.thebalance.com/us-gdp-by-year-3305543

 

And after the breathtaking deflation of 1930-1932, prices would not surpass the level of 1928 until 1942.  But the conventional measure of economic welfare, Gross Domestic Product per Capita, surpassed the previous peak (1929) as late as 1940 (see Figure 2).

 

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Source: Author’s graph, with data based on estimates by Angus Maddison, from http://socialdemocracy21stcentury.blogspot.com/2012/09/us-real-per-capita-gdp-from-18702001.html.

 

Visible in the two graphs is the fact that the Great Depression actually consisted of two slumps: 1929-1933 and 1937-38.  In between was an episode of healthy per capita GDP growth of 7.05% (1934), 6.9% (1935), and a whopping 13.5% (1936).   

 

The year, 1936, proved pivotal not only for economic growth, but for several new themes that enriched further our understanding of the Great Depression.

1.      Rise of populism.  Social and civic stress blossomed into various kinds of social protest.  Labor unions strengthened and struck.  Radio broadcaster Father Charles Coughlin fanned popular anger with virulent anti-establishment, anti-elite, anti-semitic, and nationalistic messages. Senator Huey Long sought to “make every man a king” through a “share the wealth program.”   Communist sympathizers pointed to the supposedly robust health of the USSR and excoriated the capitalist system.  Fascists pointed to Hitler and Mussolini as exemplars for fixing American government. The populist sentiments pulled FDR to the left in an effort to retain his coalition.  Indeed, his speeches and messages criticized monopoly power, the wealthy, and private enterprise as causes of the slow recovery; the President attacked “economic royalists.”  This change in tone had the effect of legitimizing the message of social protest and alarming business decision-makers.  Robert Higgs has argued that the intervention in markets, rising regulation, and hostility toward business created investment uncertainty that brought on the second slump.  In contrast, Barry Eichengreen cites rising labor costs as a depressant on economic growth in the late 1930s, reflecting growing union militancy.

2.      Shift from reform to relief.  The legislative record of FDR’s first term substantially consisted of new laws and regulations designed to make the economic system fairer and more stable, and to promote recovery.  FDR sought to “save capitalism” by reforming the system.  In December, 1933, John Maynard Keynes had written to FDR, criticizing him for emphasizing reform over relief.  Notwithstanding the legislative successes of his first term, employment had not recovered.  Furthermore, the Supreme Court ruled unconstitutional the National Industrial Recovery Act (the centerpiece of FDR’s reforms) and other New Deal laws.  Shortly after his re-election, FDR sought to “pack” the Supreme Court by increasing the number of justices from nine to 15; but Congress balked.  With that, FDR pivoted toward policies by which the government itself would put people to work.  The so-called “Second New Deal” successfully passed the Works Progress Administration (to give unemployed Americans jobs), the Wagner Act (to give labor unions the right to organize), and the Social Security Act (to give assistance to the aged, the unemployed, dependent children and the blind.)  Moreover, FDR abandoned a commitment to balance the federal budget and endorsed deficit spending as a stimulus to economic growth.  Finally, FDR reorganized the Executive Branch and creating the Executive Office of the President to give him more targeted advice with which to motivate and direct the bureaucracy. 

3.      From national toward international.  American sentiment was isolationist during the 1930s. FDR was an economic nationalist during his first term.  And between 1935 and 1939, Congress enacted five neutrality laws to prevent engagement in foreign wars.  Isolationism was a natural outgrowth of the Depression and the memory of defaulted loans that financed allies in World War I.  However, Japan’s full-scale invasion of China in 1937, Stalin’s “Great Purge” of 1937-38, Germany’s occupation of the Rhineland in 1936 and annexation of Austria and Czechoslovakia in 1938, and the Spanish Civil War of 1936-38 awakened American policy makers to threats to world peace.  With the commencement of hostilities in Europe on September 1, 1939, FDR formalized aid to China and Britain. 

 

To this narrative of the lengthy unfolding of the Great Depression, Barry Eichengreen’s Hall of Mirrors brings a valuable perspective on at least three topics.

 

Why the Depression lasted so long.  Eichengreen points to the steep trajectory of recovery from 1933 to 1936 and implies that at that rate, the depression would have ended soon.  Indeed, looking at Figure 2 and extending the slope of recovery in 1936 forward in time, it seems plausible that the Depression would have returned to pre-crash GDP per capita in the next year.  Eichengreen argues that the second downturn was the result of two policy errors: fiscal austerity and monetary tightening.  He wrote,

“It thus took a concerted effort by everyone from FDR on down to produce another recession.  The president had again become obsessed with balancing the budget.  Large deficits, as he saw it, were a sign that the economy was still ill.  Balancing the budget , on the other hand, would signal that the emergency was over.  Doing so would give a welcome boost to confidence.  Not for the last time in the annals of economic policy , there was also an element of political expediency involved.  Having campaigned in 1932 on a promise to balance the budget, FDR became fixated on the idea with the approach of the 1936 election.  It was not so much criticism from the Republican Right that the president feared.  Rather, he worried about a challenge from the Left in the person of the radio priest Father Charles Coughlin, who…turned against him on the grounds that the New Deal was insufficiently ambitious; it marked “two years of surrender, two years of matching the puerile, puny brains of idealists against the virile viciousness of business and finance, two years of economic failure.”…Thus, balancing the budget and populist tax policies could go hand in hand.  This political strategy led FDR to push, and the Democrat-controlled Congress to agree to, higher taxes…More important, surely, was the restrictive turn in monetary policy…The decision by the Federal Reserve Board…to raise reserve requirements from 13 to 19.5 percent in August 1936, 22.5 percent in March 1937, and 26 percent in May was intended to restore the effrectiveness of the central bank’s conventional policy tools…Treasury Secretary Morgenthau was among those preoccupied by the specter of inflation…To neutralize the inflationary threat, the Treasury Department now sold bonds from its portfolio…mopping up the additional cash and removing it from circulation.”  (Pages 266-270.) 

The combined impact of actions by the Fed, Treasury, and President was highly contractionary.  Eichengreen seems to suggest that none of the three parties took a systems view or tried to understand that together they would nip recovery in the bud.

 

The Great Depression versus the Great Recession.  Hall of Mirrors is an impressive exercise in the comparison of two economic calamities.  Chapters of the book interleave episodes of the two events.  This literary approach was probably adopted to promote comparisons.  But the back-and-forth induces chronological whiplash.  The grand takeaway is that government policy makers in 2008-9 may have averted a second Great Depression, but that the long duration and slow recovery stemmed from some of the same errors as Hoover, FDR, and associates.  What went well in 2008-2014 was the generally stimulative monetary policy of central banks.  On the other side of the ledger, regulatory stabilization of financial institutions was inconsistent (think of Lehman); fiscal stimulus was too soon and where it occurred, petered out too early; given the absence of fiscal unity, the European Monetary Union seemed doomed to fail; and the lapse into fiscal austerity in the U.S. and Europe in 2010 choked off growth.   

 

Economic theories about growth.   Eichengreen argues from Keynesian principles that the length of the Great Depression and Great Recession were due to policy errors that favored austerity.  The classical Keynesian view is that downturns are attributable to slackening demand and can be reversed by government-sponsored stimulus, especially by deficit spending.  Keynes envisions that a dollar spent by government will result in more than a dollar of economic output; therefore, stimulus spending by the government can help to restore economic growth.  

 

On the other hand, neoclassical economists take the view that consumers, managers, and investors make economic decisions by looking at tradeoffs.  Therefore, cyclical downturns are due to distortions in decision-making that adversely influence the production and consumption of goods and services—what matters are the expectations of decision-makers.  Thus, Robert Barro argues that the spending multiplier might well be less than one, if an added dollar spent by the government means higher taxes and lower growth in the future to repay the debt incurred today.  In particular, supply-side economists assert that the supply of labor, products, services, and money creates demand.  Therefore, the government should deregulate and reduce tax rates to stimulate growth.  Lee Ohanian, an economist at UCLA, reviewed Hall of Mirrors and took a different view from Eichengreen and argued that government interventions in the Great Depression and in the Great Recession prevented the normal return to growth. 

 

In short, one side would urge governments to fight a depression by stimulating the economy through fiscal spending.  The other side would urge relaxing the temptation to intervene. 

 

Conclusion: the value of historical comparisons 

 

If economists can’t agree on what causes depressions and recessions, why should we engage in the exercise of comparing the crises?  (President Harry Truman famously said that if you laid economists end to end, they would point in all directions.)  The deeper question is why study history at all?  Eichengreen responds,

“The historical past is a rich repository of analogies that shape perceptions and guide public policy decisions.  Those analogies are especially influential in crises, when there is no time for reflection.  They are particularly potent when so-called experts are unable to agree on a framework for careful analytic reasoning.  They carry the most weight when there is a close correspondence between current events and an earlier historical episode.  And they resonate most powerfully when an episode is a defining moment for a country and society.” (Page 377.)

Economic and financial crises are messy and chaotic events.  There is no checklist or handbook to tell decision-makers what to do.  Under such circumstances, it seems reasonable to look at precedents for inspiration about what to do and for caution about what not to do.  In that respect, Hall of Mirrors helps to build our frame of reference by recounting two economic calamities.  While it is true that more can be said about these episodes, the book is a valuable foundation for critical thinking when (not if) we enter the next calamity.

 

Works Referenced

 

Robert J. Barro, “Government Spending is No Free Lunch,” Wall Street Journal, January 22, 2009.

 

Barry Eichengreen, 2015, Hall of Mirrors: The Great Depression, the Great Recession, and the Uses—and Misuses—of History, Oxford: Oxford University Press.

 

Robert Higgs, 1997, “Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War,” Independent Review, Vol. 1: 561-590.

 

Lee Ohanian, 2016, “The Great Recession in the Shadow of the Great Depression: A Review Essay on “Hall of Mirrors: The Great Depression, the Great Recession and the Uses and Misuses of History,” Cambridge, MA: National Bureau of Economics Working Paper Series #22239.

 

 

 

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Liveblogging the Presidents: George H.W. Bush

An important lesson of the presidency of George H.W. Bush is the importance of an identity to the success of a leader.  An identity refers not only to substance (as in an ideology) but also style (as in how one gets things done.)  Identity emerges as a crucial issue in a reading of Bush’s memoir, All the best, G. Bush: My Life in Letters and Other Writings and two biographies of him.   This is one of the oddest presidential memoirs to be found—mostly tidbits of diary and correspondence in chronological sequence, but not a narrative argument.  What did President Bush intend for us to take from this? 

 

Eleven students and I are reading our way through the autobiographies and biographies of the post-Watergate U.S. Presidents. [1]  George H.W. Bush brought to the White House a resume of considerable experience: decorated veteran of World War II, successful entrepreneur, Congressman, Chairman of the Republican National Committee, Ambassador to the U.N., Chief of the U.S. Liaison Office to China, Director of Central Intelligence, and Vice President.  As President, Bush invaded Panama and arrested the military dictator, Manuel Noriega, for drug-dealing.  Bush marshalled some 80 nations in wresting Kuwait away from Saddam Hussein in 1991.  And he adroitly managed relations with China in the wake of the massacre at Tiananmen Square in 1989 and with USSR at the fall of the Berlin Wall and breakup of the Soviet Union.  Yet he failed to gain re-election in 1992, and joined the club of nine other Presidents who sought a second term and where defeated.  To most of these ten Presidents, history has not been kind.  Judged in the longer view, historians rank him at around #22 among all 44 Presidents.  There is no legacy for George H.W. Bush of the kind that graces the memory of his predecessor, Reagan.  Five considerations help to explain why.

 

Circumstances.  George H.W. Bush (hereafter, “Bush41,” which helps to distinguish the 41st President from his son, the 43rd President, “Bush43”) presided over massive changes in geopolitical history.  The dissolution of the USSR and reunification of Germany narrowly escaped a crackdown and coup attempt by Soviet hardliners.  The massacre at Tiananmen Square threatened to derail the rapprochement with China.   The invasion of Kuwait by Iraq in 1990 and the massing of Iraq’s troops on the border with Saudi Arabia threatened stability in the Middle East.  For his careful handling of these temblors, historians grant him good to very good marks.

 

Bush41 also inherited the legacy of the Reagan Revolution that had achieved tax cuts without offsetting budget cuts.  The S&L Crisis and onset of a recession in 1990 threatened to deliver record-setting government deficits.  In reaction, the Republican coalition fractured, and generated two populist challengers on the right, Ross Perot and Pat Buchanan.

 

Character.  Much is made of Bush41’s privileged background.  He was the son of a successful banker who was elected U.S. Senator.  His mother instilled strong values of loyalty, respect, service, and the “obligation to lead” (page 391).  The first eight pages of his memoir are a glossary of names that reveal a great deal about what Bush41 valued: “close,” “closest,” “friend,” “trusted,” describe almost half of them.  Other themes that figure heavily in describing those he values are loyalty, support, intelligence, integrity, honesty and respect.  More than any other presidential memoir, Bush41 displays a strong relational bent.  His memoir is riddled with references to “faith, family, friends” (page 391), “family is key” (page 388).  In describing his reaction to the loss of the presidency in 1992, Bush41 wrote,

“Hard to describe the emotions of something like this…But it’s hurt, hurt, hurt and I guess it’s the pride too…be strong, be kind, be generous of spirit.  Be understanding and let people know how grateful you are.  Don’t get even…finish with a smile and some gusto and do what’s right and finish strong.” (Page 572.)

 

Choices.  Belying the image of a pampered young man from a privileged background, Bush41 repeatedly made choices that took him out of stable and secure territory.  In 1941, he graduated from Andover and enlisted in the Navy to become an aviator—this, despite a graduation speech by Secretary of War Henry L. Stimson that urged his classmates to go to college.  It was dangerous service by any stretch of the imagination and prove so when he was shot down and rescued in the Pacific Ocean.  After the war, he graduated from Yale phi beta kappa, in a day when the social norm was for Yalies to get a “gentlemen’s ‘C’”.  Then he left the comforts of Connecticut to go to Texas, to sell oil-drilling equipment.  And then, offered a position with the prestigious banking firm of Brown Brothers, Harriman in New York, he declined the offer and instead started his own oil exploration firm.  He helped to build the Republican Party in Texas when being a Republican wasn’t politically acceptable.  He accepted political appointments that advisers said would mark the dead-end of his career (heading the legation in China in 1974, Director of the CIA in 1975).  This is the profile of an ambitious risk-taker, not a silk-stocking namby-pamby.

 

Judging from declarations and choices that Bush41 made, he positioned himself as a liberal Republican—notwithstanding his support of Barry Goldwater in 1964 and his acceptance of the Vice Presidency under Ronald Reagan in 1980.  He supported de-segregation in Texas in the 1960s, gay rights and family planning.  He purged John Birchers from the Texas Republican Party.  Clearly an internationalist in his reliance on diplomacy and treaties, he was willing to intervene where America’s strike force and moral authority would achieve outcomes for the global good (e.g., Kuwait and Panama.)  He believed in less government intervention in everyday life, and more volunteerism and charity. 

 

In coaching his speechwriter, Peggy Noonan, about drafting his acceptance speech at the Republican Convention in 1988, he wrote,

Vision. On the domestic side jobs, but jobs in an America that is free of drugs, that is literate, that is tolerant.  On the foreign policy side—peace, but peace in a world that offers more freedom, more democracy to the people of the world.”  (Page 351.)  “What drives me comforts me: family, faith, friends.  We have a special obligation to lead.  We must not forget our responsibility…We owe it to the free nations of the world to lead, to stay strong, to care…strive for a truly bipartisan foreign policy—and never give up on liberty.” (Page 391.)

Noonan fleshed out this brief advice into a broad summation of Bush41’s worldview: a tendency to see life as a series of missions; a “kinder, gentler nation;” gun rights; the death penalty; first rate education; drug free America; inclusion of the disabled; world peace through strength; celebration of the individual; in all, an “enduring dream and a thousand points of light,” “a message of hope and growth for every American to every American” (watch here).  And in his inaugural address of 1989 (watch here),  Bush41 said that he took as his guide “the hope of a saint: In crucial things, unity; in important things, diversity; in all things, generosity.” 

 

But viewed from the span of 28 years, these addresses look like boilerplate, mainstream Republican orthodoxy.  What, exactly, would Bush41 add to the political stew in Washington?  In what ways would he actually lead?  The acceptance speech and inaugural address presaged Bush41’s signal problem during his presidency, “the vision thing.”  People found it difficult to know what he stood for.  Timothy Naftali wrote that when Bush arrived as a new Congressman in January 1967,

“Bush’s thinking evolved once he reached Washington.  He had few, if any settled policy ideas.  What he had were tendencies: Bush disliked extremism of any kind; he preferred to seek solutions outside of the federal government; he believed in a strong defense and in strong support for the U.S. military; he preferred spending cuts over higher taxes; he opposed segregation and racial discrimination, but he was uncomfortable in having Washington mandate good behavior.  Despite his conservative temperament, Bush proved to be pragmatic and emotional.  Quickly dropping any pretense to being a Texas conservative, he allied himself with moderate civic Republicans, who believed in the goals of the Great Society and the war in Vietnam but wanted both to be managed more efficiently.” (Pages 16-17.)

As one reads or listens to Bush’s speeches in 1992, he seemed continually to be evolving.  Bush contrasted starkly with his predecessor, Reagan, who had framed a series of stirring visions for voters and who had articulated a strong ideology. Whether Bush41 could hold together the coalition of moderate and conservative Republicans would depend on his execution of the vague vision.   

 

Execution.  The memoir of Bush41 highlights several attributes about the way he executed his responsibilities:

·        He listened.  Bush41 wrote, “Leadership is listening then acting.  Leadership means respect for the other person’s point of view, weighing it, then driven by one’s own convictions, acting according to those convictions.  If you can’t listen, you can’t lead.” (Page 351.)  As a relational leader, listening is paramount.  The inclination to lead by listening proved to be of paramount importance in navigating through the international crises Bush confronted. 

·        He took measured steps in conflict.  At the massacre in Tiananmen Square in Beijing in May, 1989, Bush43 wrote, “Dad struck a careful balance…He denounced the Chinese government’s use of force and imposed limited economic sanctions…Dad drew on his personal connections and wrote a private letter to Deng Xiaoping…whom he addressed as “Dear Friend.” (Page 192.)  Bush43 summarized his father’s decision to liberate Kuwait: “I admired the way Dad handled the situation.  He had taken his time.  He had explored all options…He had rallied the world and Congress to his cause.” (Page 199.)

·        He played the long game.  Bush41’s memoir suggests that he foresaw the economic collapse of the USSR as early as the mid-1980s, but was patient.  To try to hasten change would risk arousing hardliners who might respond in force—as they ultimately tried to do in a coup d’etat against Gorbachev in 1991.  In 1990, Bush delayed recognition of the breakaway Baltic republics to temper the anxieties of Russian hardliners and gain time for a united Germany to be included in NATO.  Timothy Naftali wrote, “Thus, George H.W. Bush for a moment, at least became a great President…risked his international prestige [and negotiated the bipartisan budget] in each case Bush sacrificed short-term political gain for what he considered the national interest.” (Page 98.)

·        He dealt in relationships, not transactions.  In addition to addressing Deng on a friend-to-friend basis, he developed a similar rapport with Gorbachev.  Bush43 wrote,

“Dad’s strategy was to develop his friendship with Gorbachev while privately urging him to allow the Soviet Union to unwind peacefully.  The strategy paid off in early 1991 when Gorbachev agreed to allow a free election for President of the Russian Federation…He believed that encouraging Gorbachev—not provoke the Soviet hardliners—was the best way to avoid a crackdown…I don’t believe Gorbachev could have endured without a partner in the United States.” (Pages 212 and 214.)

·        He played by the rules.  Bush 41 defended his decision not to pursue Saddam Hussein into Iraq, and instead respected the strict limitations of the U.N. mandate to liberate Kuwait: “I still do not regret my decision to end the war when we did.  I do not believe in what I call “mission creep.”” (Page 514.)

·        In victory, he did not gloat.  Humility is one of the dominant sentiments in Bush41’s memoir.  His son echoed this attribute in describing the moment that the Berlin Wall fell in November, 1989:

“Dad faced enormous pressure to celebrate…Dad refused to give in to the pressure.  All his life, George Bush had been a humble man.  He wasn’t trying to score points for himself; he only cared about the results…Freedom had a better chance to succeed in Central and Eastern Europe if he did not provoke the Soviets to intervene in the budding revolutions.  “I’m not going to dance on the wall,” he said.” (Page 195.)

 

In other respects, Bush41 may have listened, but did not hear so well.  Here he is, recounting his response to White House aides who were worried by a possible challenge from Ross Perot in 1992:

“I told them that in three months, he will not be a worry anymore.  Perot will be defined, seen as a weirdo…Their view is that the move for change is so much outside that outsiders are in and insiders are out; and that Perot can take his money and parlay himself into victory or into a serious threat.  We need to be very wary of this, but time will tell…[On the same page in a footnote, he declared,] They were right and I was wrong.  In the final analysis, Perot cost me the election.” (Page 555.)

 

But was the problem only Perot?  Bush41 was challenged by Pat Buchanan as well.  Both challengers came from the populist right-wing of the electorate.  At the core of their challenge was Bush’s failure to shrink government spending at the moment of budget crisis in 1990 and to renege on his pledge at the 1988 nominating convention, “Read my lips: no new taxes.”  “The budget agreement was a disaster,” wrote Bush43.  It fractured the Republican Party, obscured other domestic accomplishments and reflected a poor job of communicating and defending the agreement.  Timothy Naftali wrote,

“Whether due to naivete, renewed self-confidence, or arrogance, Bush assumed that his personal charm, his honesty, and his sense of a mutual interest in good government would suppress his opponents’ interest in seeing him hurt politically…Bush became an object of increasing public scorn…made matters worse by reacting ineptly to his image problem.” (Pages 99 and 140.) 

Lyn Nofziger later commented, “He was an ineffective one-term President.  [He] walked away from the Reagan legacy and tried to create his own—and failed at that.” (In Naftali, page 161.)

 

Outcomes.  The paradox is that close observers like Nofziger deem Bush41 a “failed President,” despite the many accomplishments on Bush’s watch.  The wins would include the end of the Cold War, the successful expulsion of Iraq from Kuwait, the arrest of Manuel Noriega, the unification of Germany, the American Disabilities Act, the Civil Rights Act of 1991, the Clean Air Act Amendment of 1992, the Points of Light Project, and the appointment of two Supreme Court Justices.  Not shabby for a one-term President.

 

On the other side of the ledger, Bush41 lost to Bill Clinton and prompted moderate Republicans to flee the field.  Clinton won with 43% of the popular vote and 370 electoral votes; Bush received 38% of the popular vote and 168 electoral votes; Perot took 19% of the votes.  The right-wing populists gained momentum as the heirs to the Reagan Revolution and under the leadership of Newt Gingrich wrested leadership of the House of Representatives in 1994.  Essentially, this faction echoed the ideology of Pat Buchanan and Ross Perot: cut the deficits, balance the budget, protect American industry, oppose foreign wars, and generally oppose the establishment and longstanding incumbents.

 

Epitomizing the incredible reversal in fortunes for Bush41 was his approval rating.  The following graph reveals that during Bush’s first two years, he was popular, if not even highly approved.  His rating peaked at 89% (Feb. 28, 1991) at the end of the Gulf War and hit bottom at 29% 18 months later, on July 31, 1992, at the outset of his campaign for re-election.  By the date of Clinton’s inauguration, Bush’s approval rating was back in positive territory. 

 

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Source: Gallup Historical Presidential Job Approval Statistics http://www.gallup.com/poll/116677/Presidential-Approval-Ratings-Gallup-Historical-Statistics-Trends.aspx

 

In October, 1987, Newsweek magazine published a devastating cover-story article on Bush, titled, “Bush Battles the ‘Wimp Factor’”. 

“Bush suffers from a potentially crippling handicap — a perception that he isn’t strong enough or tough enough for the challenges of the Oval Office. That he is, in a single mean word, a wimp.  ‘A problem’: The epithet has made its way from the high-school locker room into everyday jargon and stuck like graffiti on Bush. What’s come to be known as the vice president’s “wimp factor” is a problem, concedes Bush pollster Robert Teeter, “because it is written and talked about so much.”… “Fairly or unfairly, voters have a deep-rooted perception of him as a guy who takes direction, who’s not a leader,” says Democratic pollster Peter Hart… (Literally. Last week the “Doonesbury” strip portrayed voters matter-of-factly describing Bush as a wimp.)…Why, then, is he so cruelly mocked? The reasons are both stylistic and substantive. Television, the medium that makes Ronald Reagan larger than life, diminishes George Bush. He does not project self-confidence, wit or warmth to television viewers. He comes across instead to many of them as stiff or silly… Beneath such surface qualms lie deeper doubts. What does Bush really stand for? His two decades in government have produced an impressive resume — congressman, U.N. ambassador, Republican Party chief, China envoy, CIA director, vice president. But his imprint on all those jobs is indistinct, even his friends admit, and he seems to have avoided the great social and political controversies of a quarter century. In short, Bush is by and large a politician without a political identity.”

Biographer Timothy Naftali wrote:

“In the nearly quarter century since his first run for federal office, Bush had yet to fashion for himself a political program.  He had coexisted with three major Republican leaders, Goldwater, Nixon, and Reagan, each of whom saw the world differently, and Bush had served each of them loyally.  Many observers considered Bush’s political adaptability a sign of weakness…No one questioned the physical courage…It was his political courage that was in question.” (Page 51.)

 

The memoir of Bush41 recounted the wimp episode with emotion.

“Handlers want me to be tough now, pick a fight with somebody…the ‘wimp’ cover, and then everybody reacts—pick a fight—be tough—stand for something controversial, etc. etc.  Maybe they’re right.  But this is a hell of a time in life to start being something I’m not.  Let’s just hope the inner strength, conviction, and hopefully, honor can come through.” (Page 369.)

 

Reflections for leaders

 

What explains the unusual format of Bush’s memoir?  As with most memoirists, he wanted to explain himself, not just what he did, but who he was.  This was his last, best shot at establishing his identity.  He wrote,

“When I left office and returned to Texas in January, 1993, several friends suggested I write a memoir.  “Be sure the historians get it right,” seemed to be one common theme.  Another: “The press never really understood your heartbeat—you owe it to yourself to help people figure out who you really are.”  I was unpersuaded…Lisa Drew suggested that what was missing is a personal book, a book giving deeper insight into what my own heartbeat is, what my values are, what has motivated me in life…It’s all about heartbeat.” (Pages 21-22.)

 

George H.W. Bush offers a useful basis for thinking about the identity of a leader.  The undercurrent of Bush41’s career was the lingering question, “Who is George Bush?”  The simple answer is that a mushy vision and political adaptability render the answer, “I don’t know.”  But we can do better than that. The five elements suggest at least two dimensions along which we could size up a leader.

1.      Relational versus transactional.  What distinguished Bush41 from Reagan, Carter, or Ford was his candor about his intense network of relationships, based on family, friends, and faith.  His memoir is unlike any other presidential autobiography that one can find: rather less about policy and politics and much more about relationships.  One of the most important ways to parse leadership styles is the extent to which it is transactional versus relational.  And I hasten to add that no one who is elected to the White House is totally one or the other; but it is very useful to consider tendencies. 

 

The ultimate transactional leader is the piece-rate bargainer: everything about an exchange is measured in tangible “gives” and “gets”—think of the deal-making of Lyndon Baines Johnson or the “government by deal” implied by the early actions of Donald J. Trump.  With such a leader, extra effort or output wins immediate reward; similarly, retribution for failing to meet goals is quick and Darwinian (think of Trump’s show, The Apprentice, and “you’re fired!”)   The transactional leader may promote competition among followers.  There is no reward for assisting a colleague—it just takes time that you could be using to stay ahead.  Boiler-room sales operations work like this; in more elegant surroundings you will find that some professional services firms and financial organizations offer essentially the same environment.  To get ahead in such organizations, you must stay ahead of the average of your colleagues.  Never admit weakness.  And never hesitate to ask for a better deal.  “If you don’t ask, you don’t get” might be the cultural motto.  The transactional leader can be stressful to work for; the employment demands are clear and the consequences immediate.

 

The relational leader reflects a more complicated social contract.  What matters is the long-term relationship, not just the near-term tradeoff.  Surely, as the relationship prospers, the individual tends to prosper.  But the contract goes well beyond piece-rate and may include expectations for a contribution to the success of the team, contribution over time rather than in the moment, and contribution to quality rather than simply volume.  As the term, “relational,” implies, the glue for such leaders is not the individual transaction, but rather the strength of the network.  Relational leaders can impose big burdens on their employees, who are asked to live up to a strong internal culture; the employment demands are probably ambiguous and open-ended.

 

2.      Ideological versus pragmatic. The ideologue is dogmatic and uncompromising, adhering to principles and ideals, a focused partisan.  The principles or ideals derive from values: economic, political, social, or religious.  For the ideologue, justifying a principled stand often entails an emotional appeal to values.  In the public mind, Ronald Reagan and Margaret Thatcher were ideologically-motivated leaders.  Jimmy Carter pursued the Egyptian-Israeli Peace Treaty out of religious conviction.  To follow an ideological leader entails demonstrating loyalty by espousing the right ideas—one needs to drink the Kool-Aid, and do it in a way consistent with the ideology.

 

The pragmatist, on the other hand is focused especially on the means to achieve some goals.  “To make an omelet, you must break a few eggs,” as the French say.  Ideas are valuable if they are practically useful.  Lyndon Johnson was famous for back-room deal-making in pursuit of his Great Society programs.  Richard Nixon supposedly declared, “We’re all Keynesians now” and supported greater state intervention in markets in the midst of a financial crisis.  To follow a pragmatist leader entails achieving the right outcomes in a way that is efficient and effective.  It is not what you say, but what you do, that counts.  

 

3.      Morally courageous versus passive.  History has dealt harshly with Presidents who declined to confront and grapple with the supreme challenges of their day.  James Buchanan (1856-1860) allowed “bleeding Kansas” to bleed and did virtually nothing to stop the momentum toward civil war.  Andrew Johnson (1865-1868) declined to implement policies to integrate liberated slaves into society.  “Moral courage,” the willingness to fight or confront problems, is the premier attribute of a leader, according to the memoir by Ulysses S. Grant (1868-1876).  And Theodore Roosevelt wrote:

“It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.”  (Speech at the Sorbonne, April 23, 1910.) 

 

Our readings about George H.W. Bush suggest that he tended to be a relational pragmatist—and he showed remarkable moral courage at important moments in his career.  Ironically, his adaptability, and his ability to engage with virtually everyone, and his inarticulate summation of what he stood for contributed to his defeat.  A sense of identity makes it easier for followers to know what the leader stands for.  It will be a topic of enduring discussion in our seminar whether the leader chooses the identity, or the times confer the identity on the leader.  The answer resides in the interdependence among circumstances, character, choices, execution, and outcomes.

Works Referenced

 

George H.W. Bush, All the Best: My Life in Letters and Other Writings, New York: Scribner (2013, revised edition).                

 

George W. Bush, 41: A Portrait of My Father, New York: Crown Publishers, 2014.

 

Timothy Naftali, George H.W. Bush, American Presidents Series, Times Books, 2007.

 

 

 

 

 

  1. After our first seminar meeting, I distilled our discussion into five components for understanding a President: circumstances, character, choices, execution, and outcomes.  And I argued that these components are interdependent, making it challenging to understand causality: when we encounter a successful or failed President, the temptation is to point to simple explanations.  Our study of the Presidents this year suggests that success or failure is usually a more complicated story. []
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Liveblogging the Presidents: Ronald Reagan

 

“This idea — that government was beholden to the people, that it had no other source of power is still the newest, most unique idea in all the long history of man’s relation to man. This is the issue of this election: Whether we believe in our capacity for self-government or whether we abandon the American Revolution and confess that a little intellectual elite in a far-distant capital can plan our lives for us better than we can plan them ourselves.” – Ronald Reagan, “A Time for Choosing,” Goldwater Campaign speech, 1964. (Read here.)

 

“Let’s make America great again.” – Reagan campaign poster, 1980.

 

“It’s morning again in America. Today more men and women will go to work than ever before in our country’s history. With interest rates at about half the record highs of 1980, nearly 2,000 families today will buy new homes, more than at any time in the past four years. This afternoon 6,500 young men and women will be married, and with inflation at less than half of what it was just four years ago, they can look forward with confidence to the future. It’s morning again in America, and under the leadership of President Reagan, our country is prouder and stronger and better. Why would we ever want to return to where we were less than four short years ago?”  — Reagan re-election campaign, 1984 (Listen here.)

 

 

Reagan communicated very effectively.  The political power of the word spoken well may be the prime lesson of Reagan’s presidency.  Of course, his presidency stands out for other attributes as well: his conservative ideology, his muscular foreign policy, and for a “revolution” in the relationship between government and governed.  As an aspirant to the White House, he was disparaged as a Hollywood actor.    Yet he was elected to two terms as Governor of California (one of the largest states in the nation) and in 1980 was elected President by a “landslide,” gaining 489 electoral votes. [1]    He was the first President in 28 years to serve two full terms.  ((Dwight Eisenhower’s second term ended in 1960; Reagan’s ended in 1988.))  Judged in the longer view, historians have been kind to him, ranking him recently at #9 among 43 Presidents.  And the “Reagan Revolution” appears to have had lasting impact.  It would seem that Reagan’s presidency holds some lessons for students of leadership.

 

This post continues my reflections stemming from the year-long seminar that I’m leading on the “Leadership Lessons of the Post-Watergate Presidents.”  In that seminar, we’re reading the memoirs and biographies of these Presidents.  In my first course post, about Gerald Ford, I offered a model for thinking about the Presidents that focuses attention on five elements: circumstances, character, choices, execution, and outcomes.  Reagan’s profile on these elements is distinctive, especially in comparison with his two immediate predecessors, Ford and Carter:

1.      Circumstances:  The Watergate scandal and associated revelations of 1972-1974, Arab oil embargo of 1974, America’s ignominious exit from Vietnam in 1975, recession of 1974-75, “stagflation” of 1978-79, and the Iran Hostage Crisis of 1979-80 put the electorate in an ugly mood for the 1980 presidential election.  The incumbent powers in national politics (left/liberal Democrats and centrist Republicans) seemed played out.  Conservative Republicans had been building momentum since Reagan’s first election as Governor of California in 1967.  Reagan entered office with a crisis in the public sector (in contrast to Franklin D. Roosevelt, who entered office with a crisis in the private sector).  Reagan wanted to be identified with a resurgence, a recovery of domestic conditions, with “Morning in America.”  Reagan’s overarching goals during his presidency were to reduce the scope of government and end the Cold War.

2.      Character: Almost a third of Reagan’s memoir, An American Life, is devoted to his upbringing and preparation as a politician.  Born into a humble socio-economic setting, son of an alcoholic father and of a mother of strong character, Reagan made his own way.  Indeed, much of the memoir is the portrayal of Reagan as everyman, the iconic American, who, through hard work, ingenuity, faith, optimism, and fair dealing, succeeded in family, career, and service to others.  Pivotal character-building experiences for Reagan included learning to broadcast sports events (helping listeners “see” a game through Reagan’s words), expelling communists from the Screen Actors Guild of which Reagan was president, and speaking to employees of General Electric (a graduate school in political science, he said.)    Reagan wrote, “During eight years of travels for General Electric and during the campaign for governor, I’d gotten a good idea of what was on the minds of people.  They wanted their government to be fair, not waste their money, and intrude as little as possible in their lives.”  (Page 170.)

3.      Choices:  One chooses one’s ideology.  By 1980, Reagan had views that were distinctive, fresh, and appealing to the electorate.  “Conservative” was a label tarnished by memory of such people as Herbert Hoover (the “Great Engineer” who failed to avert the Great Depression and then railed against the New Deal), Joseph McCarthy (demagogic Senator and communist-chaser), George Wallace (racist), and the John Birch Society (right-wing conspiracy theorists).  The identity of such conservatives was to be against trends in society.  Reagan on the other hand seemed to frame an ideology for values that had broad appeal: freedom (from an intrusive government), light taxation, law and order, right to work, and capitalism.  Reagan wrote, “The classic ‘liberal” believed individuals should be masters of their own destiny and the least government is the best government; these are precepts of freedom and self-reliance that are at the root of the American way and the American spirit.”  (Page 135.)   Reagan believed in small government and quoted James Madison (“there are more instances of the abridgement of the freedom of the people by gradual and silent encroachment of those in power than by violent and sudden usurpations”) and Thomas Jefferson (“What has destroyed liberty and the rights of men in every government that has ever existed under the sun?  The generalizing and concentrating of all cares and powers into one body.”) (Page 196.)  And Reagan was a staunch defender of capitalism and critic of socialism and communism.  He broke a diplomatic taboo by labeling the Soviet Union the “Evil Empire” and wrote, “The great dynamic success of capitalism had given us a powerful weapon in our battle against Communism—money.  The Russians could never win the arms race; we could outspend them forever.  Moreover, incentives inherent in the capitalist system had given us an industrial base that meant we had the capacity to maintain a technological edge over them forever.” (Page 267.)   Reagan believed in American exceptionalism.  In one speech, Reagan said, “I, in my own mind, have thought of America as a place in the divine scheme of things that was set aside as a promised land…this land of ours is the last best hope of man on earth.” (Weisberg, pages 30-31.)

4.      Execution:  Four attributes stand out regarding Reagan’s leadership style: excellent communication, determination, and delegation. 

a.      Communication: Reagan portrayed a charm and approachability that established warm rapport with an audience.    He told stories and jokes with ease (listen here and here.)  Reagan’s memoir conveys his rules for speaking, “I prefer short sentences; don’t use a word with two syllables if a one-syllable word will do; and if you can, use an example.  An example is better than a sermon…I usually start with a joke or story to catch the audience’s attention; then I tell them what I am going to tell them, I tell them, and then I tell them what I just told them.” (Pages 246-7.)   For more insight into the possible impact of the spoken word, you should listen to Reagan’s two inaugural addresses (1981 and 1985), his “Evil Empire” speech in 1983 (here), and the speech in Berlin in 1987 (“Mr. Gorbachev, tear down this wall.”) (here). 

b.      Determination:  Perhaps reflecting his strong ideology, Reagan emerges not as the Washington-style pragmatist (like Ford, Bush41, or Clinton) but as a friendly but firm advocate for his principles.  The Reagan administration was unable to reduce federal spending because he had no majority in the House of Representatives, which originates spending bills—“This was one of my biggest disappointments,” he wrote.  (Page 335.) But Reagan’s determination may be best reflected in his dealings with the Soviet Union and his aspiration to eliminate nuclear arms.  Reagan wrote, “As the foundation of my foreign policy, I decided we had to send as powerful a message as we could to the Russians that we weren’t going to stand by anymore while they armed and financed terrorists and subverted democratic governments.  Our policy was to be one based on strength and realism.  I wanted peace through strength, not peace through a piece of paper.”  (Page 267.) The Strategic Defense Initiative (SDI) relied on unproven speculative technology.  But SDI proved to be an important bargaining chip.  Even though many American experts doubted the effectiveness of the technology, Reagan quipped that as long as Gorbachev thought it would work, Reagan was going to pursue it.  His strategy paid off with a breakthrough accord to reduce nuclear arms.  

c.      Delegation:  Reagan was a champion delegator—in strong contrast to Carter, who might be deemed a micromanager.  But he did not monitor his delegates very carefully.  He trusted his appointees to implement his directives, which ultimately got Reagan into trouble in the Iran-Contra Affair that tarnished his second term.  Almost a quarter of Reagan’s memoir is preoccupied with the scandal.  In essence, a scheme to trade arms for hostages violated Reagan’s ban on negotiating with terrorists.  And a subterfuge in marking-up the sale price would provide financial support to anti-Sandinista guerillas in Nicaragua—this violated laws prohibiting such support.  Congressional investigations and the Tower Commission, which studied the affair, strongly criticized Reagan for inattention and lack of supervision of subordinates.  On March 4, 1987, Reagan addressed the nation on TV and took full responsibility for the affair, though in his memoir, Reagan admitted, “On any given day, I was sent dozens of documents to read, and saw an average of eighty people   I set the policy, but I turned over the day-to-day details to the specialists.  Amid all the things that went on, I frankly have had trouble remembering many specifics of the day-to-day events and meetings of that period, at least in the degree of detail that subsequent interest in the events has demanded.” (Page 516.)  Twelve subordinates were indicted for violation of the law.  Oliver North and others have asserted that Reagan knew what was going on.  Some observers think Reagan was lucky not to be impeached.  Yet as the “Teflon President,” Reagan emerged in January 1989 with a 64% approval rating, the highest end-of-term approbation for any President up to that time.

5.      Outcomes: In his 1980 campaign, Reagan asserted that America was losing faith in itself.  By 1988, America seemed to have rediscovered its mojo.  Aside from an assertive foreign policy that stood up to Soviet expansionism, the American economy recovered. 

 

 

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Source: https://www.google.com/search?q=1980s+economic+timeline&sa=X&biw=1024&bih=490&tbm=isch&imgil=QSZr-t18gsl0aM%253A%253BvFPNW38S4QLuGM%253Bhttp%25253A%25252F%25252Fwww.economicshelp.org%25252Fblog%25252F630%25252Feconomics%25252Feconomy-in-1980s%25252F&source=iu&pf=m&fir=QSZr-t18gsl0aM%253A%252CvFPNW38S4QLuGM%252C_&usg=__Kv1wep2d2CedBkzhD7_KwrfipRQ%3D&ved=0ahUKEwjH14DGt-LQAhXJLyYKHQWJDgQQyjcIRQ&ei=oC9IWMeHNMnfmAGFkrog#tbm=isch&q=US+1980s+economic+growth&imgrc=8Cb9F-4Uqs5I6M%3A

 

Many political scientists note that the approval ratings of Presidents are highly sensitive to economic growth and employment.  No doubt, Reagan benefited from the buoyant economy.  The booming economy was due in part to the dramatic Reagan tax cut in his first term, which owing to the inability to cut spending, contributed to the debt problem the country faces today.

 

From the long view of 28 years, the legislative, diplomatic, and administrative achievements of the Reagan administration seem dwarfed by the larger and more inchoate legacy of the “Reagan Revolution.”  Biographer Jacob Weisberg wrote, “What Reagan did change was the public’s attitude toward government, for better or worse.  Reagan followed a string of foreshortened presidencies: those of Johnson, Nixon, Ford, and Carter.  Many political scientists came to believe that the job had become impossible: the executive branch was too vast and complex for any one person to manage.  Reagan’s popularity and accomplishments restored the idea that someone could be successful in the job.” (Pages 152-3.)

 

Judging from the primary campaigns and debates in 2016, the Republican Party platform reflects the long legacy of Reagan. [2]  Stephen Skowronek, a political scientist at Yale, has offered a theory that presidential leadership and ideology cycle through time and that the liberal ideology of Franklin D. Roosevelt’s New Deal ran out of public support with the Carter administration and that the election of Reagan marked a new cycle in “presidential time.”  Skowronek wrote, “[Ronald Reagan] came to power in circumstances that recalled the great reconstructive crusades of the past.  An economic crisis had highlighted the accumulated burdens of the old regime and indicted its political, institutional, and ideological supports.  The Republicans took control of the Senate for the first time in twenty-eight years, and, with the Democratic party in disarray, the administration quickly fashioned a working majority in the House of Representatives…His administration opened with a broadside assault on the ruling formulas of a bankrupt past: “In the present crisis, government is not the solution to our problem; government is the problem.”  This message would be hammered relentlessly over the next eight years, each blow directing the presidential battering ram against the institutions and principal clients of the liberal regime.” (Page 414.)  Skowronek’s assessment in 1993 was prescient.  In the election of 2016, the Republic Party celebrated gaining control of both houses of Congress, the White House, and 38 out of 50 state governments.  As the following figures show, the Republican base in Congress has grown more conservative over time.

 

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Perhaps the trend in Congress reflected the trend in the Republican voter base.  The following figure shows growing conservatism among Republican voters.

 

 

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Source: both graphs downloaded from https://www.washingtonpost.com/news/the-fix/wp/2015/06/02/congress-sets-a-new-record-for-polarization-but-why/?utm_term=.89202ee3e5b9

 

Reflections for leaders

 

Reading Reagan’s memoir and various biographies of him highlight lessons about communication, delegation-and-control, determination, ideology, and character.  To synthesize among these lessons, here are four final reflections.

1.      Get a vision.  What distinguished Reagan from Carter or Ford was his ability to plant a vision in the popular consciousness: the “city on a hill,” American exceptionalism, freedom from government intrusion, and pushback to socialism and communism.  The difficulty of the “vision thing” would contribute to the downfall of Reagan’s successor, George H.W. Bush.  A vision creates a sense of identity for the leader, making it easier for followers to know what the leader stands for.  In my own experience as Dean, I found that alignment of a community around mission and vision made the rest of leading more fruitful (not necessarily easier, but more productive.)

2.      Presence matters.  So many observers argue that Reagan was the “Great Communicator.”  But in watching videos of his speeches, one gets a sense that it was more than that.  He had great presence.   Reagan’s presence was a blend of folksy approachability and conservative determination.  In contrast, Carter and Ford seemed awkward in the presidency—if they had any presence, it was due more to the office than the person.  Presence contributes to the leader’s identity, but it also commands respect.  Amy Cuddy and others have interesting books on developing leadership presence.   My colleague, Lili Powell, teaches an excellent course on the subject.

3.      Coordinator-in-chief.  Reagan delegated too much and monitored too little.  His famous saying, “trust but verify” worked in negotiating nuclear arms reductions with the Soviets, but was not observed in his oversight of Poindexter, North, and the Iran-Contra people.  The President cannot manage all the details, but needs to balance delegation with monitoring.

4.      Is a leadership model repeatable?  The correspondence between Reagan and the candidacy and election of Donald Trump is eerie.  One sees similar campaign mottoes (“Make America Great Again”), similar repudiation of elites and conventional thinking, and unusual communication skills and strategies.  Will 2017 mark the beginning of one of Skowronek’s presidential cycles?  The history of Reagan suggests that it will take a few decades to tell.

 

Works Referenced

 

Reagan, Ronald, An American Life, New York: Simon & Schuster, 1990.

 

Skowroneck, Stephen, The Politics Presidents Make: Leadership from John Adams to Bill Clinton, Cambridge: Belknap Harvard, 1993.

 

Weisberg, Jacob, Ronald Reagan, New York: Times Books, 2016.

 

 

 

 

 

 

  1. Reagan’s landslide accrued only 50.7% of the popular vote, less than other popular presidents.  The American Constitution entails a weighted voting system that favors less-populous states. []
  2. In some material ways, the leadership of Donald Trump departs of the Reagan model, which calls into some question its sustainability. []
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Liveblogging “Financial Innovation” Week 14: Following a Path

 

But now it looks to me as though I was following a path that was laid out for me, unbroken, and maybe even as straight as possible, from one end to the other, and I have this feeling, which never leaves me anymore, that I have been led.

— Jayber Crow, Wendell Berry

This has been a big course: 28 class sessions, about 1,400 pages of required reading, numerous in-class exercises and videos, and eight visiting speakers.  And we went off the rails compared to most Darden courses: no case studies, just articles; flat classroom, iLab location; discussions led by students; liveblogging by the instructor; and diverse attendance from Darden, the Law School, the Batten School, and the Economics Department.   So, after all of this, where have we come to? 

Along the path

Conventional wisdom is that the task of teachers is to get students to a destination of greater mastery.  But an unrelenting focus on a destination can lead to rote instruction, teaching to the test, and rather dull learning.  Important mastery arises from the process of learning.  As Michel de Montaigne said, “It is the journey, not the arrival, that matters.”  The most important learnings are about how and why to get somewhere, rather than the “what” of the there that is there.  Financial innovation is changing so rapidly that anything one might say about the blockchain or fintech today would be obsolete in a year.  Rather, what matters is the ability to ask the right questions, to think critically, and to translate values and analysis into actions.  We esteem competent technicians and software engineers, but you can hire those skills.  Larger value-added comes from conceiving new markets, institutions, instruments, services, processes, social impacts, and government policies.  Through a process of reflection, exercises, and exposure to instructive examples, one grows in the ability to add value through financial innovation.  So, the course design reflects an effort to grow that ability. 

The result has been this rather unconventional path for the past 14 weeks.  It would be the height of hubris to suggest that I laid out the path with certainty about the experience you would have.  It’s a messy, dynamic, even chaotic subject—we should question pundits who claim to have it all figured out.  Given such disorder, it is wrong for a teacher to impose false order.  Therefore, the course embraced the disorder and had to be taught differently.  Like taking an inflatable raft down the New River Gorge (I highly recommend it), we wouldn’t stay dry if you depended on me to paddle alone.  We all had to pull at the oar.  We all had to contribute to making sense about this subject. 

Now, the key to success in an enterprise like this is to listen very very hard to what the subject is telling you.  Judging from the astute comments you offered in class, you’ve been doing that.  These blog posts are evidence of my own listening to the subject.  What happens when you learn this way is that the subject pulls you along.    As Wendell Berry says, you’re on a path, but you’re actually being led.    

In the way of leading, the syllabus to the course listed three objectives.  It said, “A great university education entails growth in knowledge, skills, and wisdom.  Here’s how this course aims to contribute to that outcome:

·        Growth in knowledge about: 

o   the spectrum of financial innovations over time and currently;

o   various stimulants and inhibitors of financial innovation; and

o   basic tools, concepts and vocabulary related to financial innovation. 

·        Growth in skills, such as

o   Integrating a range of perspectives, such as finance, economics, system dynamics, law, politics, and history—in doing so, the course exercises the ability of students to integrate learning across disciplines.  We will survey a large and growing literature about financial innovation: academic scholarship, professional case studies, and practice-oriented materials. 

o   Assessing the welfare impact of financial innovations (who wins, who loses?);

o   Managing innovation efforts; and

o   Constructive criticism of “pitches” and concepts for financial innovations. 

By the end of the course, you should be able to think more confidently about and discuss concepts for financial innovations. 

·        Growth in wisdom, including:

o   Social awareness: sensitivity to the context of financial innovation; how market and social sentiment can produce receptivity or rejection for innovations.

o   A critical point of view about financial innovations and the opportunities and problems they may present.  We will review criticism and defense of financial innovation in general.

o   Strategic awareness about the vision, and positioning among competing innovations of financial innovations.

o   Ethical awareness about the sustainability, social impact, and success of financial innovations.

o   A bias for action: acceptance or rejection of innovations based on the foregoing.”

The course promoted knowledge through the wealth of readings.  It promoted skills through the exercises and discussions.  And it encouraged wisdom through the reports and discussions.  Ultimately, each student is both the author and judge of progress made. 

 

Ending with the system

 

Our exercise in the last two days of the course focuses on innovations to build stability in the financial system.  It’s a fitting conclusion because systemic instability is perhaps the knottiest problem in finance and presents the gravest threat.  But as Jerry Seinfeld would say, “Experts are working on this!”  (Think of the Financial Stability Oversight Council and others.)  Therefore, it may seem presumptuous for us to deign to intrude.  Yet such would have been the charge against successful financial innovators over time.  Moreover, the invitation to participate in a hackathon on systemic stabilization offers the opportunity to exercise ideas we’ve encountered throughout the course and in other courses as well.  One could:

·        Tackle causes.  Researchers aren’t aligned on exactly what causes financial crises, but explanations that have received the most attention focus on these points.

o   Complexity makes it hard for people to know what is going on.  In times of stress, the less-informed players in a market begin to imitate the actions of more-informed players.  This causes herd-like runs on financial institutions.  Therefore, innovate on behalf of simplicity and transparency.

o   Connectivity means that trouble can travel.  Therefore, innovate on behalf of circuit-breakers, and firewalls.

o   External shocks can set in motion the domino-like cascade of a crisis as weak institutions collapse, followed by other institutions.  Think of natural disasters, geopolitical events (wars, trade wars, regime changes), and sharp turns in markets outside of the financial sector.  We looked at catastrophe bonds.  Is it possible to create other kinds of shock absorbers?

·        Tackle symptoms.  Two of the most prominent symptoms of a serious crisis are market crashes and widespread bank runs.  These reflect sharp changes in expectations and confidence.  Is it possible to apply the insights of behavioral finance to stop and/or reverse the adverse changes?  (Think about “nudges.”)

·        Tackle adverse outcomes.  Crises damage the financial system, typically leading to a seizing-up of markets and collapse of credit, the life-blood of commerce.   Financial crises spill over into the real economy and cause extensive damage.  Think of unemployment, consumer hoarding (rather than spending), cuts in capital spending, and negative GDP growth.   

A “hackathon” is a brainstorming session.  Let’s see what you can do with this challenge.

 

Coda

 

In the way of closure for the course, you may hanker for a grand summary of the blog posts and class sessions.  But that would be a waste of time.  The student leader reports on each class and the blog posts are already in your hands.  And what is more important is the meaning that you, yourself, make of the course.  Rather, consider three final reflections.

Invention, imitation, and innovation.  The course focused on the word, innovation, but repeatedly chafed at the edges of invention and imitation.  Imitation is pervasive in this field.  The vast number of fintech elevator pitches I’ve heard aren’t inventions or innovations.  They are bald imitations.  Learn to parse the original from the duplicate.  Innovation, as dictionaries define it, is the commercialization of inventions.  But in finance, the boundary between invention and innovation is permeable.  John Law, Jerry Nemorin, Robert Shiller, and Doug Lebda were simultaneously inventors and innovators.  The invention/innovation difference is artificial.  Instead, think of it as a unified activity.  This matters because the process of creating social and financial value makes more sense that way.  For instance, where should you seek out the creation of new markets, institutions, instruments, processes, social impact and regulations?  It seems that players on the periphery invent and innovate and that big, established incumbents carry forward the innovation to higher scale.  Innovation tends to originate in the periphery of finance, not the center; it seems to increase in times of social and political change rather than in quiescent periods; and it tends to be led by entrepreneurial visionaries rather than pushed by the general market.  The business and economic context creates challenges and opportunities for financial innovators.  Government policies interact significantly with financial innovation, either ex post, in the form of regulations of markets, institutions, and instruments, or ex ante, in the form of incentives or constraints to which innovators respond. 

It’s not about seeing, but about looking.  Seeing is relatively passive; looking is definitely active.  For what should you look?  As the course unfolded we explored the ways that innovations in markets, institutions, instruments, processes, social impact, and government regulations worked (or didn’t work.)  And we discovered a great connectedness among the parts. 

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It proved hard to discuss an innovation in instruments without also considering implications elsewhere.   To create a new financial instrument has implications for markets where it will trade, for the institutions who will intermediate it, for the processes to service it, for the consequences for society, and for regulation—as we have seen, all of these implications can stimulate financial innovations in those other areas.  The biggest implication is that there are no simple stories about financial innovations.  You need a wide mental aperture to take in the broad range of possible reactions.  Think systemically about feedback effects, dampers and amplifiers of the reactions.  Look actively.

Success.  How do you know the outcome of a financial innovation was good?  High financial return is the superficial answer.  We discussed a wide range of indicators such as liquidity, sustainability, customer satisfaction, fulfillment of a social need and reputation.  Innovations that help markets function well— through completeness or greater efficiency—can be profoundly beneficial to others.  Robert Shiller (and others) have argued that the problems associated with financial innovation are not because of too much, but rather too little, innovation.  This implies that the incompleteness of markets (the inability of participants to do what they need) is the dominant problem and opportunity of financial innovation.  Success might also reside in prevention of adverse outcomes or even gain prosperity in the presence of adversity—this is the aspiration of Nassim Nicholas Taleb’s concept of “antifragility.”  The point is that if you tend to get what you measure, then choosing the measures of success is of paramount importance.   At various points in the course, we confronted the possibility of adversities.  Easy access to credit markets through “teaser” mortgage rates prompted some borrowers to binge on credit.  Income-linked student loans might tempt graduates to spend years on the beach.  Structured investment vehicles make it easy for corporations to hide bad assets or too much debt (e.g. Enron).  “Dark pool” markets enabled speedy traders to exploit the slow.  Generally, complexity in the design of markets, institutions, instruments, and processes impeded the perceptions of investors, credit rating agencies, boards of directors, and regulators.  Try to work on chewy problems in a way that can advance, not degrade, the human experience.  ((We discussed worthy problems such as wage inequality, pension shortfalls, and volatility in home values.))  All of this brings us around to James Tobin’s remark that the most important decisions one makes are what problems to work on.  Financial entrepreneurs face a blizzard of opportune problems.  So, work on the worthiest ones. 

*  *  *

This is the end of this path (or maybe the part of your path where I walk alongside).  But I hope you feel sufficient momentum to keep walking—or in the sense of Wendell Berry of being led by the ideas and experiences we’ve shared.  Be well and prosper. 

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Liveblogging “Financial Innovation” Week 13: Government Policy Innovations: Proposals to Regulate Financial Innovations and Innovators

In the penultimate week of our course, we returned to the subject of regulation of financial innovation.  This was the sequel to our work in Week 5, where we discussed regulation as a driver of financial innovation—left unsaid that week was the question, “If we don’t think regulation works so well, what should we do about it?”  So, after reviewing the very wide range of financial innovations, we turn to that question.  In addition, giving some attention to regulation invites us to lift our gaze to the very highest level of financial innovation and consider how we might sustain systemic stability through regulation.

 

If it’s broke, fix it.

 

Our visiting speaker, Jo Ann Barefoot, helped to frame for us some fundamental challenges with financial regulation.  She noted that the finance sector of the economy is the most pervasively regulated sector after health care.  And our readings and discussions this semester remind us that frauds, panics, and other outcomes against the public interest occur regularly.  Enforcement gets some of the miscreants.  And pre-emptive remedies work imperfectly.  Pricking an asset bubble is very hard to do well.  Disclosure of information is boring, uninteresting, and doesn’t protect people very well.  The financial system seems structured to discourage access: some 70 million Americans are unbanked or underbanked.  The regulatory regime is fragmented and fraught with internal turf battles.  The regulatory process is slow to change: it takes two years to make a new regulation.  And new regulations tend to look backward at problems just occurred, rather than forward at threats on the horizon.  Regulators have some discretion about enforcement, can get captured by the industry they regulate, and/or can be sleepy or overoptimistic in their enforcement efforts.  Some regulators try to pick winners and losers in an industry, thus pre-empting and distorting the discipline of markets.  Finally, regulators resist change and/or attend to their own self-interest, to protect their prerogatives and obtain a budget appropriation for the next year. 

 

Some of these criticisms echo my blog post in Week 5.  There, I challenged the reader to consider why we regulate the financial sector.  Releasing firms and individuals from regulatory constraints has popular appeal, as candidates in the recent election suggested.  But there is less clarity about what that business environment would actually look like.  In the pure state of nature without any laws and regulations, life would be (as Thomas Hobbes put it) “solitary, poor, nasty, brutish, and short.”  Almost no one advocates an absolutely free market, so the question comes down to how much regulation to impose.  The answer to that question depends, as I wrote in my earlier post, on what kinds of risk and how much risk one is willing to accept in daily life.

 

The aims of financial regulation are to promote values that prevail in society: fairness, equality of opportunity, honesty, transparency, and stability (i.e. risk management).  Of these, stability warrants more consideration.  Throughout the course, we focused on discrete segments of the financial sector.  But as I argued at various points along the way, the parts of the financial system are so tightly interconnected that the impact of a financial innovation in one area is bound to be felt elsewhere.  Trouble can travel.  I’ll have more to say about stability in my post for Week 14.

 

In short, it is hard to find anyone who is truly satisfied with the current system of financial regulation.  But totally eliminating financial regulation seems unlikely to gain a majority in Congress.  We are left with tinkering with the existing system.  It’s broke, so let’s fix it.

 

How to fix it?  Some proposals.

 

Our readings for the week and our visiting speaker highlighted some of the prominent proposals.  These aren’t an exhaustive list of the bright ideas floating around.  But our discussion helped to exercise skills of critical assessment that might be shone on other proposals that come along.

1.      Privatize deposit insurance.  We could demand that banks participate in a private insurance company that would take the FDIC out of business.  Bert Ely argued that this would give banks even more “skin in the game,” reduce moral hazard, and take the taxpayers off the hook as funder of last resort.  Gary Gorton countered that while the proposal would improve the incentives for responsible lending among individual institutions, it removes a valuable crisis-fighter in the event of another financial system meltdown.

2.      Establish an FDA-like agency to review and certify new financial products for their “social utility.”  Posner and Weyl argued that financial products can be dangerous to the wealth of individuals.  Just like the FDA certifies the efficacy of new drugs, a new watchdog for financial products could certify financial innovations.  The goal would be to assure that such innovations are used for insurance, not gambling.  On the other hand, this proposal would discourage financial innovation, lengthen the time-to-market, drive entrepreneurs out of the country, and/or drive up the cost of new financial products.  The distinction between insurance and gambling is fraught.

3.      Boost the capital requirements for banks.  Anat Admati and Martin Hellwig argued that the Basel III requirement for about 9% % capital/assets is inadequate and that the effort to calibrate equity requirements to the risk of a bank’s assets creates false confidence.  They suggest that the target capital requirement should be raised to ~20-30% of assets.  This would put more equity capital at risk, deepening the ability to absorb loan losses, countering moral hazard, and perhaps turning banks into sleepy utilities rather than go-go risk-takers.  As one might imagine, the banking industry vehemently opposes this, declaring it a misuse of capital that will destroy the economic incentives, constrain the availability of capital and depress economic growth.  But more recently, I have heard some bankers argue that they would accept the higher capital requirements if the government rescinded most (or all) other regulations on the industry.

4.      More macroprudential regulation and structural redesign.  As opposed to “microprudential regulations,” which aim to protect the individual firm or person, “macroprudential regulation” seeks to reduce instability in the financial system.  Since the Panic of 2008, macroprudential regulation has been a hot topic.  Such regulations measure monetary aggregates, leverage to GDP, capitalization and liquidity of banks, as well as the correlation in performance among banks, i.e., a recognition that trouble can travel.  Kathryn Judge argues for greater regulatory intervention to redesign the financial system.  She notes that financial innovation and the consequent growth in complexity of the financial system heightens systemic risk.  With more complexity there is a greater loss of information.  And because of the rapid rate of innovation, more disclosure of information won’t suffice.  Regulators need to intervene to shorten the intermediation links between the issuer of claims and the investor.  As business process engineers tell us, simplification is generally a good thing.  But at what cost?  As with the FDA-like proposal (#3 above) experience suggests that greater regulatory intervention might clog the system rather than declutter it.  And why is the judgment of a regulator better than the market itself?  The regulator may be able to instill some order in the common interest, but the market participants are closer to the technical challenges and doubtlessly have a great deal of “skin in the game.”

5.      Get tech savvy.  Cornelia Levy-Bencheton shifts our gaze from the challenges posed by the recent financial crisis and toward the current wave of financial innovation, “fintech.”  She acknowledges the enormous compliance burden on banks imposed by Dodd-Frank—by her analysis, it takes 24 million person-hours of work per year for the U.S. banking system to comply with that regulation alone.  And she also points to the disruptive force of fintech.  “We are in hell,” she wrote, because of the “four V’s” of big data: volume, variety, velocity, and veracity.  Her solution: banks must develop a data-driven culture; they must “leverage emerging digital business models, modernizing traditional channels and modeling what is happening in other industries…And new data that needs to be integrated into existing information sets to make banking organizations more agile and effective if they are to stand a prayer of staying relevant.”  Our visiting speaker, Jo Ann Barefoot, outlined some big issues facing regulators as they strive to stay relevant as well.  She cited data management, privacy, fairness, discrimination, failures of disclosure, systemic health, speed of innovation, and the complex regulatory framework.  Reg tech” is bringing technology to address regulatory challenges of disclosure, compliance, risk identification, and risk management.  15-20 countries have “regulatory sandboxes” in which financial innovators can try out their ideas on live customers with less regulatory intervention during the research process.

 

So what?

 

The subtext of our work this week is a radical idea, that we can expand the definition of “financial innovation” beyond the private sector to include financial policy innovations in the public sector.  If we define the perimeter of the financial system to include the regulatory actors, we gain more clarity about opportunities and problems associated with financial innovation.  And defining the perimeter more broadly invites us to consider how transferrable is the business perspective into public policy, and vice versa.  We want rules and watchdogs motivated by the public interest, rather than the welfare of some subset of society.  But as our review of the pros and cons of particular proposals suggests, critical scrutiny and wisdom know no country. 

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Liveblogging the Great Depression: Crash and Onset of Depression

This post continues a commentary on readings about the Great Depression.  For the third meeting of our seminar, Richard A. Mayo and I assigned three readings: The Great Crash by John Kenneth Galbraith, The Memoirs of Herbert Hoover: 1929-1941; The Great Depression, and a segment of Freedom from Fear by David Kennedy.  The aims of this session were to study the onset of the depression itself (1929-1933) and to consider critically the early dynamics of the Depression and its causes.  Three questions were the special focus of our discussion:

·        Did the Crash of 1929 cause the Great Depression?  If not, what did cause it and when did the Great Depression begin?

·        What other events marked the descent into the Great Depression?

·        How did President Hoover respond?

 

The Crash of 1929 and Beginnings of the Great Depression

 

Our last two sessions looked at the end of World War I, war reparations, technological innovation, and the wave of deflation that swept the U.S. and other countries in the 1920s.  In the popular mind, the Great Depression began with the stock market Crash of 1929—indeed, many people seem to think that the Crash caused the Great Depression.  As I’ve outlined in earlier posts, exactly when the Depression began depends on what you mean by “begin.” 

 

The National Bureau of Economic Research (a not-for-profit organization of economists) is the accepted authority on defining the starts and stops of economic cycles.  They determine that the downturn that is regarded as the Great Depression occurred in two waves: August 1929 to March, 1933 and May, 1937 to June, 1938.  We will look at the second of these downturns in the spring semester. 

 

As regards the first downturn in the Great Depression, a cyclical downturn was probably dictated by the Fed’s increase in interest rates in January, 1928.  At the time, the Fed was worried about excess liquidity stimulating a stock market bubble.  By January, 1929, economic conditions were starting to deteriorate.  In June, 1929, business production peaked.  The NBER tells us that a decline began in August, before the stock market crash of October, 1929.   

 

A recession is shorter and shallower than a depression.  Our readings for this session suggest that the conversion of a recession into a depression was the result of many factors.  Still, did the crash trigger the depression, or was it a consequence?  The economic record suggests that it was a contributor, a turning point, but not the sole cause.   David Kennedy wrote, “The disagreeable truth, however, is that the most responsible students of the events of 1929 have been unable to establish a cause-and-effect linkage between the Crash and Depression.” (Page 39.)  Kennedy reports that 97.5% of the U.S. population owned no stock in 1929.  Thus, the impact of the crash must have been small in terms of the direct “wealth effect.”  But it seems to have had a great influence in the psychology of consumers, investors, and leaders in business and government.  The evaporation of equity value would prompt investors to cut spending and hoard their remaining wealth.  The extent of the wealth effect remains a matter of debate, though Galbraith wrote that it had a “traumatic influence on production, income and employment.” (Page ix.)

 

By the way, the “Crash” was only part of a larger destruction of equity market value.  The following figure shows that the initial slump from September 5, 1929 (when Roger Babson warned that “a crash is coming”) to November saw the Dow Jones Industrial Index fall from 381 to 210—a decline of 45%.  But from November, 1929 the sell-off continued until July, 1932, sending the Dow from 210 to 42, a decline of 80%.  Overall, the decline from 381 to 42, was a decline of 89%. 

 

Figure 1.  Dow-Jones Industrial Average, 1929-1932

 

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Source: Macrotrends at http://www.macrotrends.net/2484/dow-jones-crash-1929-bear-market

 

The Decline

 

Similar to the stock market decline, the decline in economic activity worsened steadily over four years.    Galbraith called the economic decline that began in the summer of 1929 “the beginning of the familiar inventory recession.”  The NBER estimates that downturns last about 18 months on average.  What prolonged this?  What drove it so deep?  The severity of the depression is displayed in the next two figures.  Figure 2 shows that the Great Depression collapsed Gross Domestic Product far below the normal capacity of the economy.  Figure 3 shows that unemployment peaked at about 24%. 

 

 

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Source: Business Insider at

http://www.businessinsider.com/how-real-per-capita-gdp-fell-during-crises-2014-1

 

 

Figure 3: Unemployment Rate, 1929-1939

 

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Source: Author’s preparation from data at http://www.shmoop.com/great-depression/statistics.html.

 

As we deepen our understanding of the Great Depression, it seems that its severity draws from many factors that seemed to reinforce each other.  Our readings for this session offered three authors’ perspectives. 

 

Galbraith attributed the crash and severity of the Depression to five causes.  First was the bad distribution of income: a lot of wealth was put in the hands of a few, who used the wealth to speculate.  Corporate profits rebounded significantly in the 1920s, but wages increased relatively modestly.  Second was bad corporate structure: the rise of investment trusts (“a profound source of weakness”) encouraged rent-seeking on the part of promoters.  Galbraith wryly refers to the “bezzel,” the value appropriated by promoters from credulous investors.  Third was a bad banking structure: too many small, undercapitalized banks.  Fourth was the dubious state of foreign debt balances.  The overhang of war debts and reparation payments was a massive drag on European economies and led to the collapse of the gold standard.  Fifth was the poor state of economic intelligence—not only did decision-makers not have much clarity about the economic trends going into the Depression, but also their economic orthodoxy led to actions by the Fed and Treasury that were counterproductive to recovery.  For Galbraith, the story of descent into Depression is an economic story, framed largely around rent-seeking and the flaws in the capitalist system. 

 

Herbert Hoover marshals considerable evidence to tell what is, essentially, a political story.  He recounts the Depression as consisting of several phases.  At each phase, public policy decisions are made that create a “degenerating vicious cycle.” (Page 87.)  The Depression did not start in the U.S.  The “storm center” was in Europe and originated in the Versailles Treaty of 1919.  Post-war optimism in America created “new era thinking.”  And a stimulative Fed policy created a stock market bubble.  All of this happened “before I entered office.”  After the Crash occurred, “The record will show that we went into action within ten days and were steadily organizing each week and month thereafter to meet changing tides.” (Page 31.)   In 1930, Hoover organized a voluntary commitment by business leaders to maintain wages and employment.  This proved to be unsustainable in the face of continued decline.  From April to July 1931, Hoover focused on “indirect relief” to provide jobs, support wages and prices, limit immigration.  He also sought appropriations for public works.  In 1931, it became evident that European nations would not be able to meet scheduled payments of debts and reparations.  Hoover declared a moratorium on payments.  Still European government engaged in what Hoover called “kiting” of payments among themselves.  Then Britain collapsed and took itself off the gold standard, which damaged business confidence further.  In 1932 Hoover sought Congressional support for an 18-point legislative program of reconstruction finance, land banks, home loan banks all of which encountered political resistance, “a rottenness worse than I had anticipated.” (Page 128.)  Hoover couldn’t understand the failure of Congress to support his program.  He described one Senator as “a curiously perverse person with alternating streaks of generosity and hatred…a profound reactionary.” (page 113.)  In the months between FDR’s election in November, 1932 ,and FDR’s inauguration in March, 1933, the President-elect declined to cooperate with Hoover on a recovery program.  And so on.  Hoover’s memoir reads like a classic tragedy: good man brought low by forces beyond his ken.

 

David Kennedy’s history of the Great Depression expresses some sympathy for the “ordeal of Herbert Hoover.”  But Kennedy seems interested in giving a history that is more than economics or politics—he features plenty of both but adds a somewhat more social/psychological perspective.  Kennedy tells us about Hoover’s Quaker upbringing and of his belief in the efficacy of volunteerism instead of state intervention. Hoover was an internationalist, but caved in to the populist/nationalist sentiments of Congress when he signed the infamous Smoot-Hawley Tariff.  The nadir of Hoover’s efforts was not measured in economic or political terms but in the expulsion of a social protest movement, the “Bonus Army,” from Washington D.C. in July, 1932—it was, said Kennedy, “the lowest ebb of Hoover’s political fortunes.” (Page 92.)  Kennedy suggests that leadership mattered in the deepening Depression.  Kennedy’s profiles of the major participants lend the view that the awful downward spiral was not dictated solely by large social forces.  Rather, the predilections of key players also mattered immensely.  For instance, of Hoover, he writes,

“Herbert Hoover forged his policies in the tidy, efficient smithy of his own highly disciplined mind.  Once he had cast them in final form, he could be obstinate.  Especially in his last months in the White House, he had grown downright churlish with those who dared to question him.  Roosevelt’s mind, by contrast, was a spacious cluttered warehouse, a teeming curiosity shop continuously restocked with randomly acquired intellectual oddments.  He was open to all number and manner of impressions, facts, theories, nostrums, and personalities.” (Page 113.)

 In responding to the Depression, Hoover clung to what was familiar (like the volunteer effort in fighting famine in Europe) rather than inventing a new response appropriate to the circumstances of 1929-1933.  In short, Kennedy’s history affords the third narrative, about attributes of leadership.

 

Largely missing from these narratives of 1929-1933 is the dramatic collapse of the U.S. banking system during those years.  Overpopulated with competitors (numbering 26,213 national, state, Building and Loan organizations, savings banks, private banks, and other at June, 1928), [1] unprepared, undercapitalized, and under-regulated, the industry suffered a dramatic contraction.  (In 2016, the U.S. has 5,141 banks.) [2]  Throughout the 1920s, the failure rate of banks was high, averaging 600 per year and concentrated especially among small unit banks in agricultural areas.  As Figure 4 shows, the annual failure rate spiked during the downturn. 

 

Figure 4: Bank Suspensions During the Great Depression

 

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Source: Author’s analysis drawing on data from Wicker Banking Panics of the Great Depression (1996).

 

Thus, during the first stage of the Great Depression, the banking industry contracted by about 20% in the number of players.  Lending declined as bankers sought the high ground of exposure to only the most creditworthy debtors.  Individuals hoarded their savings.  In the absence of deposit insurance, a bank failure would mean the loss of some of the depositor’s savings.  The extent of actual losses due to suspensions was probably sizable, but dwarfed in impact by the loss in confidence in the business economy and the increase in fear.

 

Synthesis: A Pernicious Self-Reinforcing Cycle

 

The three books for this session help to convey the plurality of narratives for the awful descent into the Great Depression.  The stock market Crash of 1929 occurred shortly after the onset of recession and cannot be said to have caused the Great Depression.  But it probably helped to accelerate and deepen the recession through the “wealth effect” and loss of confidence.  Maladroit responses by government leaders also deepened the Depression.  The Smoot-Hawley Tariff probably had a smallish impact on the U.S. economy but imposed a major chill on diplomatic relations that obstructed coordinated response to the Depression.  Economic historians point to lurches in monetary and fiscal policy that created a drag on recovery—orthodox economic thinking of the day embraced balanced budgets and the “real bills doctrine” in Fed lending into the financial system.  The international economic malaise weakened what should have been a robust economy.  Technological change in agriculture and manufacturing imposed a deflationary bias on the economy.  And finally, attributes of leaders (including obstinacy, pessimism, slow reaction, and weak communication skills) hampered the mobilization of collective action. 

 

Elements of this saga seemed to reinforce each other, creating a feedback loop that accelerated and deepened the downturn.  Tight Fed policy, recession, stock market crash, political in-fighting, a distressed banking system, and reactive leadership made a toxic stew.  In coming sessions, we will consider what it takes to break a pernicious self-reinforcing cycle.   

  1. 1928 Report of the Comptroller of the Currency, https://fraser.stlouisfed.org/files/docs/publications/comp/1920s/compcurr_1928.pdf []
  2. Source: https://fred.stlouisfed.org/series/USNUM []
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Liveblogging “Financial Innovation” Weeks 11 and 12: Criticisms and Defenses of Financial Innovation

Approaching the end of our course on financial innovation, it is appropriate to review the pluses and minuses of such activity.  We deferred this until after our survey of the different kinds of innovations so that our reflection on criticisms and defenses would be more acute.  I have combined our reading and discussions across two weeks into one post in order to synthesize some larger insights.  How one views financial innovation depends on how one views the pluses and minuses to society—and in particular, the effect of financial innovation on stability of the financial system. 

 

Today, a conversation about the criticisms and defenses of financial innovation is framed by recent experience.  The Panic of 2008 has become the dominant reference point for critics and defenders.  Therefore, before getting into the pros and cons of financial innovation, it is useful to sketch some highlights about the late unpleasantness.

 

The Financial Crisis as the Stage for Debate

 

By year 2000, economists seemed to declare victory over the recurrence of depressions and panics.  Olivier Blanchard and John Simon (2001) reported that since the mid-1980s, variability of GDP growth had declined by half and variability of inflation had declined by almost two-thirds.  Nobel Laureate Robert Lucas, in his Presidential Address to the American Economic Association in 2003 said,

“macroeconomics in this original sense has succeeded: the central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades…the potential for welfare gains from better long-run supply-side policies exceeds by far the potential from further improvements in short-run demand management.”  ((Lucas (2003) page 1.))

And a study by Nobel Laureate Joseph Stiglitz, Jonathan Orszag and Peter Orszag (2002) found a smaller than 1:500,000 chance that Fannie Mae would fail.  And in a speech to the Eastern Economic association in 2004, Federal Reserve Board Governor Ben S. Bernanke attributed “the Great Moderation” to the structural supply-side changes to which Lucas earlier referred, to improved monetary policies, and to good luck. 

 

Then the panic hit, and economists resurrected notions that the capitalist economy was prone to financial instability.  Financial innovation was an obvious target.  New markets, new technologies, new institutions, and new instruments—many with unpronounceable names and inscrutable justifications—surfaced at the center of institutional insolvencies and bailouts.  Investigative journalists reported practices by mortgage loan administrators, bond rating agencies, lenders, traders, and investors that illustrated the propensities toward neglect, deception, corruption, and predation that Minsky and others hypothesized.  Nolan McCarty, Keith T. Poole, and Howard Rosenthal (2013) wrote,

“In addition to deregulation, financial innovation was central to the crisis.  The problems in the home mortgage market would not have produced a crisis bubble without important changes in how these loans were securitized.  The innovations involved the development of three new products: privately issued mortgage-based securities, the tranching of the securities, and the swaps market that insured the securities.  But perhaps the most important innovation involved the extent to which these investments were leveraged.”  ((McCarty et alia, (2013) page 140.))

The report of the U.S. Financial Crisis Inquiry Commission (2011) highlighted “gaps in oversight of critical areas with trillions of dollars at risk, such as the shadow banking system and over-the-counter derivatives markets.”  ((Financial Crisis Inquiry Report (2011) page xviii.))  The Commission was not able to agree on causes and remedies.  Six of the ten Commission members were appointees of the Democratic Party, and concluded:

“But underneath, something was going wrong.  Like a science fiction movie in which ordinary household objects turn hostile, familiar market mechanisms were being transformed.  The time-tested 30-year fixed-rate mortgage, with a 20% down payment, went out of style.  There was a burgeoning global demand for residential mortgage-backed securities that offered seemingly solid and secure returns.  Investors around the world clamored to purchase securities built on American real estate, seemingly one of the safest bests in the world.  Wall Street labored mightily to meet that demand.  Bond salesmen earned multimillion-dollar bonuses packaging and selling new kinds of loans, offered by new kinds of lenders, into new kinds of investment products that were deemed safe but possessed complex and hidden risks…”All this financial creativity was a lot like cheap sangria,” said Michael Mayo, a managing director and financial services analyst at Calyon Securities (USA) Inc.  “A lot of cheap ingredients repackaged to sell at a premium,” he told the Commission.  “It might taste good for a while, but then you get headaches later and you have no idea what’s really inside.”  The securitization machine began to guzzle these once-rare mortgage products with their strange-sounding names: Alt-A, subprime, I-O (interest-only), low-doc, no-doc, or ninja (no income, no job, no assets) loans; 2-28s and 3-27s; liar loans; piggyback second mortgages; payment-option or pick-a-pay adjustable rate mortgages.  New variants on adjustable-rate mortgages, called “exploding” ARMSs, featured low monthly costs at first, but payments could suddenly double or triple, if borrowers were unable to refinance.  Loans with negative amortization would eat away the borrower’s equity.  Soon there were a multitude of different kinds of mortgages available on the market, confounding consumers who didn’t examine the fine print, baffling conscientious borrowers who tried to puzzle out their implications, and opening the door for those who wanted in on the action…The instruments grew more and more complex: CDOs were constructed out of CDOs, creating CDOs squared.  When firms ran out of real product, they started generating cheaper-to-produce synthetic CDOs—composed not of real mortgage securities but just of bets on other mortgage products.    Each new permutation created an opportunity to extract more fees and trading profits.  And each new layer brought in more investors wagering on the mortgage market—even well after the market had started to turn.  So by the time the process was complete, a mortgage on a home in South Florida might become part of dozens of securities owned by hundreds of investors—or parts of bets being made by hundreds more.”  ((Financial Crisis Inquiry Report (2011) pages 6-8.))

 

Four of the ten members of the Commission were Republicans and wrote dissents to the majority report.  One dissenter argued that the crisis was attributable to the creation of government-sponsored entities combined with aggressive lending mandates from the Department of Housing and Urban Development.  Three of the dissenters acknowledged that financial innovations played a role in the onset of the crisis, but that the impact of these innovations was dwarfed by a confluence of ten causes.  ((The ten causes were credit bubble, housing bubble, nontraditional mortgages, credit ratings and securitization, financial institutions that concentrated correlated risks, leverage and liquidity risk, risk of contagion, common shock, financial shock and panic, and an ensuing economic crisis.)) The dissenters wrote,

“Some focus their criticism on the form of these financial instruments [mortgage-backed securities].  For example, financial instruments called collateralized debt obligations (CDOs) were engineered from different bundled payment streams from mortgage-backed securities.  Some argue that the conversion of a bundle of simple mortgages to a mortgage-backed securities, and then to a collateralized debt obligation, was a problem.  They argue that complex financial derivatives caused the crisis.  We conclude that the details of this engineering are incidental to understanding the essential causes of the crisis.  If the system works properly, reconfiguring streams of mortgage payments has little effect.  The total amount of risk in a mortgage is unchanged if the pieces are put together in a different way….Rather than “derivatives and CDOs caused the financial crisis,” it is more accurate to say

·                  Securitizers lowered credit quality standards;

·                  Mortgage originators took advantage of this to create junk mortgages;

·                  Credit rating agencies assigned overly optimistic ratings;

·                  Securities investors and others failed to perform sufficient due diligence;

·                  International and domestic regulators encouraged arbitrage toward lower capital standards;

·                  Some investors used these securities to concentrate rather than diversify risk; and

·                  Others used synthetic CDOs to amplify their housing bets.”  ((Financial Crisis Inquiry Report (2011), pages 425-427.))

 

VIEW CON: Financial innovation is pernicious. 

 

The indictment of financial innovation rests on at least four avenues of criticism: economic productivity, financial stability, culture, and ideology.  Consider each of these in turn.

 

Financial innovation degrades the stability of the financial system.  Hyman Minsky (1986) argued that financial innovation contributes to instability of the financial system and thus, to the occurrence of financial crises.  The invention of new money was driven by

“…profit-seeking activities by businesses, financial institutions, and households as they manage their affairs.  In this process innovation occurs, so that new financial instruments and institutions emerge and old instruments and institutions are used in new ways.  These changes, along with legislated and administrative changes that reflected the aura of success of this period, transformed the financial and economic system from one in which a financial crisis was unlikely into one that was vulnerable to crises.”  ((Minsky (1986) pages 78-79.))

Ongoing innovations in markets, institutions, and instruments ensure ongoing systemic vulnerability.  The solution to cycles triggered by the instability of the financial system, said Minsky, was both increased regulation of the financial sector and very liberal management of the demand side of the economy i.e., through public works programs, full-employment schemes, and so on.  Bruner, Carr and Mehedi (2016) examined five major U.S. financial crises to explore the relation between financial innovation and crises.  The natural functioning of markets, in which prices adequately reflect the current situation and outlook for the future, was impaired.  While financial innovations don’t necessarily cause financial crises, they may well increase the propensity for crisis.  Financial innovation seems to promote systemic fragility by:

·        Making it easier for participants to access the capital markets and to increase leverage.  Securitization enhanced the ability of subprime borrowers to obtain mortgages in the early 2000s.  Bank notes made it easier for frontier borrowers to obtain loans in the early 1830s.  The introduction of interest-bearing checking accounts attracted consumers to trust companies.  HELOCs (home equity lines of credit) made it possible for consumers to obtain loans in the 2000s.  Financial innovations made it easier for participants to act on euphoric expectations.  Every crises is preceded by a bubble, founded on unsustainable expectations.

·        Increasing complexity, which creates information asymmetry.  Information problems create risks of adverse selection (i.e., exploitation of the less-well informed by the better informed), amplify the sensitivity to signals about the state of the market, and promote herd-like behavior (where the less-well informed seek to emulate actions by the better-informed.)  The account of Bookstaber (2007) suggests that the traders of a major financial institution really did not understand the risks of mortgage-backed securities that the traders were buying in advance of the Panic of 2008.

·        Deepening connectedness among participants in the financial markets.  In 1837, banks held bank notes issued by other banks.  In 2008, large banks linked more broadly to other banks, shadow banks, and corporations through the repo, ABCP, and CDO markets

·        Shifting risk in new ways.  The extension of credit spread beyond the chartered banking system into the shadow banking system in 1837, 1907, and 2008.  In the 2000s, Structured Investment Vehicles shifted risk from the balance sheets of banks to these affiliates.    

 

Financial crises occur a matter of years (in some cases, decades) after the introduction of the financial innovations that were indicted in the crises.  Clearly, the introduction of the innovation did not spark the crisis.  The long elapsed time allows for any number of factors to create a crisis.  Yet, something about the way in which financial innovations disseminated and were used contributed to the crises.   For instance, securitization of mortgages began in the 1920s.  But it was not until the aggressive engineering of securitized mortgages (with tranching and high leverage) that such securitizations became toxic.

 

Perhaps financial innovations contribute to the slow-fast occurrence of a crisis: innovations spread gradually, like an epidemic or social fad and then morph as financial entrepreneurs apply increasingly aggressive tactics to increase the returns and other measures of attractiveness.  Gradually, these financial products become more complex, customized, and opaque, as Richard Bookstaber has written  ((Richard Bookstaber, “Does Financial Innovation Promote Economic Growth?” Blog, November 4, 2009, at http://www.economonitor.com/blog/author/rbookstaber3/.))  —and they become more destabilizing to the financial system.  Andrew Palmer described this process:

“In simple terms, finance lacks an “off” button.  First, the industry has a habit of experimenting ceaselessly as it seeks to build on existing techniques and products to create new ones (what Robert Merton, an economist, termed the “innovation spiral”).  Innovations in finance—unlike, say, a drug that has gone through a rigorous approval process before coming to market—are continually mutating.  Second, there is a strong desire to standardize products so that markets can deepen, which often accelerates the rate of adoption beyond the capacity of the back office and the regulators to keep up.”  ((Andrew Palmer, “Playing with Fire,” the Economist, February 25, 2012, page 5 at heep://www.economist.com/node/21547999.))

 

Financial innovation does not strengthen economic productivity, growth, or welfare.  Echoing Minsky, Luigi Zingales has written that “There is no theoretical basis for the presumption that financial innovation, by expanding financial opportunities, increases welfare.”  ((Zingales (2015) page 9.))  He notes that research by Oliver Hart (1975) and Ronel Elul (1995) challenged the idea that completing markets is always beneficial: Hart found that in the case of incomplete markets (which is likely the reality today) adding another market can worsen welfare.  And Elul affirmed Hart’s finding and suggested that the welfare loss is even more pervasive than previously believed.  Elsewhere, Zingales explored the darker attributes of financial innovations.  He wrote, “I fear that in the financial sector fraud has become a feature and not a bug.”  ((Zingales (2015, page 19.))  In 2009, former Fed Chairman, Paul Volcker, said, “The most important financial innovation that I have seen the past 20 years is the automatic teller machine…I have found very little evidence that vast amounts of innovation in financial markets in recent years has had a visible effect on the productivity of the economy.”  ((Paul Volcker, quoted in New York Post, December 13, 2009, accessed at http://nypost.com/2009/12/13/the-only-thing-useful-banks-have-invented-in-20-years-is-the-atm/.))  Paul Krugman added, “it’s hard to think of any major recent financial innovations that actually aided society, as opposed to being new, improved ways to blow bubbles, evade regulations and implement de facto Ponzi schemes.” [1]

 

Financial innovation distorts culture.  The article by Per Hansen argued that the Panic of 2008 was a tipping point for reaction against financialization and that financial innovation was the bandwagon by which financial ideas and norms came to dominate society.  “Financialization” refers to the perceived reduction of social values into financial transactions and values—for instance, care for the poor and elderly is reduced to social relief payments; increased social inclusion is reduced to democratization of credit and increased financial access; risk-sharing is reduced to insurance.  Financialization results in the increasing intrusion of financial markets, institutions, and products into the real economy and into daily life.  Critics point to the growth of the financial sector (in terms of percent of GDP and employment): in 1870, the total economic cost of financial intermediation was less than 2% of GDP to 5% in 1980 to almost 9% in 2010.  ((Source:  Thomas Philippon, Rethinking the Financial Crisis.  See summary at   https://tcf.org/content/commentary/graph-how-the-financial-sector-consumed-americas-economic-growth/ .))   And financial industry profits as a share of business profits have grown over the last three decades (the following figure is from James Kwak.)  ((See https://baselinescenario.com/2012/02/29/why-is-finance-so-big/)) 

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The critics of financialization assert that it distorts democratic politics (through campaign finance and regulatory capture), misallocates human talent away from productive uses in the real economy, promotes economic inequality, and increases the use of leverage and risk-taking.  Securitization, derivatives, shadow banking, private equity and other manifestations of financial innovation are lightning-rods for critics.

 

Reading into the critics of financialization one finds strong ideological currents, such as populism, communitarianism, egalitarianism, and a profound distrust of finance.  Common to many of these is an appeal to fairness and equity.  Such sentiments represent common ground for social protest movements such as Occupy Wall Street and the Tea Party.  Per Hansen points to an asymmetry of outcomes from financialization: “profits are privatized while the costs of the financial crisis have been socialized.”  Because of the asymmetry, government intervention in markets is warranted.  And predation figures importantly in movies such as “Wolf of Wall Street” and in the infamous article by Matt Taibbi which characterized Goldman Sachs as a  “vampire squid wrapped around the face of humanity.”   And the movie, “The Big Short,” conveys incompetence, inattention, a lack of fiduciary duty, and perhaps self-dealing among investment managers leading up to the Panic of 2008.  All of this fed the anger with financialization and financial innovation.

 

VIEW PRO: Financial innovation is largely benign. 

 

Financial innovation is a systemic stabilizer.  Neoclassical economists hold that economies are self-correcting and will tend toward equilibrium and that instability is due not to the internal structure of the economy or to innovation, but to shocks from outside (e.g., wars, natural disasters, poor harvests, etc.)  Market participants are assumed to be rational; and markets are assumed to be efficient.  There is a role for government in stabilizing economic cycles, but not for deep and longstanding intervention. 

 

From this perspective financial innovation seems largely benign: new markets, new institutions, and new instruments arise to complete the markets, match investment returns to consumption needs over time, provide diversification for portfolios, shift risk, reduce transaction costs, increase liquidity, reduce agency costs among different parties, or adapt to changes in technology and other environmental conditions.  Among these environmental conditions could be taxes and regulation: Merton Miller suggested that financial entrepreneurs innovate in an effort to arbitrage (or avoid) such constraints.  To advance innovation, government should eliminate policies that discourage investment and innovation, tax schemes that produced legal but arduous tax-avoidance behavior, rigidities in the labor market, and generally a suppression of risk-taking.  Along these lines, Peter Wallison, a member of the Financial Crisis Inquiry Commission contended that structural impediments to healthy market function, many of them imposed by government, had caused the Panic of 2008.

 

In the midst of strong civic reaction to the Panic of 2008, Robert Shiller, Nicholas Barberis, and Michael Haliassos (2013) contended that the problem was not too much financial innovation, but too little.  Investors did not have the markets, institutions, and instruments by which they could hedge the risk of a collapse of housing prices.  The constraints imposed by political and regulatory scrutiny might be averse to the prevention and/or recovery from financial crises.  For instance, Robert Shiller wrote,

“I want to emphasize that the best process in fixing the economy after this crisis, or after any crisis, consists of moving ahead by all forms of new invention, including financial invention.  Financial crises are often tied up with the uncertainties associated with the recent application of some financial innovation.  The process of innovation creates the potential for accidents.  But the response to accidents shouldn’t be to reverse the innovation.  The response should be moving the economy ahead to be even better, not to patch holes in an existing theory.” [2]

This echoed the view of Franklin Allen and Glenn Yago that, “True innovation in capital markets and finance has made access to credit and the ability to build equity more flexible and less costly. …We believe that financial innovations are the cure for instability, not the cause.”  ((Allen and Yago (2010) page 21.))

 

Financial innovation promotes growth, productivity, and welfare.  Many economists hold that a well-functioning financial system is essential for a nation’s economic development and that an aspect of “well-functioning” is financial innovation.  Joseph Stiglitz wrote, “over the long sweep of history, financial innovation has been important in promoting growth.”  ((Stiglitz (2010).))  There seems to be a tradeoff between the costs of financial innovation (systemic fragility, market volatility) and its benefits (faster growth).  Thorsten Beck et alia (2012) studied the investment in financial innovation across 32 countries and 21 years and confirmed the tradeoff: more investment in financial innovation was associated with faster GDP growth per capita; but countries with more innovation experienced more volatility and systemic fragility.  The authors wrote, “Our findings show that financial innovation provides significant benefits for the real economy but also contains risks that have to be managed carefully.”  ((Beck et alia (2012) page 3.))

 

Financial innovation strengthens society and culture.  The ideology of many financial innovators is founded on values of freedom, accountability for one’s own actions, and the virtue of increased connectivity with markets and with other individuals.  Innovation brings lower costs, higher quality, greater convenience, more transparency—all of which improve life.  Sensible risk-taking is desirable as a stimulus for innovation.  Promoting investment in housing and financial securities by all social classes helps to create an “ownership society” that gives a stake for everyone in the performance of the private sector.  And an ownership society justifies a focus on shareholder value as a measure of the performance of an enterprise.  Improved efficiency is desirable and private markets achieve higher efficiency better than the public sector. For that reason, deregulation, privatization, and tax cuts are warranted.  Failure happens, but is not terminal.  Markets manufacture important information that helps people make better decisions.  Integration among markets (for instance, through lower tariffs) and greater engagement of individuals in those markets promotes a higher quality of life.  No economic measure adequately captures the benefits of increased quality and convenience, entertainment, and connectivity.  The defenses of financial innovation are roughly associated with the ideology of neoliberalism and laissez-faire.

 

Conclusions

 

Our purpose in the course over these two weeks was not to drive an outcome in favor of either the critics or the defenses, but rather to build a familiarity with the key lines of argument.  As a practical matter, it seems unlikely that public policy will be gravitate entirely into one camp or the other.  Anyway, we will spend the class meetings in Week 13 discussing the regulatory implications of financial innovation.  Therefore, the story is not yet complete.  But the association of financial innovations with financial instability raises some final considerations.

 

Through history, financial crises show some association with financial innovations.  We have seen this before.  This historical association is perhaps the main novelty of this essay and sustains other insights about crises, innovations and civic reaction.    But association cannot confirm causation: in the major financial crises in history, financial innovation figured prominently; but not every financial innovation in history is associated with a financial crisis.  It might be more appropriate to say that financial innovation is an instrument of larger causes of financial crises. 

 

What seems to threaten financial stability is the convergence of financial innovations with episodes of high growth.  In the most buoyant times, innovations will be used more aggressively.  And in those times, the infrastructure on which financial stability depends—the technological, managerial, and regulatory spine of financial institutions and the financial sector—fails to keep up with the more aggressive application of the innovations.

 

Financial innovations associate with financial crises in at least four important ways:

·        Make it easier for market participants to act on their euphoric expectations.  Every crisis is preceded by a boom or bubble, founded on unsustainable expectations (e.g., “housing prices can only rise.”)

·        Make it easier to get money.  Many financial innovations create new money or enhance access to money.  This can lead to increased leverage and bubble-like pricing of assets.

·        Make it hard to know what is going on.  Innovations bring complexity.  Complexity increases opacity.  The result is that some market players know more about the real state of the markets than do others.  This information asymmetry fuels panic psychology.

·        Deepen connectedness among participants in the financial system.  As a result, instability in one part of the financial system can travel to other parts, despite shock-absorbers and regulatory fire-walls.

 

If financial innovation contributes to financial crises, how can we anticipate the origination of destabilizing innovations?  The answer must entail actually looking for them, and in less-obvious places.  Innovation occurs at the frontiers, not at the centers of the business economy.  Frontiers matter for the understanding of the processes and substance of innovation. 

·        Demand: The frontiers are where one finds the unmet needs.  Organizations at the center of the business economy focus intensively on efficiency, which tends to produce standardization of products and services.  And the center tends to deepen its investment in incumbent technology, which produces a disbelief in the need for new products and services.  The segments of world population that are “unbanked” and therefore cannot gain access to financial services is huge in absolute terms.  New systems of micro finance and electronic payments are being developed to serve this need.

·        Supply: And the frontiers are where one tends to find the outsiders–the entrants–who bring a fresh point of view.  The centers of the business economy are dominated by incumbents, whose conventional thinking summon products and services that serve a predictable demand.  Mind you, incumbents also invest in innovation, but the transformational innovations seem to emerge from entrants at the frontiers, not the center, of business economics.

 

 

Works Referenced

Allen, F. & Gale, D. (2000). Financial contagion. Journal of Political Economy, 108(1), 1–33.

 

Allen, F. & Gale, D. (1991) Financial Innovation and Risk Sharing, Cambridge: MIT Press.

 

Allen, F, and Yago, G. (2010) Financing the Future: Market-Based Innovations for Growth, Upper Saddle River, NJ: Wharton School Publishing.

 

Beck, T., Chen, T., Lin, C., Song, F. (2012) “Financial Innovation: the Bright and Dark Sides,” VOX CEPR’s Policy portal, at http:/ voxeu.org/article/financial-innovation-good-and-bad.

 

Blanchard, Olivier, and John Simon (2001) “The Long and Large Decline in U.S. Output Volatility,” Brookings Papers on Economic Activity, Vol. 1, pages 165-173.

Bookstaber, R. (2007). A demon of our own design: Markets, hedge funds, and the perils of financial innovation. Wiley.

 

Bookstaber, R. (2009). “Does Financial Innovation Promote Economic Growth?” Blog, November 4, 2009, at http://www.economonitor.com/blog/author/rbookstaber3/

 

Bruner, Robert F., Sean D. Carr, and Asif Mehedi, (2016), “Financial Innovation and the Consequencies of Complexity: Insights from Major U.S. Banking Crises,” in Complexity and Crisis in the Financial System: Critical Perspectives on American and British Banking, edited by Matthew Hollow, Folarin Akinbami, and Ranald Michie, London: Edward Elgar Publishing.

Elul, R., (1995), “Welfare Effects of Financial Innovation in Incomplete Markets with Several Consumption Goods,” Journal of Economic Theory,  65, 43-78.

The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, (2011) New York: Perseus Books.

 

Haliassos, M. (ed.) (2013). Financial Innovation: Too Much or Too Little? Cambridge: MIT Press.

 

Hanson, Per, (2014), “From finance capitalism to financialization: A cultural and narrative perspective on 150 years of financial history,” Business History Conference, pages 605-642.

 

Hart, O. (1975), “On the Optimality of Equilibrium When the Market Structure is Incomplete,” Journal of Economic Theory,  11, 418-443.

 

Krugman, P., (2009), “Money for Nothing,” New York Times, April 26, 2009, http://mobile.nytimes.com/2009/04/27/opinion/27kurgman.html?

 

Lucas, R. E. (2003) “Macroeconomic Priorities,” The American Economic Review, Vol. 93, No. 1. (Mar.), pp. 1-14.

Marshall, Alfred (1890), Principles of Economics, New York: Macmillan & Co. (1938 edition).

 

McCarty, Nolan, Keith T. Poole, and Howard Rosenthal, 2013, Political Bubbles: Financial Crises and the Failure of American Democracy, Princeton: Princeton University Press.

 

Minsky, Hyman, (1986), Stabilizing an Unstable Economy, New York: McGraw-Hill.

 

Palmer, A. (2012) “Playing with Fire,” the Economist, February 25, 2012, page 5 at heep://www.economist.com/node/21547999.

 

Shiller, R. (2012).  Finance and the Good Society, Princeton: Princeton University Press.

 

Shiller, R. (2000). Irrational Exuberance, Princeton: Princeton University Press.

 

Stiglitz, J. (2010), “Financial Innovation: Against the Motion that Financial Innovation Boosts Economic Growth,” The Economist, February 23-March 3, http://www.economist.com/debate/days/view/471.

 

Wallison, P. (2011), “Dissenting Statement to the Financial Crisis Inquiry Report” in Financial Crisis Inquiry Report, New York: Perseus Books.

 

Wicker, E. (2006). Banking Panics of the Gilded Age. Cambridge University Press.

 

Zingales, L. (2015), “Does Finance Benefit Society?” Journal of Finance, Vol. 70, Issue 4, pages 1327-1363..

 

 

  1. Krugman (2009). []
  2. Haliassos, (2013) page 4. []
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Liveblogging “Financial Innovation” Week 10: Financial Innovations for Social Impact

 

The focus of our course this week was the use of financial innovations for promoting desirable social outcomes, such as more savings, more education, better health, safer behavior, cleaner environment, etc.  We saw some financial innovations for social impact purposes earlier in the course, such as pandemic bonds, markets for kidneys, and home value insurance.  This week we considered social stock exchanges, debt-for-nature swaps, CO2 trading, tradable shares in not-for-profit organizations, and various proposals to promote saving by individuals.  It turns out that the point of view we’ve been developing for use in the for-profit economic impact sphere is equally applicable to the social impact sphere.

Much of the attention to social impact starts from a recognition of a social problem and then reasons backward to consider how financial innovation might intervene to alleviate the condition.  In the for-profit sphere, one might recognize an incomplete market, a market inefficiency, a barrier to arbitrage, a persistent cognitive bias, a monopoly or other restraint of trade, or an onerous regulation—all of which are market failures in one way or another—and then imagine how a financial innovation might resolve the market failure.  In the case of social impact, one might imagine how a financial innovation might help to resolve the social failure.  

Many possible solutions.  The article by Tufano and Schneider considered ways to promote saving by individuals.  It outlined six possible avenues: 1) coercion, 2) opt out policies that make it hard not to save; 3) convenience tactics that make it easier to save; 4) bribes to encourage people to save; 5) leveraging social networks (such as savings circles) to use social influence to encourage people to save; and 6) making saving exciting through devices such as lottery-linked schemes  (Wal-Mart just announced a new program whereby you might win money by saving money.)  One might generalize from Tufano and Schneider to suggest that any given social failure might be addressed by a number of possible financial innovation remedies.

Income-Linked Loans.  The visit by Miguel Palacios and the reading by Robert Shiller illustrate the possible tailoring of debt instruments to meet a social need (such as the desirability of more education for those who cannot afford it).  The idea originated with Milton Friedman in his 1962 book, Capitalism and Freedom, in which he asked why individuals cannot find the kind of financing available to corporations (i.e. equity financing, in which investors gain a claim on a part of income).  Another precedent is the income bond, in which debt service is contingent on the debtor’s ability to pay.  

The creation of income-linked loans illustrate an important function of financial innovation, to transform the costs/payoffs in (socially) useful ways.  Essentially these proposals amount to converting a fixed-income debt security into a call option.  The following diagram represents the Net Present Value payoff (vertical axis) from two types of loans as related to the debtor’s income (horizontal axis):

·        Standard loan (green line) entails a fixed interest rate and schedule of principal payments.  In theory, the creditor gets paid no matter what, which accounts for the flat line across all levels of income.  But in reality, as the debtor’s income approaches zero, the creditor will incur costly expenses for collection services, lawyers’ fees, bankruptcy proceedings, or payoffs to the mafia to get repaid.  As a result, the creditor’s payoff will tend to dip downward, the lower the debtor’s income.

·        Income-linked loan (orange line) entails interest and principal payments contingent on the income of the borrower.  Presumably the terms permit zero debt service if the debtor’s income approaches the poverty level—with zero debt service the creditor’s payoff is negative, equal to the value of the loan.  But as the debtor’s income rises, payment to the creditor eventually kicks in, and the payoff line begins to rise.  At higher levels of the debtor’s income, the return to the creditor from the income-linked loan exceeds the return from the standard loan. 

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Why would an investor agree to back income-contingent student loans?  If one were purely motivated by profit, it would be rational to invest in the loans if you were confident in your ability to identify the future Bill Gates’s or Mark Zuckerbergs.  And option-pricing theory tells us that the option on future income will be more valuable in the presence of greater risk, due perhaps to an uncertain employment environment, uncertain career preferences of the debtor, and uncertain impact of the education on the individual.  The transformation from a standard loan to an option transfers risk from one who is less able to bear it to another who can do so.  Finally, if one were motivated by social reasons (such as helping poor kids pay for tuition at charter schools or college) then you might be willing to accept the possibility of zero or negative return as a kind of charitable contribution.

We discussed the problem of “optics” with income-linked loans to individuals: they might look like indentured servitude.  To this, Robert Shiller replies that in a nation of laws, nothing about an income-linked loan interferes with the individual’s civil rights—indeed, it has the socially-beneficial result of reducing the individual’s risks of hardship and bankruptcy.  Another possible criticism is that income-linked loans may be discriminatory: the tendency of lenders may be to search out those students most likely to succeed and thus “cherry-pick” the candidates most attractive in terms of economic return.  Needless to say, markets generally tend to discriminate in that fashion.  But information problems (such as the inability to identify high-potential candidates in certain segments of society) and biases (such as race, ethnicity, gender, or economic class) warrant careful scrutiny by the social impact investor.   

Miguel Palacios offered that the discount rate for determining the NPV an income-linked loan should be negative.  He argued that more education tends to increase employability and income levels and provides a safety buffer in the event of layoffs.  Such seems to be the case for Darden graduates.  You might take some time to ponder how a negative discount rate works and why it might make sense.

Social impact platforms, marketplaces, and exchanges.  Markets manufacture information—they afford an arm’s-length assessment of the performance of a participant in the market.  A dilemma for many donors to organizations in the social mission and not-for-profit sector entails the assessment of performance.  Can marketplace designs help in this respect?  Two articles this week offered interesting speculative notions.  Robert Shiller imagined the “participation nonprofit” that would sell shares to donors in lieu of charitable contributions.  This would give participants a psychological stake in the organization, akin to ownership.  Would a marketplace concept help to price the performance of such firms?  Could it provide liquidity for disaffected contributors?  The article by Sarah Dadush discussed “social stock exchanges.”  She highlighted the risk of conflicts of interest between commercial and social aims of participants in these exchanges.  To that, one could add other considerations, highlighted in our earlier discussion of innovation in new financial markets—chief among these is volume of activity and/or liquidity.  The sustainability of a new market depends entirely on its ability to attract participants.

Environmental finance.  The reading by Allen and Yago illustrated how financial innovation might serve environmental conservation and remediation.  Environmental degradation arises from negative externalities and the “tragedy of the commons.”  The authors discussed three innovations in environmental finance: state revolving bond funds to provide seed money for self-sustaining project financing; debt-for-nature swaps; transferrable fishing quotas; and C02 emissions trading.  They wrote,

“The point of departure is the identification of specific market failures that result in environmental degradation.  By developing techniques to account for environmental goods and services, innovators can devise market mechanisms and capital market solutions to environmental problems, opening the door to real progress in the quest to conserve air, water, fisheries, wildlife, and biodiversity.  The tools already exist to identify and internalize environmental costs, discover prices for environmental goods and services, and finance projects that address environmental needs.” (Italics added)  ((Allen and Yago, page 143.)) 

Limits and risks of social impact finance.  To think critically about financial innovations is to look for both the strengths and the weaknesses of any proposal.  On the plus side, financial innovations on behalf of social impact help to channel private funds into products and organizations that can alleviate chronic social problems.  Questions we raised included these:

1.      Are the benefits measurable?

2.      Are the organizations and their leaders accountable for performance?  What are the protections against corruption and conflicts of interest?

3.      Does the benefit depend on greater scale and/or “critical mass?”  Many projects, though reasonably financed, start out small and are doomed to fail because of the scope of the problem.

4.      Are the benefits and the organizations sustainable?

5.      Does it divert money from projects that might otherwise be financed by the private sector?

6.      Is it limited to countries where contract law is enforceable?

7.      Will it promote “mission drift” by the recipient of the social impact finance?

Insights for the financial innovator.  Perhaps the dominant message of our brief exploration is that the tools and techniques observed for financial innovators in the for-profit sector are equally applicable to activities for social impact.  Consider that the following points have appeared in previous weeks and appeared this week as well:

1.      Find market failures.  This was the generic advice stemming from our study of the drivers of financial innovation.  Such failures include: market incompleteness stemming particularly from failures of arbitrage; market inefficiencies stemming particularly from information asymmetries; cognitive biases; restraints of trade owing particularly to monopolies, patents, trademarks, and technological expertise; and distortions and unintended consequences arising from regulation.  Every market failure presents the seed of opportunity to the financial innovator.

2.      Apply existing tools to transform the failure.  The example of income-linked loans shows that converting a standard debt to a call option on a person’s income may afford an opportunity to change incentives and promote a desirable outcome.

3.      Keep it simple.  Plenty of models exist in the for-profit sector that one might adapt for social impact.  No need to invent from scratch.  Innovate and adapt from existing examples.

 

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Liveblogging “Financial Innovation” Week 9: Products and Instruments

 

Instrument NOUN

1. A tool or implement, especially one for precision work: ‘a surgical instrument’ ‘instruments of torture’ ‘writing instruments’

2. A measuring device used to gauge the level, position, speed, etc. of something, especially a motor vehicle or aircraft: ‘a new instrument for measuring ozone levels’ ‘myriad instruments and switches’

4. A means of pursuing an aim: ‘the failure of education as an instrument of social reform’”

Oxford English Dictionary

 

In Week 9 of “Financial Innovation,” we turned attention to new financial products and instruments.  As the dictionary suggests, “instrument” means rather many things: tool for precision work, measuring device, and means to an end.  Our readings and discussions this week suggest the relevance of all three meanings to an understanding of new financial products and instruments.

Products or instruments are claims.  I give you my money; in return, you give me a claim on some future performance.  For instance, I lend you my money; in return, you give me a debt agreement in which you promise to pay interest and repay my loan on some schedule.  Another for instance, I pay my monthly fire/auto insurance premiums and get a claim in which you promise to replace my destroyed property in event of disaster—disaster insurance is basically a put option.  For yet another instance, I invest in the common stock of your highly-levered company and look forward to uncertain dividends and capital gain when I sell the stock sometime in the future—and I get to vote in the election of directors and in other matters that come before the shareholders’ meeting.  What is all too easily lost in fancy analysis is the basic quid pro quo (Latin for “this for that”).  The basic question to ask in studying any new financial product or instrument is, “What are the gives and gets here?” 

Valuation: Cash is King.  To value a claim (i.e., a new financial product or instrument), you must lay out the cash “gives and gets” over time, and discount them back to the present at a rate consistent with the risk of those cash flows.  Every simple and/or sophisticated model in financial economics is some variation on this approach.

Design of new products and instruments is a marketing problem.  Breakthrough research in marketing over the past 50 years affirms that consumers are willing to pay more for products that have trusted brands and features that address their unique needs.  Thus it is with financial instruments and products.  We can suppose that the issuer of a new financial product or instrument has clarity about its own requirements; but to find the needs of the investor is a discovery process.  To aim to discover new unmet needs in the market implies that markets can be incomplete.  Today, virtually all products and instruments are customized to some extent.  They might exploit special “windows of opportunity” caused by market volatility, regulatory change, and technological change.  They might serve special needs of the issuer such as speed to market, confidentiality (through bank loans or private placements),

What constitutes “success” of an instrument?  We have not delved very deeply into the attributes of success or failure in financial innovation, though some interesting discussion along these lines developed in class this week.  Also, the article by Mark Flood offered some insights.  Flood compared the success of market index funds to the failure of Canadian coin futures.  The latter was redundant and offered no special advantages of holding claims on bullion.  Therefore, trading in the futures stagnated and halted.  But redundancy might also apply to market index funds, since any consumer can construct his or her own portfolio of the market.  However, the exception in that case is that index funds can achieve the benefit for consumers at lower cost (time and money) and greater convenience than doing it oneself.

From the standpoint of an issuer of a new product or instrument, success can be defined in terms that are internal and external to the developer of the new claims.  From an “internal” standpoint, success depends on the fit between the claims offered and the firm’s ability to service those claims.  Also the new instrument might help to resolve an inefficiency about the value of the firm—the use of Structured Investment Vehicles is an effort to let the market value specific assets in a firm, thereby resolving an inefficiency.  And of course, the issuer will deem that success depends on the money raised, on the sales volume for the instrument, the price, and on “reputation”—reputation embodies a range of considerations consistent with the issuer’s mission, values, and sensitivity to social impact. 

From the standpoint of the investor, success depends significantly on price and quality, where price is framed by the investor’s appetite for risk and return, and where quality is framed by performance against a host of expectations.  In the case of the market index fund, convenience proved to be an overriding aspect of quality. 

Finally, there is a third dimension of evaluating success that should matter to us: social welfare.  Innovations can spawn positive and negative externalities.  For instance, innovations could be used either to promote or reduce crime.  Tax evasion and fraud have been abetted by bearer bonds and secret off-shore bank accounts.  Complexity in the design of instruments may help to transfer value from unwitting or unsophisticated market participants.  On the other hand, innovations could promote greater transparency, accountability, and speed of transactions (e.g. blockchain technology).  Measuring the social welfare impact of an innovation may be difficult, but nonetheless belongs in the mindset of decision-makers in the public and private sectors.   

Trend #1: Plain è Complex.  Over time, claims have grown more elaborate, from “off the rack,” one-size-fits-all to highly-tailored.  In this course, we have seen examples of the transformation of instruments in various ways:

·        Mortgages:  Before the 1930s, house purchases were typically financed with five-year balloon payment loans.  After that, the 30-year self-amortizing mortgage became the standard.  The Federal Housing Administration had intervened in the mortgage market to lower the risk of financial panics by mandating longer terms and avoidance of balloon payments.

·        Government bonds:  The article by Niall Ferguson highlighted the development of the government bond market in Europe.  Up through the mid-18th Century, a government typically would borrow from bankers and in its own currency.  With the Napoleonic Wars, it became necessary for governments to finance themselves more broadly, thus creating a public debt market.  As wars, depressions, and other calamities came and went, governments sought to finance themselves even more broadly, from investors outside national borders and in currencies other than home.  Thus emerged the Eurobond market.  And as inflation ate away at the wealth of bondholders, governments issued income-protected bonds.  The reading by Robert Shiller described the innovation of government bonds indexed to a basket of commodities in post-Revolution America.  Then the innovation lay dormant for two centuries until high inflation reappeared.  In 1997 the U.S. Treasury auctioned $7 billion in 10-year Treasury Income-Protection Securities.  By 2010, some $550 billion in TIPS were outstanding. [1]

·        Corporate bonds: Up to the late 19th Century, firms typically borrowed from bankers.  But to finance large capital-intensive projects, such as railroads, canals, and public utilities, companies turned to bond underwriters, such as J.P. Morgan, to sell bonds to the public—typically, these were payable in gold and in the home currency.  After World War II, the advent of large dollar balances overseas prompted U.S. firms to issue Eurobonds denominated in dollars and many other currencies. To finance rapidly-growing firms, issuers offered investors convertible bonds that could be exchanged for the firm’s common stock at a fixed price. 

·        Equity financing: Until the late 19th Century, corporate ownership came in one flavor: common stock.  Then in the wake of a wave of bankruptcies, railroads began issuing preferred stock to give risk-averse investors priority over common stockholders in the event of liquidation in bankruptcy.  Then, to promote investment in capital-intensive industries (such as public utilities), the government permitted cash-rich corporations to exclude 85% of dividends if they invested spare cash in other corporations (this increased the appetite of corporations and institutions to invest in preferred stock). 

Tailoring typically starts with a “plain vanilla” security and adapts it to the interests of issuer, investor, or both.  Here are some dimensions that tailoring might take:

1.      Schedule of payments:  Today, many loans amortize equally over time.  But income bonds pay interest and principal only if the issuer has cash available to make the payments.  If not, default is not triggered.  Some extendible bonds carry the right to extend the amortization schedule.  Other structures such as balloon-payment zero coupon bonds require no principal payments until the final date.

2.      Basis:  Interest on debts and preferred stock dividends can be a rates that are fixed or floating.  Floating rate issues, issues whose rates are indexed to some external benchmark, and adjustable-rate preferred stocks are attractive to investors who fear rising inflation rates.

3.      What is paid:  Some bonds issued by highly-levered firms “pay in kind” (i.e., in more bonds) until the firm earns enough money to pay in cash.  Some unusual bond issues have paid in a commodity instead of cash or were redeemable in cash at a value indexed to a commodity: in 1973, the government of France issued a bond with a redemption value indexed to the price of gold, and the Confederacy issued bonds payable in cotton.  Some issuers offered their investors “dividends” paid in tickets, discounts at retail outlets, and consumer goods.  From time to time, banks lured depositors with a free toaster or other kitchen appliance to open an account.

4.      Security:  Equity has a claim on the residual value of the company, after the claims of liabilities are honored.  Secured debt has a specific claim, typically on land and buildings (as in mortgages) or on inventories and receivables (as in working capital loans).  Some loans are unsecured, and rely on the “full faith and credit” of the issuer.  Subordination of a claim in the event of liquidation is typically accompanied by a higher interest rate.  Security is enhanced through the use of sinking fund provisions that require the issuer to make periodic payments into a legally-protected fund in advance of principal payments—typically, sinking fund provisions are associated with lower interest rates to investors.

5.      Currency of payment: Issuers in emerging economies find it difficult to issue securities payable in their home currencies and therefore issue in U.S. dollars or currencies of other developed economies—the massive Eurobond market is a testament to the willingness of issuers to tinker with currency of payment.  Dual currency bonds pay interest in one currency and principal in another. 

6.      Options: Most securities are riddled with contingent commitments.  The right to convert the bond into equity or another kind of security, or to exchange common stock into bonds represent call options.  In the event of a change-of-control transaction, some bonds permit the holder to put the claim back to the company for full repayment, regardless of the amortization schedule.  Provisions that either permit the early redemption of a bond issue or prohibit it are hugely significant to institutional investors.  “Drop-lock” options shift the interest rate on a bond from floating to fixed if market rates fall to a particular level: these anticipate interest-rate declines.  In class, and in a presentation by Dr. Hamilton Moses, we discussed catastrophe bonds—these impound options for payoffs that trigger in the event of an epidemic or other disaster.

7.      Control features:  In any financial instrument, the issuer will have made choices about subtle control trade-offs, including who might exercise control (for example, creditors, existing shareholders, new shareholders, or a raider) and the control trigger (for example, default on a loan covenant, passing a preferred stock dividend, or a shareholder vote). How management structures control triggers (for example, the tightness of loan covenants) or forestalls discipline (perhaps through the adoption of poison pills and other takeover defenses) can reveal insights into management’s fears and expectations. Clues about external control choices may be found in credit covenants, collateral pledges, the terms of preferred shares, the profile of the firm’s equity holders, the voting rights of common stock, corporate bylaws, and antitakeover defenses.

The implication of the trend toward tailoring is that the design of most instruments today is bespoke.  Therefore, it is best not to make too many assumptions about the intent of the counterparty.  Read the fine print!

Trend #2: Mediated è Direct-to-market.  The article on consumer finance by Ryan, Trumbull, and Tufano showed that consumers have gained greater access to the financial system over time.  But with this greater access came greater risk to the consumer, through the elimination of buffers of volatility.  “Do-it-yourself” finance carries rewards (e.g. lower cost) but also possibly higher risk.  Through the late 20th Century, it was true (and to some extent still is) that a person, firm, for government seeking to issue claims would need the assistance of an underwriter, advisor, or intermediary.  This reflected the need for specialized skill of investment banks as well as the advantages of network economics that they could exploit.  And it also grew out of the wave of securities regulation that began in the 1930s, in the effort to prevent fraud in the market.   But in the late 20th Century, issuers began to go more directly to the capital markets.  This has been reflected in several smaller trends:

·        Corporate finance:  However, since the 1980s, large firms have tended to internalize the advisory function, relying on investment banks for distribution and certification of claims through opinion letters.  Capital-intensive firms raised funds directly from investors through dividend-reinvestment programs.  And some firms offered sales of stock directly to customers through direct stock purchase plans.  Smaller firms work directly with venture capitalists or through crowdfunding processes to raise money.  In 2012, Congress passed the Jumpstart Our Business Startups Act, which eased various securities regulation and made it possible for younger companies to offer securities without the benefit of an intermediary.

·        Consumer savings: Until 1977, consumers deposited their savings into banks and trust companies.  But with the wave of inflation of the late 1970s, and Regulation Q that prevented interest payment at rates greater than 5%, consumers were motivated to place their funds elsewhere.  Into the breach stepped The Reserve Fund, founded in 1971, which allowed investors to earn a return on short-term and liquid debt securities and also enjoy check-writing ability on their investment—this was a direct competitor to bank checking accounts.  Merrill Lynch actually patented its design for the Cash Management AccountFortune magazine said the CMA was “the most important innovation in years.” [2]  Since then, money market funds have proliferated to almost 700, representing over $2.7 trillion in assets under management in 2011.

·        Investment management:  Investors have always had the ability to place funds directly in the markets.  But to do that well required the advice and management by experts.  Then, research found that about 80% of active managers failed to beat the market each year.  And modern portfolio theory advised investors to hold passive, well-diversified investments—this led to the invention of the index fund by Jack Bogle in 1975.  In 2005, exchange-traded funds debuted.  Both innovations entailed direct-to-market investing.  The application of artificial intelligence and algorithmic trading are likely to reduce the intermediation of investment advisors—we looked at online advisors such as Betterment and other firms.

Trend #3: static è cyclical rates of innovation.  From the end of World War II to 1971, financial instrument design seemed to adhere to standard models such as fixed-rate secured debt with few “bells and whistles.”  Then, profound changes in financial markets (such as new technology, globalization, floating currencies, deregulation, etc.) seemed to unleash a new dynamic in which capital market conditions exert a major influence on innovation in financial instruments.  Market sentiment oscillates between depressed and manic, as researchers in behavioral finance reveal.  In “cold” market conditions, instruments that are standard and “plain vanilla” seem to appeal to issuers and investors.  In “hot market” conditions, the more complex and unusual instrument designs emerge. 

“Hot markets,” like bubbles, are frequently defined in retrospect rather than while they are happening.  Examples would be the Reagan stock market of the 1980s, the equity market for technology issues in 1998-2000, the housing market in the mid-2000s, and perhaps today.  Hot markets are not equal to capital market bubbles, though they share some characteristics: high prices, high trading volumes, and “new era” thinking.

The relationship between market conditions and financial innovation warrants research.  Therefore, I can only offer a hypothesis based on my observations over the past few decades that the amplitude of the cycle has increased: as markets swing over time from hot to cold to hot again, the swing from “plain vanilla” to exotic designs has increased.

What’s going on here?  We have seen the drivers of financial innovation at other points in this course—the familiar list is applicable here as well.  A powerful motive is profit-seeking through completing a market—money market funds, index funds, exchange-traded funds, high-yield bonds, and Eurobonds would be examples.  The issuance of new instruments can also profit from exploiting market inefficiencies and cognitive biases.  Risk management is another important driver, exemplified by virtually any instrument that embeds an option, such as variable rate insurance policies, convertible bonds, and income-contingent student loans.  Finally, innovation in new instruments can assist in the legal avoidance of taxes and in regulatory arbitrage.  In addition to other examples in this post, consider the following cases, drawn from the hot market of the 1980s:

·        In 1988, Prudential Insurance issued the first-ever “death backed bonds”—bonds backed by loans to life insurance policy holders.  Demand was so strong that the size of the issue was doubled from $220 million to $445 million.  In essence, Prudential securitized and sold its portfolio of loans to policy holders.  The loans are repaid out of the proceeds of a life insurance policy issued by Prudential, making the risk of default very low.  It may be attractive for firms to splif-off specific assets if they believe that market inefficiency causes the firm to be undervalued: through the split-off, particular assets can be valued independently and the inefficiency eliminated.  An executive said that the loans are illiquid; “There’s not a lot you can do with them…there’s a lot you can do with a big lump of cash”—liquidating this portfolio was “changing lead into gold.”

·        In 1984, the Student Loan Marketing Association (“Sallie Mae”) issued $5 billion in 38-year zero-coupon notes.  The notes were sold mainly in Japan, where implicit interest was not taxed.  Nor were capital gains on bonds taxed at maturity.  Because of the great demand, the issue was priced at a premium, and yielded a lower return than 30-year U.S. Treasury bonds.  This issue completed the market.

·        In 1984, Salomon Brothers created Certificates of Accrual on Treasury Securities (CATS), in which they purchased a portfolio of U.S. government bonds, and stripped out claims only on their interest and principal payments, and issued the claims in bearer form (i.e., with no identification for taxation) in Europe.  Europeans paid a premium for the CATS, viewing them as risk-free securities with the added advantage of privacy.  In addition to completing the market, this issue seemed to enable the avoidance of taxes (some European governments claimed it promoted tax evasion).

·        In 1985, Chubb Corporation issued $150 million of Convertible Exchangeable Preferred Stock.  These securities could be converted at the investor’s discretion into Chubb’s common stock, or exchanged at Chubb’s discretion into convertible subordinated debentures.  Chubb was losing money and could not take advantage of the tax advantage of interest payments, therefore, it did not issue the debentures directly.  And if Chubb’s performance continued to deteriorate, it wanted the option to force the exchange of the preferred stock into common stock.  Investors were attracted by a relatively high dividend yield and by the prospect of a turnaround in Chubb’s performance.  This is an example of tailoring for risk management.

Thinking critically.  One point of view is that much of the tailoring in the innovation of new financial products and instruments that one observes is frivolous or rent-seeking  (pocket-picking).  This view holds that innovation in the design of financial instruments is a market-discovery process and that issuers will seek to design products to extract the highest price from investors, regardless of their need for the innovative feature. 

·        Complexity makes it difficult to understand the “gives and gets” of a new financial product or instrument.  The Consumer Financial Protection Bureau is pursuing the payday loan industry for greater transparency and simplicity in its presentation of costs to the consumer.

·        Information asymmetry creates the “lemons problem” of the kind that threatens buyers of used cars.  The issuer of a financial instrument knows more about the risks of that instrument than does the buyer.  This asymmetry stokes adverse selection, in which buyers are willing to offer only low prices and are unwilling to pay more for genuinely good used cars.  Credit rating agencies, securities analysts, financial journalists, and expert financial advisors reduce (but don’t eliminate) the asymmetry. 

·        Cognitive biases and emotion can steer an investor away from a rational decision.  Knowing this, issuers (or their representatives) can exploit the investor’s weaknesses.  High-pressure sales operations (see the “boiler room” in the movie, Wolf of Wall Street) exploit the fear of missing out (FOMO) and urge the investor to act now to “get in on the ground floor!”  Bernie Madoff created the largest Ponzi scam in history by appealing to affinity (people he knew in religious, cultural, and community organizations).  Walt Disney Company sells “Disney Dollars,” legal tender for purchases at its theme parks and found that these are rarely converted back into local government currency; Disney also sold shares of stock with the familiar animated characters gracing the certificates—in both cases, consumers with children rarely cashed them in and instead held them as mementoes. 

Questions for innovators in new financial products and instruments:

The Oxford English Dictionary says that an instrument is a tool for precision work, a measuring device, and/or a means of pursuing an aim.  Owing to their complexities, some instruments are extraordinarily precise tools.  And to the extent that financial instruments resolve market inefficiency or incompleteness, they serve as measuring devices for value.  And certainly, many (if not most) issuers and investors would transact in new financial products and instruments to pursue overarching goals.  These attributes raise some considerations for the financial entrepreneur:

1.      What is the problem that this new product or instrument solves?   How does it solve this problem better than the older products or instruments?  From what one sees happening in the fintech world, the benchmark of comparison should not only be the incumbent processes, but rather, the best new processes available in the markets. 

2.      Toward which segment of the market are you targeting these instruments?  Many instruments are aimed to complete market demand.  Is the targeted segment deep enough to warrant the effort?

3.      How do the novelties within this new instrument affect their cost and benefit?  For instance, flexibility is always costly to issuers to provide it, and always beneficial to the investors—in such a case, how would the flexibility affect the cost to the issuer and the return to the investor?

4.      Can you estimate the risk associated with the new product or instrument?  The complexities of new instruments may prevent a rigorous assessment of risk.  Dr. Moses asserted that the risk associated with the World Bank’s pandemic bonds could not be estimated by any actuarial method.

5.      Does the new instrument create value?  If so, for whom?   

  1. See Fleckenstein, Longstaff, and Lustig, at   https://faculty.chicagobooth.edu/john.cochrane/teaching/35150_advanced_investments/Fleckenstein_Longstaff_Lustig.pdf. []
  2. “Merrill Lynch Quacks Like a Bank”, Fortune, October 20, 1980. []
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