“[K]nowledge advances when striking real-world events and issues pose puzzles we have to try to understand and resolve. The most important decisions a scholar makes are what problems to work on. Choosing them just by looking for gaps in the literature is often not very productive and at worst divorces the literature itself from problems that provide more important and productive lines of inquiry.”
– Professor James Tobin, Essays in Economics, Vol. 4
This post continues a series of postings related to my course, “Financial Innovation: Opportunities and Problems.” We devoted classes on September 5 and 6 to discussing some important drivers of innovation, such as profit-seeing, risk management, industrial change and incomplete markets. And we had a video visit from Nobel Laureate in Economics, Robert Shiller, who is a professor at Yale. At the end of the second day, this famous quotation by James Tobin (another Nobel Laureate) came to my mind. Tobin basically says, “If you’re going to spend your time, don’t work on trivial problems”—this applies to business professionals as much as it does to scholars. More on that in a moment.
Here are some points from the week that may seem obvious at first, yet are quite subtle and warrant some of your time to reflect upon:
1. Financial innovation pays. This is the main finding of research by Lisa Scholar, Bernd Skiera, and Gerard Tellis. It’s good to know that financial entrepreneurs get a reward for their labors. Following the Global Financial Crisis, it seemed that all we heard about were innovations that blew up and cost their inventors, customers, and investors a lot of money. But looking beyond the recent episode at a lot of innovations over a longer time period yields a conclusion at variance with the popular schadenfreude. But why would it be a surprise that innovation pays? As we saw in earlier classes, the evidence is that financial innovation is a fairly steady ongoing phenomenon (with some peaks and valleys). Would innovation occur without the financial incentive that success affords? Probably not. But our discussion of this paper summons two questions:
a. Does it pay commensurate with the risks? The study focused on innovations commercialized by established financial institutions. What’s missing are those start-ups that fail and ideas hatched within larger companies that never go to market. It’s nice that innovation pays; but does it pay enough?
b. Does financial innovation create value? It’s nice that innovation pays, but are we all better off because of the innovation or did the innovation just transfer wealth from the pocket of Peter to pay Paul? This was the gist of Paul Volcker’s famous claim that he hadn’t seen a worthy financial innovation since the ATM—“worthy” as he went on to discuss, meant that it would increase national productivity (i.e., create wealth). It’s a worthy research question, probably better tackled at the level of individual case examples rather than large-sample research.
2. Look for opportunities to “complete” markets. The demand in most markets is not satisfied with “one size fits all.” Some consumers want tiny Smart cars; others want big SUVs. So much of the artistry in business consists of recognizing unmet demand and tailoring products and services to meet that demand—this is called “completing” the market. Advanced techniques, such as conjoint analysis that one learns in an MBA program, help to identify segments of the market and the extent to which they are completed. Many of the fintech pitches one hears today, and of the financial innovations in history have at their core a proposition to complete the markets. One reason we should want to promote the completion of markets is that we are all better off to the extent it occurs—this is the insight of two Nobel Laureates in Economics, Kenneth Arrow and Gerard Debreu. In theory, a general equilibrium (a world of complete markets) is pareto efficient or “as good as you can make it” without enhancing the welfare of one person by reducing the welfare of another. But the practical businessperson is probably much less interested in the theoretical case of perfectly complete markets and much more interested in the instance of incomplete markets, in which we find ourselves today. That markets are incomplete pleads a few questions:
a. Where are the gaps? Big data, advanced analytics, A/B testing, and machine learning can help one answer this question.
b. How big are the gaps? Arrow and Debreu hypothesized a global economy so segmented that each person represented his or her own market segment. That may be a nice thought experiment, but if the demand in a certain gap has a population of one, it won’t be large enough to sustain an innovation effort (unless that person is someone like Warren Buffett or Bill Gates).
c. Why do the gaps exist? Perhaps the economics in that segment of the market really stink. Or maybe there are regulations or patents that get in the way. Analyzing the barriers to entry to a market is by now an advanced art-form
d. If you enter that gap, what competitive reaction might that elicit? Big players on the edge of a market segment are unlikely to sit still if you penetrate that segment. Dreams of big rewards might evaporate as the market gap suddenly fills. Fintech entrepreneurs often fail to answer this question adequately.
3. So many segments, so little time. In class, we discussed the case of MacroMarkets, a firm founded by Robert Shiller and that brought to market in 2009 a kind of insurance against falling house prices. Shiller noted that for most families, the home is the largest asset they own and a significant, if not dominant percentage of wealth. People insure against illness, fires, and auto accidents—why not insure against a decline in the value of one’s home? So he got to work and through a process of experimentation with others developed a succession of product designs over time—the case illustrates, again, that financial innovation is most often a process of incremental advance. Eventually, he brought his perfected innovation to market, but was hampered by market conditions (Global Financial Crisis), the aversion of most people to dwell on the downside likelihood, and generally, marketing. The new instruments failed to gain the trading volume and liquidity and were withdrawn from the market. It seemed to consumers that buying the house value insurance really was considered a bet “against” one’s home. The implication for many students was that even if you have a market-completing innovation, regulations and poor market conditions can prevent a successful roll-out. And we listed a range of issues that challenge the success of new financial products and services: consumer myopia, regulation, non-standard assets (e.g. houses), institutional momentum, tangibility, emotion, moral hazard, and cost. Robert Shiller seemed unfazed by the outcome. He said, “A lot of things have slow beginnings. Life insurance was first offered in ancient Rome and grew very slowly until it took off in the 20th Century. I’ve made my peace; I brought this idea to the world; its time will come.” In his writings (see especially his Finance and the Good Society) Shiller argues that financial innovation can address substantial problems facing society, such as wage inequality, pension shortfalls, and volatility in home values. By example and exhortation, he encourages us to work on consequential needs in the world.
All of this brings us around to James Tobin’s remark that the most important decisions one makes are what problems to work on. Financial entrepreneurs face a blizzard of market gaps. So, work on the worthiest problems. These might be defined by potential scale and scope, and by social impact. How do you define “worthy?”