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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Liveblogging “Financial Innovation” Week 8: New Services and Processes

“Sure, it’s a bank.  But I think of it as a factory.”  — John Reed, EVP, Citibank, circa 1975 [1]

I once worked in a very large bank for the SVP who ran all of the back-office operations.  In those days (the 1970s) banks were just commencing the vast wave of automation that continues to this day.  My boss was not a jovial relationship banker nor an aggressive deal-doer; he was a cool engineer.  And, like John Reed, his mission was to improve efficiency.  He saw not a bank, but a factory.  Information technology was his instrument for change.  I observed the very rapid changes induced by automation and information technology.  This experience impressed me with the power of innovations in processes and services.  Though one may like to think of financial innovation in terms of markets, institutions, and instruments that the individual can see, the out-of-sight/out-of-mind innovations in processes and services may well be the most significant. 

Ubiquity.  The “back office” innovations in financial services are significant because they are everywhere and ongoing almost continuously.  The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies by Erik Brynjolfsson and Andrew McAfee tells a sobering story about the inexorable advance of automation and process improvements through artificial intelligence, big data, machine learning, and so on.  If you think you are somehow exempt from this trend, think again.  And look around you: recently, you’ve probably used one of the most important financial process innovations:

·        Automated Teller Machine (ATM).  Since introduced in 1965 in the U.K., and in 1969 in the U.S., the ATM has grown to some 2.2 million units installed around the world.  The machines, originally designed to dispense cash, now handle a range of routine functions that might have otherwise entailed a human teller, including bill paying, money transfers, deposit acceptances, updating passbooks, purchasing tickets for movies, concerts, lotteries, and trains, and donating to charities. 

·        Automated Clearing House.  Clearing houses were initially founded as associations among banks, at which the daily exchanges of checks and money were made.  The first clearing house in the U.S. was established in New York in 1853.  In the early 1970s, bankers decided to automate the daily bank clearings because of the enormous growth in volumes that threatened to overwhelm the legacy processes.  The National Automated Clearing House Association (NACHA) was founded in 1974 to integrate and standardize the clearing technology.  NACHA reported, “Each year it moves more than $40 trillion and nearly 23 billion electronic financial transactions, and currently supports more than 90 percent of the total value of all electronic payments in the U.S. As such, the ACH Network is now one of the largest, safest and most reliable payment systems in the world, creating value and enabling innovation for all participants.”

·        Point of sale transactions.  Advances in hardware and software have helped to integrate the retailer with the financial system, eliminating time-consuming and costly handling of paper, credit card information, and records of sales.

If what I saw in the 1970s was a “wave” of automation, we have today by comparison a “tsunami” of automation, prompted by artificial intelligence, big data, machine learning, and device-driven guidance.  My colleague, Ed Hess, has published a new book, Learn or Die: Using Science to Build a Leading-Edge Learning Organization, that describes this phenomenon in more detail—I recommend it.  And the advent of blockchain technology is all about process improvements.  Suffice it to say, financial innovation in services and processes is a very big deal.  The literature on topics in the area of automation and process improvement is vast.  A casual search on Amazon.com summons up thousands of book titles:

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Therefore, it is impossible to summarize in a couple of days (or even a semester) what the general subject area entails.  But the focus this week was on a few ideas that are relevant to financial innovation and fintech today.  I sought to motivate these ideas with a selection of readings that deal with credit rating practices and the diffusion of new processes in the insurance industry.

Credit processes and credit growth.  The article by Rotheli described the rise in the 1920s of new credit risk evaluation methodologies.  “Credit barometrics” were based on quantitative measurement of a prospective debtor’s creditworthiness.  Before the 1920s, a debtor’s character, capital, and capacity were the largely qualitative foundations of a credit decision.  The introduction of credit barometrics in 1919 triggered a movement toward the algorithmic assessment of risk—the parallel to the rise of credit algorithms in today’s fintech should not be ignored.  Ratios derived from the financial statements of borrowers produced objective measures that could be compared to averages for industries.  This permitted objective judgment and differentiation among industries.  These ratios would be updated over time to produce current standards.  And the multidimensionality of the ratios was resolved by producing a weighted average across all the ratios (the weights were produced by “experimentation,” whatever that means.)  All of this amounted to “scientific management” consistent with the Progressive Era impulses running through American culture at the time.   Rotheli argues that the advent of credit barometrics permitted credit assessment on a large scale, allowing for the processing of more credit applications and perhaps encouraging banks to market their lending capabilities and expand credit.  But the algorithm did little to warn of the dangers of the credit expansion, leading to the Great Depression. 

Clusters and waves of process innovation.  The article by Robin Pearson helps to illuminate the “clustering” in time, industry, and geographic location that one can observe in process innovation.  Economic clusters have been a hot topic for a couple of decades.  In The Competitive Advantage of Nations, Michael Porter argues that geographic clusters of industrial leadership provide the basis for national advantage.  [Note to yourself: if you want to join a really high-performing firm, you are more likely to find it in a cluster.] 

But this article by Pearson prompts us to consider clusters in time: why do process innovations tend to come in waves?  Famous economists such as Schumpeter, Kuznets, and Rostow discussed the cycles of innovation and the tendency toward the batching or lumpiness of process innovations.  Batches of process innovations prompt costs to fall, processes and products to conform to new standards, then rising competition, falling investor returns and competitiveness—all of which stimulates a new wave of innovations. [2]  But in his study of innovations in the British insurance industry in the 18th and 19th Centuries, Pearson finds a different cycle: new products are introduced, followed by waves of incremental and then radical process improvements, and ultimately extended to mass markets.  ((Pages 248-9.)) 

The big idea here is that product innovation and process innovation interact and complement each other.  A wave of new products stemming from a technological breakthrough is likely to be followed by a wave of incremental and then radical process innovations.

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An example of this interaction would be the introduction of charge cards and credit cards (new products) in the 1960s that stimulated the introduction of automated teller machines (new processes) in the 1970s, which in turn stimulated the introduction of debit cards (product) and eventually stimulated the development of point-of-sale terminals (process) for the integration of retail and financial systems in the 1980s and 1990s.  Underlying this interaction between new products and new processes is technological development, though Pearson also notes that changes in markets and big events (such as natural disasters or epidemics) can stimulate process innovation.  Pearson notes a correlation between the size and growth rate of a firm and the rate of its innovation—he says that this may derive from economies of scale.  Earlier in the course, we read research that suggests large institutions are prone to introduce innovative products and processes.

By now in the course, you should be starting to make some connections among the dots.  We have seen repeated examples of innovations in some areas of finance stimulating innovations in other areas.  Innovations in markets, institutions, instruments, services and processes, tend to spark each other.  And if repetition is the first principle of learning, then the repeated appearance of the main drivers of innovation should have helped you lock them in mind: profit-seeking, risk management, regulation, inefficiency, incompleteness, and others appear repeatedly in our exploration. 

Modern algorithms, finer detection of risk.  We were visited by Jerry Nemorin, D’08, founder of LendStreet, which assists distressed borrowers with restructurings of their debts, education in financial literacy, and loans.  Nemorin said that banks charge off $25-40 billion in credit card losses per year.  For loans over 90 days delinquent, banks are willing to take a 50% “haircut,” which LendStreet shares with the borrower to reduce the burden.  LendStreet funds the settlement with the bank, giving the bank faster payout than obtainable through a bankruptcy process; in turn, LendStreet gives the consumer a better repayment plan (typically a smaller payment).  Then it sells the loans to investors, who obtain an ROI of 14-15%.  A better credit algorithm than the banks had makes this possible.  Nemorin developed a proprietary credit analytic system that focuses on “ability, capacity, and intent”—LendStreet looks to help the borrowers who are not genuinely insolvent, but who may be illiquid because of an emergency or other shock that disrupted their debt repayment plans.  He says that LendStreet seeks to help borrowers who have good financial stability, an “old middle class profile.”  The average age of the consumers they help is 55.  The average FICO score is 580, which is unattractive to most lenders.  But Nemorin said that “FICO works imperfectly.”  It is a “one size fits all” credit score that ignores important circumstances of the borrower.  LendStreet has less than a 5% default rate, while the average default rate for FICO scores around 580 is 18-20%.  “We go after a segment who are going to perform; we are picking the fallen angels,” said Nemorin.  This is an example of a financial entrepreneur seeking both to complete the markets and bring greater efficiency into the pricing of assets in those segments of the markets.

Process innovations may create path-dependency.  Frank Partnoy wrote about “the tendency [of financial innovation] to outstrip the ability, and perhaps the willingness, of investors and intermediaries to process information…Information asymmetry in financial markets tends toward cyclicality: as financial innovation builds, so do disclosure gaps and misunderstandings.”  Credit-rating agencies are viewed from two different perspectives.  One view sees the agencies as gatekeepers who issue credible information because not to do so would damage their reputations.  The other view holds that credit-rating agencies don’t issue information, but rather, “regulatory licenses,” which are the right to be in compliance with regulations that restrict the kinds of securities in which pension funds and other institutional investors might place funds.  These regulatory licenses breed “behavioral overdependence” on credit ratings and the kind of excessive and uninformed investment in new financial instruments.  Partnoy illustrated this thesis with the example of Ivar Kreuger in the 1920s and 1930s.  “Overdependence on credit ratings has a behavioral element, which is highly path-dependent and has become deeply embedded in investor culture.  It is expressed not only in regulation, but also in privately created investment guidelines and policies and the extensive use of credit ratings in financial contracts.” [3]  This overreliance began after the onset of the Great Depression: the U.S. Treasury Department and Comptroller of the Currency required ratings from two agencies to establish the quality of a bank’s bond holdings: issues rated BB or lower would have to be completely written off.  Over time, the role of credit ratings in serving “regulatory license” grew.  Thus increased the distance between the investor and the investment: in the mid-2000s, it mattered less to know exactly what kinds of mortgages were in a collateralized mortgage obligation (CMO) than what the credit rating agencies thought of it.  In hindsight, it is clear that the credit rating agencies did not fully understand the risks embedded in the CMOs and other new instruments.  As Partnoy argues, financial innovation outstripped sound practice.

Diffusion.  How “best practices” spread among financial service providers lends insight into the diffusion of innovations through a market.  The speed with which innovations spread through an economy help to determine the financial and social returns on innovation.  Who adopts these innovations, and why?  The article by Akhavein, Frame, and White looked at the adoption of small business credit scoring practices by banks.  Credit scoring is one of the foundational activities is banking.  It is used to determine whether to lend to a prospective borrower, and if so, what interest rate to charge.  The study found that “larger banking organizations introduced innovation earlier, as did those located in the New York Federal Reserve district.”    Studies of the diffusion of automated teller machines (ATMs) have found similar results.  What’s going on?  First the adoption of innovations can be expensive.  Therefore, it helps to have a large capital base with which to run alpha and beta tests—this might explain the significance of the large firms in diffusion.  Second, the concentration of diffusion within the large money centers could be attributable to the typically intense competitive environment there.  Process innovations are stimulated by a push for efficiency.

Can you manage the diffusion of process innovations into your firm or through an industry?  If innovations occur in waves, they seem to have the attributes of fads, manias, or epidemics.  Epidemiologists (and sociologists) describe the spread of an epidemic (or social mania) as driven by three factors: a hearty virus or bacterium (or an idea), a carrier (an advocate or influencer), and a receptive host.  This suggests three sets of considerations for the process manager in a financial institution (or a fintech entrepreneur trying to sell an innovation):

·        How hearty is the idea?  “Hearty” should be defined as consequential and proven by research to generate results.

·        What is the channel of adoption?  Where did the idea originate?  How original is it?  Who is advocating the adoption of this process innovation?

·        How receptive are we?  Does this innovation resolve a need?  If so, for whom?  How?

In our first week of this course, we introduced ourselves to blockchain technology—it remains in relative infancy, but seems likely to spawn a range of process innovations.  The blockchain has the potential the automate, accelerate, and improve the quality and security for a wide range of financial products and services.  To date, fintech entrepreneurs seem to be using blockchain for innovations in payment systems and account management.   Some blockchain-related trends to watch for include:

·        Innovations to promote the interoperability of systems, to provide seamless integration and reduce costs.

·        Incorporation of the cloud into processes in ways to increase the agility of operations and reduce costs.

·        Monetization of the flood of data arising from point-of-sale technology and matched with financial account data.  And a rising focus on data quality.

·        Strategies to “skim” the most attractive customers for special attention.

·        Heightened concern for cybersecurity and data privacy.

Questions for innovators in new financial processes and services:

1.      What is the problem that this new process or service solves?   How does the new process or service solve this problem better than the older legacy systems?  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.      Will the process innovation enhance flexibility or reduce it?  As most big banks found in the automation wave of the 1970s, the selection of a particular process regime made it very difficult to switch to another one, if market conditions or new technology dictated the shift.

3.      Diffusion: virus, carrier, host.  If the diffusion of process innovations is “viral” like an epidemic, then one could manage the review and adoption of the innovations with the perspective of an epidemiologist.   How significant is the new process (the “bug”)?  Who is recommending it (the carrier) and what has been their experience with it?  Can this innovation solve actual needs, or is this just a “nice to have” (how receptive are you as a host)?

 

 

  1. Quoted in R. B. Chase, Handbook of Service Science, Paul, P. Magio, Cheryl A Kieliszewski, James C. Spohrer, eds. []
  2. Pearson, page 236. []
  3. Page 438. []
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Liveblogging the Presidents: Jimmy Carter

 

“[Rosalynn] did not seem very surprised.  In spite of the bad news, we were remarkably at ease.  We talked about how my necessarily more conservative economic policies had created a still unhealed breach in the Democratic party, and how ironic it was that the issues on which we had expended the most effort were the very ones that had lost us so much political support.  We enumerated some of the times when she had urged me to avoid an issue or postpone an act or statement that might be politically costly.  Unlike some of the previous discussions, this was not an argument between us, but a mutual analysis.  Even as we faced defeat, I was still convinced that my decisions were justified.  Most things we did that were difficult and controversial, cost us votes in the long run.  Camp David accords, opening up Africa, dealing with the Cuban refugees, Panama Canal treaties, the normalization with China, energy legislation, plus the hostages and the Soviet invasion of Afghanistan—particularly the hostages.  Also, the Kennedy attacks for eight months hurt a lot.  I spent a major portion of my time trying to recruit back the Democratic constituency that should have been naturally supportive—Jews, Hispanics, blacks, the poor, labor, and so forth.”

— Jimmy Carter, Keeping Faith, pages 577-578.

 

There you have it: election day, November 4, 1980, and Jimmy Carter confronts the fact of his defeat for a second term as President.  In the whole 633-page volume, the one sentence stands out as an epitaph for Carter’s presidency: “Most things we did that were difficult and controversial, cost us votes in the long run.”  He reiterated that “the issues on which we had expended the most effort were the very ones that had lost us so much political support.”  By recounting the difficulty, controversy, and great effort, he seems to appeal for the reader’s empathy: no good deed goes unpunished.  Carter’s memoir has the makings of a Shakespearian tragedy.  What can this memoir tell us about leadership?

 

This post continues my commentary on the seminar I’m leading for Darden and the Miller Center for Public Policy on the leadership lessons of the post-Watergate U.S. Presidents.  Students and I are devoting the year to studying the memoirs, biographies, and principal speeches of each President in succession.  Though universities teach leadership from many different perspectives, deriving leadership lessons from the Presidents is a neglected opportunity.  This course aims to fill that gap.

 

Carter is a case study well worth our attention because of his uniqueness and contradictions.  He campaigned for office as a populist and ran afoul of entrenched powers and of challengers (Kennedy and Reagan) who had a strong populist appeal.  Deeply religious, he presided at a time of an unmistakable trend toward unbelief.  He sought to restore faith and trust in government only to be displaced by a successor who argued that “government is the problem.”  A former peanut farmer, he imposed a grain embargo on the Soviet Union that brought hardship to American farmers.  He sought to balance the federal budget in the face of Great Society spending habits.  He faced challenging relations with Congress, but delivered a productive record.  “Mediocre,” “sanctimonious,” “stubborn,” “cautious,” “feeble,” and “cold” are some of the adjectives used to describe Carter.  Surveys of historians rank Carter at #27 (out of 44) just behind Gerald Ford and ahead of Chester A. Arthur and Benjamin Harrison—over the years, his position in the ranking has fallen as low as #34 and risen as high as #18.  It seems that with the passage of time, history may be dealing more gently with him.    

 

An Overview

In my discussion of the presidency of Gerald Ford, I observed that our reflections seem to gather around five “buckets”: circumstances, outcomes, character, execution, and choices.  Each of these buckets interacts with the others.  And the buckets aren’t static: each will change over time, which means that we must judge a presidency in its totality, rather than by just one bucket or at just one moment in time.  In short, the business of drawing leadership lessons suggests that the really simple assessments of a presidency are incomplete, incoherent, and/or wrong.  We must embrace complexity.  So, how does one size up President Carter?

 

Circumstances. As the saying goes, “you must play the hand you’re dealt.”  Carter was dealt a very challenging hand.  He entered office following the miasma of Watergate, the retreat from Vietnam, and the difficult presidency of Gerald Ford.  Carter promised to clean up the mess in Washington.  During his term, Congress began to fracture into caucuses (e.g., based on regions, minorities, women) that made it more difficult to move an agenda.  A staff memo noted that “85% of the criticism of you during 1977 came from other Democrats.” [1]

 

Diplomacy was growing more challenging, shifting from a bi-polar world (Moscow vs. Washington) to a multi-polar world (with growing power and demands from Third World countries, China, and an increasingly integrated Europe.)  The Soviet Union invaded Afghanistan, which prompted Carter to cancel wheat exports to the USSR.  The Iranian Revolution broke out and culminated in taking 52 American hostages from the U.S. Embassy.   The hostage crisis lasted 444 days and ended just after Carter left office.  The Iranian Revolution triggered a decline in oil production that caused a sudden rise in the price of gasoline and shortages in many U.S. cities.  At large, the economy experienced “stagflation,” a nagging wave of high inflation, high unemployment, and low GDP growth.  Consumer misery and voter discontent skyrocketed. 

 

Character.  Several of Carter’s attributes stand out, among the many by which one could describe a President.   Carter was very determined, and also rather inflexible, which in the pragmatic give-and-take of Washington would prove to be a defect.  He believed that the rational benefits of his program spoke for themselves and that therefore potential allies should follow his lead.  His memoir paints the profile of a perfectionist, a micro-manager who wanted to place a personal stamp on all business flowing through the White House, a budget hawk who hated waste in government spending.  Carter was ambitious and impatient.  In contrast to some leaders who might focus on three or four main objectives to achieve during a term in office, Carter arrived at the White House in 1976 with a long list of campaign promises that he felt obliged to fulfill.  He chose to try to do it all.

 

Carter’s memoir portrays deep humility.  He walked to his inauguration.  He actively sought criticism and in his famous “crisis of confidence” speech, went public with what he heard.  He was an awkward public speaker.  His was not the kind of outsized ego whose radiance would fill a room.  He ordered the Marine Band to stop the practice of playing “Hail to the Chief” at his appearances.  Perhaps his humility stemmed from his strong religious faith.  He was the most openly devout President in U.S. history.  Carter wrote,

“Although I was surrounded by people eager to help me, my most vivid impression of the Presidency remains the loneliness in which the most difficult decisions had to be made…I prayed a lot—more than ever before in my life—asking God to give me a clear mind, sound judgment, and wisdom in dealing with affairs that could affect the lives of so many people in our own country and around the world.  Although I cannot claim that my decisions were always the best ones, prayer was a great help to me.”  ((Pages 64-65.))

His faith suggests the moral impetus that he brought to his choices and methods of execution.  He came to the White House with a high ethic of reform of the federal government, and even a “savior complex” as some alleged.  

 

Choices.  Perhaps the most important decision a President faces is the setting of priorities.  A candidate for the White House may promise voters many things, in an effort to test the electorate to see which policies resonate most strongly.  What is remarkable about Carter’s new administration was that he seemed to make a priority of everything.  He wrote,

“I took seriously the commitments I had made as a candidate.  Peace, human rights, nuclear arms control, and the Middle East had been my major foreign policy concerns.  I had also spoken out on issues closer to home: achieving maximum bureaucratic efficiency, reorganizing the government, creating jobs, deregulating major industries, addressing the energy problem, canceling wasteful water projects, welfare and tax reform, environmental quality, restoring the moral fiber of the government, and openness and honestly in dealing with the press and public.”   ((Page 70.))

Then, Carter went on to highlight some really high priority goals, including “my promise to work well with Congress,” improved public works, improved education, balancing the budget, and reducing defense spending.

 

Carter rejected the policy of Nixon and Ford, of conducting U.S. diplomacy according to rational self-interest (“realpolitik”) and instead preferred a more principled approach consistent with the ideals of American democracy.  Thus, he made human rights a priority, which strained relations with adversaries such as the Soviet Union and with authoritarian allies of the U.S.  Carter’s decision to admit the deposed Shah of Iran to enter the U.S. for cancer treatment enraged the Iranian revolutionaries, who used the admission of the Shah as a pretext to storm the Embassy in Tehran.  In response to the USSR’s invasion of Afghanistan, Carter suspended détente and enforced a boycott of the U.S. in the Moscow Olympic Games of 1980. 

 

Execution.  This dimension addresses the style, processes, practices, and procedures by which a President tries to achieve policy goals. Carter wanted to know what was going on, to be at the center of the flow of information and proposals; for a time, he served as his own chief of staff.  He insisted on personally overseeing the sign-up list for the White House tennis court.  His leadership of the Arab-Israeli peace talks at Camp David is a remarkable instance where his micromanagement paid off: by dropping all other matters for 13 days to mediate the negotiations, he lent incredible prestige and momentum to the talks.  Carter literally owned the mediation process by controlling the development of the treaty document.  An assessment by Stephen Hess in 1978 concluded that,

“The root of the problem is that Jimmy Carter is the first Process President in American history.  “Process President”—using a definition by Aaron Wildavsky and Jack Knott–means that Carter places “greater emphasis on methods, procedures and instruments for making policy than on the content of policy itself.”  Carter is an activist.  He wants to do things.  Yet his campaign statements should have warned us that save for the human rights thrust in foreign policy, his passion in government is for how things are done, rather than what should be done….But process is only a tool for getting from here to there—it is not a substitute for substance.  When a president lacks an overriding design for what he wants government to do, his department chiefs are forced to prepare presidential options in a vacuum.  Usually this is done by BOGSAT—the acronym for “bunch of guys sitting around a table.”  In other cases, where political executives have not been given some framework in which to function, they will try to impose their own hidden agendas on the president.”

BOGSAT describes many of Carter’s appointments to his White House staff.  Carter’s staff drew significantly on a circle of aides who had served him while Governor of Georgia—some were wise and capable; the naivety of others complicated Carters relations with Washington. 

 

In our study of the presidents, communication is an important element of the execution of policies.  Carter was a somewhat wooden public speaker, who was more comfortable reading his prepared speeches than connecting with his audiences on a personal level.  But even this style was overshadowed by the tone and vision of his speeches: we must economize; we cannot do it all; everyone must make sacrifices.  While the reality of this may have been indisputable, Carter offered no uplifting vision that would persuade the nation that sacrifices were worthwhile.  In speeches supporting his energy legislation, Carter wore a cardigan sweater and urged people to turn down their thermostats and generally consume less.  On July 15, 1979, Carter addressed the nation in his famous “crisis of confidence” speech that asserted a “malaise” gripped the country and that “We’ve got to stop crying and start sweating, stop talking and start walking, stop cursing and start praying.  The strength we need will not come from the White House, but from every house in America.”  ((Page 126.))  The speech garnered empathy and a modest improvement in Carter’s approval rating.  But the downbeat tone—rather than the substance—of these speeches remains a pillar of Carter’s legacy.   

 

The opening quotation of this post hints at another distinctive element of Carter’s style of execution: argument and “mutual analysis” with his wife, Rosalynn.  Up to then, no First Lady—with the possible exception of Abigail Adams and Eleanor Roosevelt—had served as a serious policy advocate or adviser to the President.  In Keeping Faith, Carter called his wife, “business and political partner…[one who] had been as familiar with domestic and foreign issues as anyone around me, and had assumed the same basic responsibilities as I had.  She had helped plan strategy…Around the White House supper table and in other family councils…were my strongest supporters, but also my most severe critics…Rosalynn had strong opinions of her own and never gave up on one of her ideas as long as there was any hope of its being accepted.”  ((Pages 33-36.))

 

Outcomes.  In his biography of Jimmy Carter, Julian Zelizer wrote that Carter’s “time in the White House remains a symbol of failed leadership…Carter is consistently remembered as a president who failed to articulate a compelling political vision and who was unable to hold his party together…[an] implosion.”  ((Page 147.))  Though Carter entered with a 66% approval rating in polls, it dropped to 34% by the time he left office.  He fulfilled his campaign promises only partially.  His legacy was tarnished by the episodes of “stagflation,” the oil shock, and his “malaise” speech; by the disastrous attempt to rescue the Embassy hostages in Iran; by ethics investigations of administration officials and family members; by the reinstatement of mandatory draft registration; and by arming Indonesia in its repressive occupation of East Timor.  He lost in a landslide to Ronald Reagan in 1980, and thereby was denied a second term. 

 

But Carter started no wars, which he claimed was one of his proudest achievements.  He negotiated the SALT II reductions in nuclear weapons, the handover of the Panama Canal, and the Camp David peace accord that ended hostilities between Israel and Egypt.  And he removed nuclear weapons from South Korea.  He appointed Paul Volker, a monetary “hawk,” to be Chairman of the Federal Reserve, whose leadership figured importantly in quelling inflation.  He launched a major deregulation wave: oil, beer, trucking, railroads, and most importantly, airlines (since then, per-mile ticket prices have fallen by about half).  And he signed reforms of government surveillance.  Carter’s memoir recounts that in his legislative program with Congress, he won “three out of four roll call votes on issues on which I had taken a clear position.”  ((Page 93.))  As the following graph shows, Carter’s legislative record ranks third behind Kennedy and Johnson among all Presidents since 1953. 

 

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Source: www.brookings.edu/vitalstats  Updated April 18, 2014.

 

Since departing from the White House, Carter has led a post-presidency that is almost without equal among the Presidents.  His peace keeping and humanitarian work earned him the Nobel Peace Prize in 2002.  He has continued to speak out on matters of public policy, even criticizing his successors in the White House.  A poll in 2009 reported that his public approval rating had recovered to 64%. 

 

Points for reflection

Our seminar discussion raised a host of valuable points, aided by a visit from Steven Hochman, Assistant to President Carter and Director of Research at The Carter Center.  Consider these four:

 

1.      Who are you?  The identity of a leader does a great deal to frame the leader’s agenda and chances for success.  Carter openly defined himself as: Southerner, peanut farmer, Christian, populist, economic conservative, and social liberal—in the context of Washington in the mid-1970s, this was in improbable stew, perhaps best defined as “outsider.”  Would you rather be an insider or an outsider?  The outsider benefits from rejecting the reputation and mistakes of the incumbents.  But framing one’s identity as an outsider or entrant will limit one’s effectiveness with insiders or incumbents whom you seek to influence.  Carter’s political identity was as a populist who would “clean up the mess in Washington.”  But insiders and incumbents have a way of circling up around the entrant the way antibodies attack a virus.  Carter entered the White House with a very ambitious agenda that would require great cooperation from allies and adversaries.  But his inflexibility and resistance to the way Washington works damaged the cohesion of his party.  Business Schools don’t spend much time training students how to enter well into a new professional setting.  Chapter 4 in Carter’s memoir, titled, “My One-Week Honeymoon with Congress,” is a cautionary tale.

2.      How important is managing well versus mobilizing?  Consider the possibility tht each depends on the other.  Julian Zelizer wrote,

“Through most of his presidency, Carter was unable to nurture strong relations with congressional Democrats or core Democratic constituencies, as too often he was unwilling to engage in the kind of deal making and compromises that were expected from the White House.  Nor did he demonstrate a good feel for what steps were necessary to create programs that had strong political support. The very qualities that allowed him to campaign successfully as an antiestablishment politician, when translated into governance, made it difficult to build a durable political coalition to which he could turn in the crisis years in 1979 and 1980.  His embrace of the complexity of policy allowed him to think beyond traditional political orthodoxies, but it also prevented him from conveying the kind of compelling ideological vision that voters sought in difficult times.  In essence, Carter’s interest lay in the challenges of presidential leadership rather than the challenges of being a party leader.  He was willing to use his political position to push the nation through difficult choices, but he was less interested or successful in taking the steps that were needed to leave his party more united and in a stronger political position by the 1980 election.”  ((Pages 149-150.))

3.      Management of multiparty negotiations: the importance of craft, social intelligence, and sheer will.   About a quarter of Carter’s memoir is devoted to the very detailed history of the Arab-Israeli peace negotiation between Begin and Sadat at Camp David over 13 days in 1979.  These pages are an invaluable illustration of many of the lessons that business schools teach about bargaining and negotiating.  Perhaps the most important of these lessons is that in any two-party negotiation, there are actually three negotiations ongoing: one between the two parties, and two more within each of the parties.  Carter artfully mediated all three simultaneously.  Carter’s achievement of this treaty (and of the decades of peace between these countries) is a dramatic testament to the power of diplomatic skill.

4.      Defining “success.”  Virtually all of the Presidents challenge our notion of success in a national leader.  One can turn to objective metrics, such as terms in office, treaties, election votes, legislative output, and polling numbers.  But the ability to frame and communicate an inspiring vision for the nation probably dominates the indicators of presidential success. 

5.      The calculus of power.   Carter’s words that “Most things we did that were difficult and controversial cost us votes in the long run.”  This implies a tradeoff: stubborn adherence to a principled position is costly, in terms of support and risk of defeat.  Settling for half a loaf and living to fight another day might be rational if you are confident of success in the long run and if the discount rate on future returns is sufficiently low.

 

Bibliography

 

Carter, Jimmy, (1995) Keeping Faith, Fayetteville: University of Arkansas Press.

 

Zelizer, Julian E., (2010), Jimmy Carter, New York: Times Books.

 

Carter is perhaps the most prolific autobiographer of all the Presidents.  I recommend, but did not assign for the course, two books that preceded Keeping Faith and that help to reveal Carter’s background and character:

·        Carter, Jimmy, (1975) Why Not the Best? Nashville: Broadman Press.  This is Carter’s “campaign biography” written in advance of his campaign for the presidency.  Unlike many campaign biographies, Carter wrote this himself.

·        Carter, Jimmy, (1992) Turning Point: A Candidate, A State, and A Nation Come of Age, New York: Times Books.  This book describes Carter’s entry into politics.  As a peanut farmer in Plains, Georgia, he denied the racism and neglect of the impoverished prevalent in the region and sought to change state policies.  In his first campaign for office he confronted voting fraud by a political machine—and won.  The book reads like a thriller, and in the final chapters is difficult to put down.  I think that the story told here helps to illuminate Carter’s persona as an outsider and populist.  And it explains his activism on behalf of election integrity in his post-presidential career.  Highly recommended.

 

 

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Liveblogging the Great Depression: James Grant’s The Forgotten Depression

This post continues a commentary on readings about the Great Depression.  In the second meeting of our seminar, Richard A. Mayo and I assigned James Grant’s The Forgotten Depression: 1921, the Crash that Cured Itself.  This book focuses on the deep economic contraction in 1920-1921: output declined 8.7% in real terms (23.9% in nominal terms), national unemployment reached 19%, and civil unrest (strikes and violence) surged.  Grant offers this story as an arresting case of “constructive federal inaction”—arresting, because today’s policy response to an economic crisis is to promote rapid recovery and provide social relief until recovery comes.  Grant writes, “federal passivity did not destroy confidence but rather enhanced it.” [1]   The contraction was brief and followed by the Roaring Twenties.  Published in 2014, this study of the crash of 1920-21 draws an inevitable comparison to the Great Depression (1929-1939) and to the Panic of 2008 and Great Recession, both cases in which government intervened extensively in the economy and recoveries were slow and painful.  Grant writes, “The depression of 1920-21 was terrible in its own way.  In comparison to what was to follow, it was also, in in its own way, a triumph.” [2]

 

This book and our discussion of it extended our understanding of the build-up to the Great Depression.  In our first meeting, Liaquat Ahamed’s Lords of Finance argued that the roots of the Depression lay in the Armistice of World War I, in the terms of the Versailles Treaty, in policies of war reparations and debt repayment, and generally, in international monetary considerations.  Grant’s The Forgotten Depression complements Ahamed by focusing on domestic U.S. economics and politics.  Grant raises a number of important themes and stimulating critical thinking about that period of time. 

 

American involvement in World War I foretold a wave of inflation and a correction.   The build-up of the American war effort increased output and unleashed a flood of federal funds into the economy.  Observers expected that a recession would follow the end of the War.  Shortly after the Armistice in 1918, the government cancelled contracts equaling 3.3% of GDP.  But the decline in domestic trade was offset by a boom in exports, especially to war-ravaged Europe. Farm production surged, as did the market price of farm land.  Bankers extended more credit to firms, consumers, and farmers.  Seeing new opportunities in banking, City National Bank (the largest at the time and forerunner to today’s Citigroup) opened 22 new branches outside the U.S. including in places such as Cuba and Russia.  And the inflationary legacy of the War proved intractable: consumer prices rose 11% in 1916, 17% in 1917, 18.6% in 1918, and 13.8% in 1919.  As the following graph shows, double-digit inflation has been a relative rarity in modern U.S. history—only nine of the 102 years since 1913.  And the inflation at World War I dwarfs the rest, for both height and duration.

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The distortions induced by double-digit inflation found their way into consumer behavior: buying goods quickly because waiting imposed the depreciating purchasing power of the earned dollar; buying on credit because repayment would become easier later as the dollar inflated; and hoarding goods for sale because tomorrow they would fetch a higher price.  Union activism increased.  Strikes, work stoppages, and mass meetings calling for the nationalization of industries occupied headlines.  Anarchists detonated a bomb outside of the offices of J.P. Morgan & Company in New York City.  Grant wrote,

“Pensioners, judges, professors—anyone on a fixed income—suffered a crippling loss in living standards.  Class rose up against class and interest group against interest group.  Especially did the great inflation set labor against management, city dwellers against farmers, creditors against debtors and the Federal Reserve against a growing legion of monetary critics…And hovering in the background of these economic conflicts was the outbreak of revolution in Europe and the triumph of Communism in Russia.” [3]

The historical regularity is that episodes of high inflation (and/or material deflation) produce social stress.  Governments hear calls to respond. 

 

Should governments intervene in an economic crisis?  The Federal Reserve System, founded in 1913, became the focus of intense interest.  Grant noted that “Price stability, that chestnut of modern central-banking doctrine, was no part of the original remit of the Federal Reserve.”  ((Page 58.))  In 1919 and early 1920, the Fed tightened the supply of money, raising the rate at which it loaned to member banks from 4% to 6%.  Such increases seem small, but they echo loudly through the economy.  On January 21, 1920, the Fed raised the rate 1.25% in one step, which Grant calls “one of the Federal Reserve’s single most violent policy strokes from that day till this.” [4]  In May 1920, W.P.G. Harding, the Governor of the Fed (today, we would call him “Chairman”) said,

“It is evident that the country cannot continue to advance prices and wages, to curtail production, to expand credits, and to attempt to enrich itself by nonproductive operations and transactions without fostering discontent and radicalism, and that such a course, if persisted in, will bring on a real crisis….[Therefore, we must] bring about a normal and healthy liquidation without curtailing essential production and without shock to industry, and, as far as possible, without disturbance of legitimate commerce and business.”  ((Pages 96-97.)) 

Despite some evidence of a moderation in the rate of inflation, the Fed again raise the interest rate on June 1, 1920 from 6% to 7%.  Deflation set in: prices in some commodities started to decline in May, others by September, and some resistant products took until February, 1921 to start to turn down. 

 

Deflation commenced.  As the graph above shows, episodes of deflation are a rarity notable by their brevity and few number.  In my blog post about the previous class meeting, I outlined the devastating dynamics of deflation (“the more debtors pay, the more they owe”), which suggest why, if governments must choose, they would rather deal with low-ish levels of inflation than with any episodes of deflation.  Warren G. Harding, President of the U.S. took office in march, 1921, as the economy was in the crunch of deflation.  He, and his new Secretary of the Treasury, Andrew Mellon, saw the depression as a time to cut government spending and balance the budget, which withdrew fiscal stimulus as a possible instrument of recovery.  Furthermore, he opposed accelerating the payment of a “bonus” to war veterans.  And he signed a new tariff bill that protected U.S. farmers from imported goods.  Finally, President Harding seemed reluctant to provide social relief to the unemployed.  “Constructive federal inaction,” indeed.

 

Harding’s reluctance comes as no surprise.  Though it is true that Progressivism was a couple of decades old by 1920, the philosophy of laissez-faire in government was much older and still had some popular support.  In the history of U.S. financial crises of the 18th and 19th Centuries, there is no precedent for a Presidential impulse for social relief.  Henry David Thoreau opened his pamphlet, “Civil Disobedience,” with a quote he attributed to Thomas Jefferson: “That government is best which governs least.”  The Presidents up to Teddy Roosevelt and Woodrow Wilson more or less observed that.  But government really pivoted in March, 1934 with the inauguration of Franklin D. Roosevelt.  To appreciate the significance of that pivot, it helps to grasp what it left behind.

 

Laissez-Faire is French for “let it do” or “leave it alone.”  It describes a point of view, consistent with 19th Century liberalism, that advocated the minimum of government intervention in economic affairs necessary for a free economic system to operate.  Discouraged are taxes, import tariffs, government subsidies, bailouts, handouts, onerous regulations, etc.  Encouraged are rights of the individual, belief that Nature is self-regulating, and a view that market competition is good.  The “it” in “let it do” is the economy or the market system.  Iconic economists and philosophers, such as Adam Smith, Thomas Malthus, David Ricardo, Jeremy Bentham, and James Mill, fought the mercantilist system in which governments intervened deeply in markets, impaired rights, restricted foreign trade, and managed competition for the sake of nationalist political goals.  By the early 20th Century, the classical economics of the early economists had been challenged by Karl Marx and transformed into “neoclassical economics,” which assumed rational individuals seeking to maximize their own utility or profits in efficient and competitive markets would produce equilibrium, a balance of supply and demand.  This idealization of equilibrium underlay the propensity of President Harding and Treasury Secretary Mellon not to intervene in markets and social distress.  Come 1934, all that would change with the activism of FDR.  In 1936, John Maynard Keynes would publish his General Theory of Employment, Interest, and Money, which would provide an intellectual argument for government intervention through fiscal and monetary policy. 

 

In short, the great value of Grant’s book is that it can provide half of a before-and-after comparison: The Great Depression was one of the most significant pivots in economic and political history.  We’ll get the rest of the story in the next few sessions of the course.

 

Our discussion did note some aspects of the book that merited further development:

1.      Social cost of intentional deflation.  By focusing mainly on policy makers and industry leaders, the human impact from the depression remains an abstraction.  What was the impact on health, nutrition, enterprise survival (i.e., bankruptcy), education, capital investment, community development, culture, and the like?  Grant notes that Massachusetts reached an unemployment rate of 30% in 1921—this was the official unemployment rate in Detroit in 2009, when the city began a sharp decline.  So, what happened in Massachusetts in 1921?  The point is not to wallow in the sorrowful conditions, but rather to understand more clearly the consequential tradeoff between crisis policies and outcomes.

2.      The international context.  1920-21 was the first major crisis faced by the new Federal Reserve System.  Therein the Fed discovered that the it could not operate in complete autonomy from the rest of the world.  Liaquat Ahamed in Lords of Finance develops this point in considerable detail.  But as a stand-alone treatment of 1920-21, Grant owes the reader more discussion than is given.  [Our class discussion raised the “impossible trilemma,” developed by Robert Mundell and Marcus Fleming, as a basis for analyzing the dilemma facing the Fed.]  In their magisterial Monetary History of the United States, 1857-1960, Milton Friedman and Anna Schwartz wrote:

“The Price and output movements of the post-World War I years in this country were, of course, part of a worldwide movement.  Throughout most of the world, for victors, vanquished, and neutral alike, prices rose sharply before or into 1920 and fell sharply thereafter.  …central bank policies nevertheless produced linkages sufficiently  strong to result in a common movement of prices in most national currencies.  …The Federal Reserve Board emphasized the international character of the price movements in justifying its own policies during that period.  It argued that changes in U.S. prices were effect rather than cause, that the Reserve Board was powerless to do more than adapt to them, and that the Board’s policies had prevented financial panic at home and moderated the price changes.  Its position was somewhat disingenuous.  The United States had by that time become a substantial factor in the world at large and could no longer be regarded as dancing to the tune of the rest of the world.”  ((Pages 236-237.))

Would the markets self-correct under these conditions?  Would interest rates naturally rise in the U.S. to quell inflation?  Not necessarily so. 

3.      The gold standard.  Grant is a longstanding advocate for a return to the gold standard.  The Forgotten Depression is not a tract advocating the gold standard.  But we get a good dose of Grant’s criticisms of fiat money, which are trenchant and often witty.  One wishes he would give similar illumination to the gold standard, to which the U.S. adhered at the time.  Under a gold standard, the money supply in a country is “inelastic,” meaning that it cannot expand to provide liquidity during seasonal shifts such as the holiday shopping season or the movement of harvests to market.  Nor does the money supply necessarily expand as the entire economy grows: a slow-growth gold supply would result in rising costs of capital which would tend to choke off an expansion.  And last (but not necessarily all) a gold standard inflames geopolitics: given that the world supply of gold is rather fixed (or growing slowly), it creates a zero-sum competition to amass gold supplies sufficient to sustain each country’s national growth aspirations.  The amassing of gold is the foundation of mercantilism, which almost all economists condemn, and which leads to serious market distortions. 

 

The crisis of 1920-21 sets the stage for us to consider the onset of the Great Depression, especially the Crash of 1929 and the policy responses of President Herbert Hoover, 1929-1934.  More to come…

 

 

 

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Liveblogging “Financial Innovation” Week 7: New Institutions

 

“When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean—neither more nor less.” “The question is,” said Alice, “whether you can make words mean so many different things.” “The question is,” said Humpty Dumpty, “which is to be master—that’s all.”  –Lewis Carroll, Through the Looking Glass

Innovation stretches and even violates commonly-led definitions.  This challenges one’s ability to make sense of the evolving landscape.  Our focus in classes on October 3rd and 4th was the theme of “Financial Innovations in Institutions.”  Right there, we confront Alice’s complaint: how can words mean so many things?  For instance, when is a fintech firm a “lender?”  Perhaps, as Humpty Dumpty said, the one who defines the terms gains a certain mastery.  More on that later. 

This post continues my commentary on the middle part of our course, where we look at innovations in markets, institutions, services, instruments, and innovations for social impact.  I argued in reviewing the first week that financial innovations tend to be “idiosyncratic,” which means that they tend to span two or more of the five buckets.  But thinking about innovations in terms of the buckets helps us approach innovations more rigorously because each of the five buckets contributes important perspectives for thinking critically.  For instance, last week, we framed markets as search engines and as manufacturers of information—this framing helped us ask how financial innovations in markets promote search and information manufacture.  Here, in week 7, we turned to innovations in financial institutions and encountered some very useful frames for critical thinking. 

Institutions manufacture/distribute claims.  Financial institutions are intermediaries; they stand in between the supply and demand of capital and help to bring both sides together in mutually profitable deals.  An investment bank facilitates an initial public offering (IPO) of a promising young firm by literally buying the shares (financial claims) from that firm and re-selling them at a slight markup to investors.  An insurance company writes (manufactures) a fire insurance policy, which is a financial claim on the insurance company’s resources if a fire destroys a home; the insurance company finances this liability from the payments by policyholders.  A bank manufactures debt by both borrowing from depositors and lending to borrowers—in doing so, the manufacturing process performs at least four kinds of economic transformations:

1.      Maturity.  Banks borrow short and lend long.  That is, banks finance themselves substantially from retail demand deposits (which could be withdrawn on short notice) and in the repurchase agreement (“repo”) market (overnight funds borrowed from corporations); in turn the banks lend those funds on terms ranging from, say, 90 days up to a 30-year mortgage loan.  Banks make money on this maturity transformation because the interest rate they pay on short-term deposits is lower than the interest rate they earn on longer-term loans.  The maturity transformation exposes banks to the risk that consumer depositors and repo lenders might suddenly withdraw their funds from the bank in a “run.” 

2.      Liquidity.  Consumer deposits and repo funds are highly liquid, whereas longer-term loans aren’t.  Banks get paid for this liquidity transformation because of the risk that consumers and repo depositors will want to withdraw their funds hastily—for this reason, banks must hold reserves to forestall a liquidity crisis. 

3.      Risk.  Banks transform risky assets into relatively less risky deposits.  For instance, U.S. Bancorp borrows in the repo market at its high (P-1/A-1) credit rating and probably re-lends to lower-rated customers.  Three reasons explain why the riskiness of the bank’s debtors does not translate into the riskiness for depositors:

a.      Risk management and reserves.  Sound banking practices entail careful scrutiny of borrowers and active management of loan exposures.  Also, government regulations require banks to hold reserves as insurance against expected loan losses.

b.      Federal deposit insurance gives consumers confidence that their bank deposits are relatively risk-free.  Banks pay a fee to the FDIC for this insurance. 

c.      By avoiding a concentration of its loans in any one company or industry, a bank achieves the benefits of portfolio diversification—this is one of the most important transformations in business.  If the returns on the components of a portfolio are less than perfectly correlated, then the risk of the portfolio will be less than the weighted average of the risks of the components.  Who benefits from portfolio diversification will be determined by competition: greater competition among banks will tend to drive downward the interest rates they charge.  Banks that enjoy a monopoly by virtue of geographic isolation or rare expertise (e.g., financing oil drilling rigs) are likely to charge higher interest rates and deliver higher returns to their shareholders. 

4.      Basis.  Banks typically borrow deposits and repo loans at floating rates of interest and lend at fixed rates—such is true in mortgage lending where banks offer long-term fixed-rate mortgages.

Bear these transformations in mind as you encounter institutions called, “lenders.”  Do they all perform the functions of a “bank?”  If not, then how do they make money?  What risks do they bear?  And how do they manufacture and distribute claims?  [Hint: Humpty Dumpty again.]

Our readings for this week affirmed the perspective that institutions manufacture and distribute financial claims.  Private equity companies purchase the equity and debt in companies that are not publicly-traded and finance those purchases through sales of partnership interests.  Kaufman and Englander said that KKR functions as a private “reconstruction finance bank that attempts to create economic value by identifying, purchasing, and restructuring underperforming or undercapitalized (even bankrupt) firms.” (page 53.)  By developing a network of limited partnerships with institutional investors and an “investor-controlled governance structure” for its portfolio firms, KKR organized (manufactured) buyouts of companies in private transactions and sold partnership claims on those companies.  Kaufman and Englander concluded that KKR’s activities increase output, jobs, and R&D spending.

Geert Rowenhorst’s chapter on “The Origins of Mutual Funds” tells a consistent story.  In 1774, Abraham Van Ketwich discerned the desire of small investors in Amsterdam to diversify their investments and founded the first mutual fund, “Unity Creates Strength.”  Previously, before the 18th Century, new investment vehicles had created an interest in pooling financial and non-financial assets.  Tontines, life annuities, and plantation loans were objects of consumer investment, but were relatively illiquid, fixed, and purchased individually.  Van Ketwich “simply repackaged existing securities that were already traded in the Amsterdam market.” (page 259.)  The mutual fund concept spread to England, with the founding of the Foreign and Colonial Government Trust in 1868, and then to the U.S. with the founding of the Massachusetts Investors Trust in 1924. Thereafter the appeal of the mutual fund model grew dramatically.  In essence, the mutual fund model entails the manufacture of financial claims on a portfolio of securities.

The visit to our class by Doug Lebda, CEO of LendingTree, illuminated the range of new intermediaries.  He said that LendingTree is a “marketplace business model…an exchange, which helps buyers and sellers to find each other.  You make money making a match.”  He contrasted LendingTree from some 300 lenders on the Internet, such as Quicken Loans, Wyndham Capital Mortgage, and EverBank who operate a “retail, cost-plus” lending model and then re-sell the loans to the investors who ultimately own the loan.  The online lenders manufacture and distribute financial claims.  But the comparison with Lebda’s marketplace business model invites the following question.

What does an institution do that a market or an individual cannot do?  In other words, why do institutional intermediaries exist?  Our discussions and readings offered several considerations:

·        Lower search and transaction costs.  Ronald Coase’s famous 1937 article, “The Nature of the Firm,” argued that the reasons firms exist at all is to offer lower transaction costs than individuals face by going directly to the markets.  We could add search costs as well.  For instance, investment advisers exist to help you sift through the plethora of investment opportunities in the world.  Surely some of this cost reduction is due to economies of scale, where the intermediary profits by spreading fixed costs across a large volume of transactions.

·        Convenience and security.  Bank innovations such as checking accounts, ATMs, and credit/debit cards make it easier to live life without having to lug around a lot of cash.  Banks hold valuables in safe deposit boxes and thus grant consumers confidence about the security of their wealth.

·        Aggregation of knowledge.  Repetitive transactions may result in the accumulation of important information about an industry, a technology, a country, or a class of borrowers.  The field of security analysis is founded on the belief that fundamental research into security values is profitable—thus, intermediaries who trade in securities may find it profitable to aggregate knowledge and build expertise.  Some borrowers prefer to share private information about their future cash flows and current financial standing with a bank rather than the public capital markets.  Banks, private wealth managers, and insurance companies benefit from this preference for privacy and the information asymmetry that results.

·        Network effects.  In 1913, the Pujo Hearings in the House of Representatives explored whether a Money Trust existed on Wall Street, similar to trusts formed in other industries—the hearings concluded that it did not, though they did find evidence of coordination among banks.  Today, such arrangements as private equity “clubs,” underwriting syndicates, and cross-guarantees among firms suggest that relationships among financial institutions may be important resources by which institutions manufacture and distribute claims more efficiently and effectively than markets.   The benefits of a network tend to grow as the number of nodes in the network increases.

·        Trust and fiduciary power.  As I mentioned in my post about Week 5, the number of enforcement actions by various government agencies suggest that markets are not clear of bad actors.  It is challenging for individuals to be constantly vigilant (and sophisticated) in looking out for their own welfare.  Institutions tend to move faster in response to financial news than do individuals.  And under the law, all financial intermediaries are held accountable to principles of fiduciary responsibility.  A trust company may manage an estate on behalf of widows and orphans.  A mutual fund diversifies stockholdings on behalf of its investors.  By delegating investment decisions to an intermediary, an investor gains professional management in place of otherwise slow, emotional, uninformed, and unsophisticated decision-making.  

Financial innovators exploit these benefits and displace incumbents.  The problem for incumbent institutions today is that the barrier between markets and institutions is growing more and more permeable.  Fintech innovators are devising new models for customer service that deliver these benefits without the trappings of traditional institutions.  Doug Lebda’s LendingTree is a marketplace: It delivers willing lenders to consumers at lower search and transaction costs. Bond Street does not take deposits, but it makes loans and then syndicates them.  Various peer-to-peer platforms bring consumer lenders and borrowers together—in such cases, the platform is the network that the old-line institutions used to service.  It is important to recognize that terms in the fintech space are thrown around with abandon, which complicates our efforts to understand the different business models we encounter.  For instance, in class we discussed Lending Club, which calls itself a peer-to-peer lender, but which stretches the concept of “peer.”  In common parlance, “peer-to-peer” would imply bringing together lenders and borrowers, individuals who have money and others who need money.  But Lending Club sources borrowers, arranges with a bank to make the loan, buys the loan from the bank, and then securitizes a portfolio of such loans which it sells to institutional investors.  At one end of this daisy chain is a consumer (the borrower) and at the other is a pension fund, insurance company, mutual fund, or some other institution (the lender).  It is hard to say that these are peers.  Are you listening to Humpty Dumpty yet?  

A long-term, ongoing process.  The displacement of older, less-innovative financial institutions by newer, more-innovative entrants is one of the enduring themes in the history of finance.  In 1987, Robert Aliber wrote what seems eerily applicable to 2016: “Some non-bank financial institutions have increased the range of their activities and so they now offer the consumer nearly all of the services and products that banks do.” (Page 1.)  Some of this “creative destruction” is due to a natural life-cycle in business enterprise: Firms start up, grow, mature, and then fade away perhaps because of the death of a founder, the rise of a feckless new generation of managers, or a simple loss of will.  In the 1980s, Aliber could look back on tremendous innovation owing to globalization of markets and deregulation.  Today, a great deal of innovation seems to stem from changes in technology and demographics (Millennial generation, immigration, retirement of the Baby Boomers, etc.)  

Interdependence among kinds of financial innovation.  By now in the course, it seems clear that financial innovations do not occur in a vacuum.  They arise from a complex set of drivers.  And I have argued that financial innovation is idiosyncratic; innovations tend not to fit neatly into one silo.  Aliber illustrates this by recounting that the advent of Merrill Lynch’s Cash Management Account in 1975 (a new instrument) drove disintermediation, which in turn drove liberalization in the banking industry (i.e., changes in products, branching, bank size, and operations).  In short, he suggests an interaction between the innovation in markets and in institutions.  This reminds us that we should not think strictly in terms of the silos of markets, institutions, instruments, or services, but rather, to look for the influence of all of them on each other—this interdependence is depicted in the following figure. 

 

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To focus only on innovations in institutions, consider four interactions we have encountered in this course so far.  ‘A’ would be represented by the rise of the Eurodollar bond market, which prompted banks to globalize.  ‘B’ is the example of Merrill’s CMA, which prompted banks to offer market yields on checking accounts.  ‘C’ is suggested by the rise of securitization and of more rigorous credit evaluation practices in the 1920s, which prompted banks to broaden the availability of credit.  And ‘D’ could be remembered as the rise of mortgage loan guarantees (Fannie Mae and Freddie Mac) and community redevelopment programs, which spurred the advent of the originate-and-distribute mortgage lending institutions such as Countrywide.

 

Questions for innovators in new financial institutions:

1.      What is the problem that this new institution solves?  Look toward the factors that emerged in our discussions and readings: costs, convenience, security, knowledge, network, and trust.  How does the new institution solve this problem better than incumbents?  And from what one sees happening in the fintech world, the benchmark of comparison should not only be the incumbent institutions, but rather, the markets.  Therefore, how does the new institution solve this problem better than the customer can find directly in the financial markets?

2.      What is the new knowledge that this new institution will aggregate, distill, and exploit?  Of all the explanations for the existence of financial institutions, the aggregation of knowledge is most compelling because it is hard to do and because it is such a reliable source of competitive advantage in business.  New tools from big data, artificial intelligence, machine learning, and advanced analytics are the exciting frontier of institutional innovation through knowledge aggregation.

3.      What will be the pattern of disruption of financial institutions?  In previous weeks, we discussed drivers of financial innovation.  And as the diagram above suggests, a search for institutional disruptors will find useful insights by looking at innovations currently occurring in markets, instruments, services/processes, and social impact.

4.      Why now?  If, as I argue, drivers and context matter in the success of financial innovations, and if the forces of change and the context continuously change, it will be valuable to consider what is the window of opportunity, and on what that open window depends.

5.      What will you call it?  Humpty Dumpty alert: the naming of financial innovations probably has something to do with their aspirations.  This is clearer now, after our foray into innovation in financial institutions.  We see a peer-to-peer lender (Lending Club) who arguably isn’t.  We see old-line banks, exchanges and marketplaces (LendingTree), originate-and-distribute firms (Lending Club), and the ultimate investors in the claims that these institutions generate—all are “lenders” in the sense that they help borrowers borrow.  But they all have rather different activities and profiles of risk and return.  The reason they call themselves “lenders” is that the ultimate consumer, the borrower, doesn’t care: all money is green, whether it comes from one kind of lender or another.  Thus, as Alice might say, they all make the word to mean so many things because some of these institutions are entrants and want a place in the market.  And as Humpty Dumpty might say, they make a word to mean so many things because of a contest for mastery.  Innovation in financial institutions is changing the rules of competition.   Thus, the descriptors for these new institutions may presage their ultimate success.   

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Liveblogging “Financial Innovation” Week 6: New Markets

The focus for our classes on September 26 and 27 was the theme of “Financial Innovations in Markets.”  At this point, we shifted our attention from the drivers of innovation, to its manifestations—we started looking at innovations in markets, institutions, services, instruments, and innovations for social impact.  The purpose of looking at financial innovations in these various forms is to develop a critical point of view.

What do financial markets do for us?  Any critical point of view has to begin with an understanding of ideal function and goals for markets.  Such understanding is the focus of the field of market microstructure within financial economics.  In his chapter on the NYSE, Richard Sylla argued that financial markets serve several needs: they pool resources; subdivide claims for investor convenience; mobilize capital by channeling funds from savers to users; allocate capital efficiently; afford ways of managing risk and create useful economic information.  To these I would add that they afford liquidity to investors and, to the extent that markets are organized in some way, they tend to promote orderliness.

Imagine a world with no markets: we would have to search for products and buy them through some barter-like negotiation.  Shopping for the bare essentials would be enormously costly in time and money.  The modern American supermarket or big box retailer gathers thousands of stocking units under one roof and offers these goods at take-it-or-leave-it prices.  In communities large enough for two or more competitors, the prices are likely to be competitive.  The upshot is that the existence of these markets might lower our costs of search and transaction. 

We have seen examples of the benefits of financial markets this week and in prior weeks:

·        The advent of trading in options and futures contracts in Amsterdam between 1550 and 1650.  As trade in spices and other commodities from the Dutch East Indies boomed, merchants needed to limit their exposure to price fluctuations.  Initially the instruments traded were bespoke designs.  As trading expanded, the instruments became more standardized.

·        The advent of new markets in kidneys and marriage partners.  In the absence of such markets, finding a counterparty is hit-or-miss, and consequences of failure are disastrous.  Innovative markets have been created that use search algorithms to match up counterparties. 

·        Electronic trading of securities on new exchanges has dramatically lowered execution costs and possibly increased liquidity. 

·        As described in Michael Lewis’s book, Flash Boys, which we discussed earlier in the course, Brad Katsuyama’s new IEX market offers an alternative to exploitative front-running in “dark pool” markets.

·        Flip Pidot (D’02) visited our class and discussed his efforts to launch American Civics Exchange (ACE), which would enable investors to trade instruments whose value derived from outcomes of elections, legislative votes, and regulatory actions.  With Flip’s assistance, we explored PredictIt.org, a prediction market; and we considered the change in polling percentages following a major presidential debate.  ACE and PredictIt could enable a participant to hedge risks that might stem from civic events or government actions.

Markets manufacture information.  Prices are the most important kind of information that markets produce.  Markets also provide useful information about liquidity, volatility, risk, and correlation.  Investors use this information to trade in the market as well as for decisions outside the market.  For instance, corporations use “beta” (a measure of the volatility of a firm’s stock price relative to the volatility of the stock market) in estimating the return that stockholders require from the company.  The cost of equity, combined with the cost of debt (informed by interest rates) determines the cost of capital for a company.  The market-based cost of capital is used in making a host of important corporate decisions about capital investments, acquisitions, restructurings, stock buybacks, and so on. 

Markets also can provide information about market participants.  The spreads of an issuer’s debt relative to risk-free bonds is an indication of the risk of that issuer.  The inability of some financial institutions to borrow in the repo funds market during the Panic of 2008 was evidence that investors doubted the creditworthiness of those institutions.

The market as a search engine.  Markets bring buyers and sellers together.  Markets lower the cost of finding a counterparty to do a trade.  This search-related benefit of markets is sometimes referred to as liquidity.  Larry Harris, former Chief Economist of the SEC, wrote, “Liquidity is the ability to trade large size quickly, at low cost, when you want to trade.  It is the most important characteristic of well-functioning markets.”  ((Larry Harris, Trading and Exchanges, 2003, Oxford University Press, page 394.))  Market makers, dealers, and brokers help to promote liquidity.  As the articles about the NYSE in 1792 and 1914 suggest, the absence of liquidity in one market can stimulate financial entrepreneurs to establish a new market.   

The benefits of a market depend on trading volume.  Growth in the number of trading participants tends to improve market efficiency.  With few participants, the views and behavior of any one participant will have an outsized effect on prices and trading volume.  Recall from our discussion in week 4 that market efficiency means that prices reflect relevant information about the asset underlying the financial instrument.  More market participants bring more diversity of opinion and more channels by which information can enter market prices.  An increase in the number of market participants increases the likelihood that prices will be efficient.  Higher trading volume helps price discovery.  

Of course, what matters is not just any kind of trading.  Uninformed day-traders simply add noise to the market prices.  The kind of traders who really help price discovery are informed traders—these tend to drive security prices toward their intrinsic values.  Informed traders reflect many styles: value traders estimate intrinsic values of securities from all the fundamental information they can find; news traders act on new information; technical traders respond to predictable price patterns caused by noise traders, shifts in market sentiment, or statistical aberrations (technical traders tend to rely on algorithmic trading models); and arbitrageurs simultaneously buy and sell similar instruments to exploit pricing anomalies.  More of this informed trading helps price discovery.

We considered examples of new markets that failed because of insufficient trading volume.  The case of Robert Shiller’s MacroMarkets house price derivatives showed that low trading volume during the panic of 2008-2009 doomed the attempt to launch the new instruments.  In his conversation with us, Shiller remained confident that a market in these instruments would arise eventually.  Also during this week, we discussed the Chicago Climate Exchange, which ceased its trading of carbon emissions in 2010 due to inactivity in trading for trading greenhouse gas emission allowances.  Though these instruments make sense as a device for adding the cost of pollution to the pricing of goods and services, the absence of a government mandate made the participation in this market voluntary for companies.  Trading volume remained insufficient and the market closed.   

In class, we conducted an exercise about locating the market for trading in sukuk (sharia compliant) bonds.  We considered London for its large and liquid markets, its desirable legal system, and its familiarity with Islamic finance.  Another candidate was Dubai, which was attractive for its ease of doing business and competitiveness as a business center.  The third candidate was Kuala Lumpur, Malaysia—the sukuk market settled in KL.  Malaysia is the largest sukuk issuer in the world, accounting for about 70% of total issuances.  And Malaysia requires that all debt issuances be rated.  And there is a big local demand for sukuk issues in Malaysia.  It seems that prospective trading volume attracted the sukuk bond market to KL.

Market disorder tends to lead to government intervention and rules.  We discussed the origins of the New York Stock Exchange.  Following financial panics in 1791 and 1792, the New York State legislature banned open-air auctions of securities.  It was thought that simply closing the financial market permanently would prevent future panics.  But dealers and investors and therefore gathered under a buttonwood tree in lower Manhattan to form a club that would facilitate trading, but only among members.  Membership in the club would be limited by certain entry criteria, and trading would occur on the basis of certain rules.  This is an early example of regulatory arbitrage, discussed in my liveblog post for Week 5.   

Another case of disorder and invention occurred in 1914.  We discussed the impact on market liquidity when the U.S. government closed the NYSE.  The government was afraid that Europeans would sell American financial securities at the outbreak of World War I and attempt to repatriate stocks of gold to their own countries.  A massive and sudden outflow of gold could destabilize the U.S. financial system.  Thus, the government simply closed the market.  But traders formed an informal securities market “on the curb” of the NYSE.  The article by William Silber found that securities prices in this alternative market remained relatively competitive and efficient.  Regulatory arbitrage struck again.

We also looked at an example of a benign influence of government: the advent of the 30-year amortizing mortgage.  The article by Rose and Snowden described the impact of the Great Depression on mortgage lending.  Before the Depression, house purchases were financed with interest-only balloon payment contracts.  The maturity of such loans during the depression when unemployment was high figured in the bankruptcy of many consumers.  The amortizing mortgage loan reduced the risk associated with longer terms.  The Federal Housing Administration, Federal Savings and Loan Insurance Corporation, and Home Owners Loan Corporation used their powers to motivate banks and S&Ls to adopt the amortizing mortgage model. 

Another example of government stimulation for innovation in financial markets was discussed in the article by Gerardi, Rosen, and Willen.  They found that federal deregulation of the mortgage market and of the S&L industry in the mid-1980s led to increased integration between real estate finance and other financial markets.  The mortgage securitization market boomed.  Consumers enjoyed greater tailoring in the design of mortgages.  And credit constraints relaxed, particularly for borrowers at the low end of the house value distribution.        

Questions for innovators in new financial markets:

1.      What is the problem that this new market solves?  What is being priced?  To whom is the pricing information useful?  In his chapter on “Market Designers and Financial Engineers,” Robert Shiller wrote, “Market designers, sometimes called mechanism designers, start with a problem—the need for a market solution to some real human quandary—and then design a market and associated contracts to solve the problem.”  ((Robert Shiller, Finance and the Good Society, page 69.))  Consistent with our studies over the preceding five weeks, consider how profit, risk, market incompleteness, market inefficiency, and government action might contribute to the case for this new market.   Another way to answer these questions is to consider the list of functions that markets perform: they pool resources; subdivide claims for investor convenience; mobilize capital by channeling funds from savers to users; allocate capital efficiently; afford ways of managing risk; create useful economic information; afford liquidity to investors and, promote orderliness—to whom are these benefits valuable, and why?

2.      Can this new market gain reasonable trading volume and liquidity?  Can it attract informed traders?  Markets are search engines.  For a search engine to be effective, it needs plenty of counterparties.  Try to identify a demand for services from the market.  How large and stable is the demand?

3.      Who rules, and how?  Obtaining a license to operate from most national governments typically requires sharp clarity about the new market’s governance and operations.  Norms and rules of operation will be necessary for orderly functioning.  These might address who can trade (are there conditions for entry into the market?), how trades are settled (by cash or credit? Over what time period?), disclosure of trading and the condition of traders (do they have the financial capacity to settle their trades?), and enforcement of infractions of rules (by whom?  When?)

4.      Why now?  The economic context has an immense influence on the eventual success or failure of the new market.  MacroMarkets introduced its new derivatives on house prices shortly after the Panic of 2008, when house prices had been battered down, and found few takers for its insurance.  Markets for greenhouse gas emission allowances have depended on government mandates and incentives to promote such trading.  Regulations generally have been known to stimulate innovations to arbitrage around the regulatory constraints.  And technological innovations can stimulate financial innovations, as evident in the rise of high frequency trading exchanges and the blockchain.

5.      Who or what is being displaced by the creation of this new market?  Incumbents can be tenacious competitors.  The algorithm-based market for kidneys displaced informal networks of unilateral search.  Match.com displaces informal social networks, bars, and professional matchmakers.  “Dark pools” displaced slower and more transparent markets.  ACE and the Amsterdam options and futures exchanges displace self-insurance.   

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Liveblogging “Financial Innovation” Week 5: Regulation

“The major impulses to successful financial innovations over the past twenty years have come, I am saddened to have to say, from regulations and taxes…[Through tax changes} The government is virtually subsidizing the progress of financial innovation just as it subsidizes the development of new seeds and fertilizers but with the important difference that in financial innovation the government’s contribution is typically inadvertent…the role of government in producing the pearls of financial innovation over the past twenty years has been essentially that of grain of sand in the oyster…the same process can be seen at work in any financial area subject to government regulation…The pressures to innovate around prohibited types of profitable transactions, or around newly imposed or newly-become-effective interest-rate ceilings, are particularly strong but, as we have come to see lately, even what purports to be deregulation can sometimes trigger changes that go far beyond the intentions of the original sponsors….The process of adaptation and selective survival in response to tax and regulatory changes has been going on throughout recorded history.”  ((Merton Miller, (1991) Financial Innovations and Market Volatility, Cambridge: Blackwell, pages 5, 6, and 19.))

Writing in 1991, the Nobel Laureate in Economics, Merton Miller, pointed toward taxes and regulations as major drivers of financial innovation.  Merton’s message complements other drivers we studied in the two previous weeks, profit-seeking, risk management, market incompleteness and market inefficiency.  The point of our exploration in week five was to lay more groundwork for a critical appraisal of financial innovations in the weeks ahead: innovations in markets, institutions, instruments, and services. 

Why regulate?  A detailed answer could fill entire libraries.  But in the abstract, regulation seeks to promote societal values, such as stability (e.g., capital requirements for banks), honesty (e.g., anti-fraud regulations), transparency (e.g., requirements about disclosing financial performance) and fairness (e.g., laws against insider trading).  Such intentions may be found in the preamble to laws, the hearings on which those laws were based, court decisions about those laws, and in statements by public officials.  The article by Campbell et al. explained that regulations aim to correct market failures that “impede efficiency or create unacceptable distributional outcomes”—such failures include externalities, search costs, market power, information asymmetries, and complexity.  

Evidently, it’s a nasty world out there.  In fiscal year 2016, the SEC filed 868 enforcement actions dealing with fraud, issuer disclosure, management accountability, fairness among market participants, insider trading schemes, misconduct by investment advisers, market manipulation, and foreign corrupt practices.  In fiscal year 2015, the Comptroller of the Currency issued 302 enforcement actions against institutions and affiliated parties and reviewed 22, 468 consumer complaints that dealt with unfair billing practices and unfair marketing practices—the revelation in September 2016 that Wells Fargo opened some two million bank accounts without customers’ permission is the most prominent recent case.  In fiscal year 2015, the Federal Reserve completed 51 formal enforcement actions and assessed $2.2 billion in penalties; and it completed another 91 informal enforcement actions that resulted in memoranda of understanding, commitments, and resolutions by bank boards.  One could review the enforcement activity of all of the regulatory agencies, but you get the picture: bad stuff can happen.

Regulation creates incentives.  These incentives might prompt businesses to do some things or stop doing others.  For instance,

·        Usury laws set maximum interest rates for loans.  Typically, the intent of such laws is to stop extortion or predatory lending.

·        Charters, granted by governments to financial institutions create protected franchises.  By screening entrants, governments seek to promote prudence, safety, and soundness in the financial system.

·        The Community Reinvestment Act of 1977 sought to stop discriminatory lending practices (called “redlining”) and to promote the availability of credit in low-income neighborhoods. 

·        Unit banking laws prohibited branch-banking.  Popular in the 19th Century and in agricultural regions of the U.S., such laws were motivated by a belief that the unavailability of credit was due to the aggregation of savings into the money centers from bank branches in rural areas and that unit banks would help to retain capital in credit-starved regions.

·        During the Panic of 2008, the Securities and Exchange Commission (SEC) used its regulatory powers to suspend short-selling in an effort to quell the cycle of panicked selling. 

·        The Dodd-Frank Act of 2010 introduced the most significant changes in financial regulation in 77 years.  In one of its provisions, the Act mandated that credit default swaps, which are traded over-the-counter, should be cleared through exchanges.  The intent was to promote standardization and transparency.

Side-effects. The reading by Acharya et al. stated that “Regulation is a tricky business; the law of unintended consequences always applies” and pointed to the mispricing of government guarantees, acceptance of opacity of firms and markets, and a narrow focus on individual, rather than systemic risk of financial firms as creating incentives for excessive risk-taking.  Regulations may create unintended incentives that stem from the two big drivers we studied in weeks three and four: market incompleteness and inefficiency.  Consider that:

·        Usury laws (like the prohibition of drugs and alcohol) may drive transactions into the grey and black markets.  Desperate borrowers may turn to the Mafia, a clear sign of market incompleteness.

·        Charter provisions and unit banking may have led to local banking monopolies or oligopolies, and therefore higher prices for consumers.  Restrictions on market entry can limit arbitrage and therefore efficiency.  As the reading by Acharya et al. reported, the collapse of Continental Illinois Bank (a unit bank) in 1984 was due to the fact that its lending business outgrew its deposit base, causing the bank to rely heavily on wholesale funding.

·        Critics accused the Community Reinvestment Act of stimulating overinvestment in housing and lending practices that produced subprime loans—this remains a fraught contention.  But in general, government mandates to invest tend to distort market prices and liquidity.

·        Bans on short-selling interfere with price-discovery, and thus market efficiency.

·        Efforts to standardize credit default swaps and other financial instruments will tend to discourage customization and may promote incompleteness.

Many of these cases illustrate the creation of moral hazard through regulation.  The clarity of rules, the backstop of a lender of last resort, and the creation of safe franchises may stimulate aggressive behavior to earn high returns while the regulator bears the risks.

Ways in which financial entrepreneurs might respond.  They see the violations of completeness and efficiency and are attracted to exploit those market imperfections to their advantage.  The readings and our classroom discussion suggest at least four kinds of response:

·        Regulatory observance could be profitable if regulation bestows valuable privileges on a few players.  Consider an entrepreneur who gains a coveted charter to operate a financial institution: like government licenses everywhere, bank charters carry their own franchise value derived in part from scarcity.   A current manifestation of this is the “rent-a-charter” phenomenon, in which an online lender who has no charter and cannot take deposits from the public, strikes a partnership with a small chartered bank in which the online lender finds the customer and structures the loan, while the bank partner actually makes and holds the loan.

·        Alternatively, the financial entrepreneur could simply ignore the laws and regulations.  But let’s be clear that regulatory violation is illegal and plainly inconsistent with the Honor Code that UVA students should carry with them through life. 

·        Co-opting regulators.  Critics have argued that the regulatory apparatus can get hijacked by special interests looking to use government power for private benefit.  Charges of “crony capitalism” have risen to some prominence in the current election season and earlier in the protests by Occupy Wall Street and the Tea Party.  Hijacking can occur when the regulations are formed (through intensive lobbying or even bribes), or later, if regulators get co-opted by the people they regulate.  Research suggests that material self-interest (e.g., through political donations or an interest in maintaining government funding) and cultural embrace (e.g., through “revolving door” personnel policies) can result in regulatory capture.  The Fed, SEC, and CFTC have been criticized as regulators captured by their wards—the accuracy of such allegations is disputable.  The Office of Thrift Supervision was dismantled in 2011 after several of its wards failed in the financial crisis of 2007-2009, owing in part to its lax regulation.  Regulatory capture is ethically suspect if it seeks to place private interests ahead of the public interest—though ill-considered laws and regulations could prompt co-option in the public interest. 

·        Regulatory arbitrage was discussed by several authors of our readings this week.   Financial entrepreneurs will seek to carry their activities to jurisdictions where regulation is light and from jurisdictions where it is relatively heavy.  Merton Miller cited the rise of the Eurodollar bond market in the 1970s as a way for U.S. firms and individuals to invest their funds overseas without incurring the costs of repatriating funds and investing in the U.S.  Why has there been a thriving estate and trust custody business in Grand Cayman and Panama?  There, low tax rates and strong privacy laws help customers to avoid (or evade?) taxes, hide wealth from grasping relatives and the media, and launder money.  Under the Basel Accords, international treaties that aimed to harmonize regulations of bank capital, banks need to hold capital in relation to the risk of the financial assets they hold.  Simon Johnson and James Kwak argue that the advent of securitization and use of off-balance sheet entities made it possible for banks to circumvent the Basel Accord capital requirements, leading up to the Panic of 2008.  In a reading for this week, Charles Calomiris wrote, “There is no doubt that the financial innovations associated with securitization and repo finance were at least in part motivated by regulatory arbitrage.”

Regulatory discretion.  Regulators retain discretion about enforcement of laws and regulations and may be reticent to sanction every infraction.  Alan Greenspan, as Chairman of the Fed was more interested in monetary policy and less interested in regulatory enforcement.  He believed that the private sector would police itself.  Therefore, he tended to discount reports of predatory lending in the housing bubble of the mid-2000s.   Charles Calomiris wrote that “The main story of the subprime crisis…is one of government ‘errors of commission’” such as the conscious under-estimation of risk, a lax Fed interest rate policy, ineffective prudential regulation, and rules that limited bank takeovers.  We want regulators to exercise some discretion since laws and regulations cannot anticipate every possible circumstance.  Yet inconsistent enforcement may prompt aggressive action by market participants.

Regulations might reflect popular sentiment rather than economic wisdom.  For instance, the concept of free trade has attracted some lively opposition during the current election cycle.  Yet, protectionism is a tax on consumers and almost unanimously opposed by experts in the economics of foreign trade.  The infamous Smoot-Hawley Tariff of 1930 contributed to the severity of the Great Depression.  The adoption of anti-usury laws and bans on short-selling typically reflect episodes of social stress (such as financial crises).   Speculators are easy targets for an angry public.  Speculation is often condemned as an immoral activity, like gambling, and often in contrast with investing, which seems to take the high ground.  Yet the boundaries between speculation, gambling, and investing are fuzzy.  In the best overview of this, Professor Reuven Brenner assessed the history of enmity toward speculators and concluded: “Behind the apparent misunderstanding lurked suspicion, envy, and resistance to providing a channel for social mobility through which a new class of people were becoming rich.”

Principles-based regulation vs. rules-based regulation.  Bright-line rules have the advantage of clarity and transparency.  One knows exactly what is illegal.  But such rules may invite aggressive behavior: financial entrepreneurs might manage right up to the bright line, and even test its robustness.  Principles-based regulation is constructively ambiguous and often dependent on court decisions to lend illumination.  This may motivate the financial entrepreneur to behave well within the ambiguous boundary out of aversion to risk.   Simplicity (in the form of principles) can be a virtue: detailed rules can be gamed.

Regulation is hard.  The regulator must stay abreast of innovations in new markets, new institutions, new instruments, and new services or practices.  Complexity makes it increasingly difficult to draft simple and straightforward regulations.  To regulate blockchain, derivatives, OTC trading, new technology (such as HFT) requires technological sophistication.  The complexity generates information asymmetry, which frustrates transparency and accountability.  And ultimately, measuring risk and welfare outcomes is difficult.

Cycle of innovation and regulation.  The readings suggested that regulation is both a cause and consequence of financial innovation—our focus this week was on the former, how regulation might cause financial innovation.  Later, in week 13, we’ll revisit regulation to consider how it becomes a consequence.  But it is worth mentioning here because regulation and financial innovation form a cycle of activity: one stimulates the other, and then the other stimulates the one.  Merton Miller wrote,

For a variety of reasons—including especially [the] desire to blunt the force of previous successful innovations by taxpayers—governments (or more properly, the shifting coalition of interest groups, that vehicle for protection and advantage) prefer to keep changing the structure, thereby altering the internal rate differentials and creating new opportunities for financial innovation.  This endless sequence of action and reaction has been aptly dubbed the “regulatory dialectic.”  ((Merton Miller, ibid. pages 5-6.))

The process of action and reaction between regulation and financial innovation has at least two big implications:

·        Stasis is unlikely.  The desire of incumbents and regulators for stability and equilibrium has been dashed repeatedly throughout history.  Innovation in a capitalist economy is relentless—this is the gist of Joseph Schumpeter’s notion of “creative destruction”: capitalism is an engine of constant change.  Therefore, the innovation-regulation cycle seems likely to continue indefinitely.

·        It seems unlikely that regulation will gain control over the cycle.  Regulation is basically reactive.  Regulators respond to news of illegal activities, to prominent failures of financial innovations, and to civic sentiments in legislatures, the media, and the population at large.  The curbs put in place tend to respond to known regulatory gaps—in that sense, regulation is backward-looking.  Like generals who are prepared to fight the last war, governments strive to ensure that the last known problem won’t reoccur. But such preparations won’t necessarily win the next war.

Isn’t self-regulation possible?  One alternative to government intervention in the private sector would be for the private sector to regulate itself.  This month, a group of online lenders agreed to form the Innovative Lending Platform Association that would promote a standardized presentation of credit costs for greater transparency to consumers.  Examples of successful regulations in the past would include member rules at securities exchanges and bank clearinghouse surveillance, started in the mid-19th Century.  But critics allege that self-regulation amounts to inmates running the asylum.  They point to the failures of private-sector debt-rating of subprime mortgages in the mid-2000s and of self-policing of public auditing in the late 1990s.  Though the tendency of federal policy has been to experiment with private-sector self-regulation as a first step, recent criticisms by populists at both ends of the political spectrum seem likely to push for a greater role for government-based regulation.

So…is regulation pointless?  The insights this week may seem downbeat.  Regulation is reactive and never quite gets control over the disruptive attributes of financial innovation.  Regulation can be a blunt instrument with plenty of unintended side-effects.  Measuring risk and the effectiveness of regulations is difficult.  Some regulations have been prompted by popular sentiment rather than economic wisdom. Regulation can get corrupted by regulatory capture.  And regulations are skirted through arbitrage.  As regulation of financial services has grown, government has assumed a greater role in the management of risk—but how much of this do we want or need?  David Moss, in his book, When All Else Fails, documents the dramatic socialization of risk that accompanies the democratization of credit.  This creates a free rider problem: costs of regulation are spread widely (taxes to support the regulatory establishment), while benefits may accrue more narrowly.  Advocates of laissez-faire would argue that regulation is expensive and ineffective and that free markets offer the best corrective mechanism.

Even so, one recoils from the regular exposure of venality, mendacity, and incompetence in finance and business.  Does that behavior make one proud to be a financial entrepreneur?  Would one be willing to accept the risks and consequences of such behavior in a laissez-faire world?  We want regulators to inspect our restaurants for cleanliness and our airplanes for safety.  It seems that people are sufficiently risk-averse to want governments to manage risks associated with financial innovations.  The big question is how much risk are we willing to accept?

Perhaps we expect too much of regulations.  For instance, is zero the maximum amount of fraud we are willing to accept?  It seems likely that the costs of surveillance, enforcement, and other market interventions would be enormous and would violate civil liberties and norms of privacy.  Maybe “pretty good” regulation is better than perfect.      

Some implications for the financial entrepreneur:

1.      Laws and regulations are complex, ambiguous, and variously enforced.  Hire excellent legal advice. 

2.      Regulations will change.  Pay very careful attention to the timing and direction of regulatory change. 

3.      Regulation is an adaptive system: participate in the adaptive process.  Have a voice.  Consider the possibility that your regulator could be an ally in pursuit of higher aims for your product, your firm, and your market.  Work with regulators to improve regulation—and if you cannot honorably fight to improve bad regulations you might face, then leave the field.

In your response to regulatory change, take the long view: do what is consistent with the kind of society you would like to bequeath to future generations.  Don’t skate to the edge of the ice.

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