A superb discussion of the need and risks of financial innovation. Evolution, complexity, simplicity, and why an equivalent of an FDA approval process may be just what the doctor ordered. Unfortunately critical thinking is probably still required:
“We are told, particularly in the U. S., that innovation is good. So it is, as a rule, but that does not mean that innovations are good. Most of them are not. To use an evolutionary analogy, innovations are the analog of mutations. Most mutations are detrimental, but some are beneficial, improving the fitness of the organism. These mutations survive and spread.
Likewise, economic innovations compete in the marketplace for survival. Some succeed, many fail. The fact that human beings consciously produce innovations means that they have a better chance of survival than random mutations, but they still face the struggle to survive.
What does it mean for an innovation to be fit? Well, its environment is human beings. It competes for the money of humans. In general, then, it must fulfill some human need or desire.
But a successful innovation need not benefit its environment. The predator does not benefit its prey, not the parasite its host. To succeed, the predator or parasite cannot do too much damage, however.
Financial dealings with consumers often have a predatory aspect, taking advantage of their ignorance, lack of sophistication, and economic weakness. The term, “loan shark”, reveals the potential for predation. You can argue that loan sharks would not exist if there were no demand for them. They certainly provide a service. However, in our society we deem that they do more harm than good. Survival in the marketplace does not mean benefiting society, even if that is normally the case.
If consumer financial instruments have a predatory aspect, what about those aimed at sophisticated investors? As recent history has shown, many of them got taken, too. And the complexity of the instruments played no small part in that. People bought what they did not understand.
I do not understand my telephone. However, if it fails, I can get another for a reasonable amount of money. I know the risks involved. But if you do not understand a financial instrument, you do not understand its risks. That fact argues against complexity in those instruments.
Min
September 28, 2009 at 11:39 am
- I particularly like Min’s allusion to mutations in this context. Most of what has been termed “financial innovation” over the last several years has actually been highly complex financial “mutations” which permitted select small groups of market mavens to extract enormous monetary profits for short periods of time until others were able to determine how they were managing what was usually a financial arbitrage and copied their practice – bringing them all down to minimal returns. This was repeated over and over again with different small groups reaping enormous, but temporary, financial benefits. The problem became critical when the overload of mathematical constructs required more and greater securitization of assets to continue functioning and maintaining the illusion of systemic solvency. The masters of finance were simply front-loading all of the long-term profits in the system into their pockets and back-loading all of the risk into the future. The future is now and our masters are once again working to re-bubbleize the economy since this is the only game they know.
John Hemington
September 28, 2009 at 4:45 pm
Reply
Humbly, both Shiller’s article and the blog entry miss the point. I would agree with Shiller that economic change -specialization, the division of labour and diversity of preferences- moves to greater complexity. This is true of all human artifacts – for instance the emergence of a new language -from pidgin to creole- is characterized by a movement from clarity to complexity – human interaction would fall apart if it relied on blunt instructions rather than on a panoply of qualifications and conditions.
Finance is no different – it has to respond to new shocks, diversify new types of risk and match new classes of savers and borrowers. Hardly surprising that finance will become complex as the activities to which it responds and reflects also become more complex.
The irony is that rampant quantification and modeling which financial innovation has embraced with gusto in the last few decades is uniquely ill-equipped to deal with these realities. At its most unrestrained, financial innovation denies complexity. Its real failure is that it is not complex enough. If our analytical tools cannot keep up, we should trim our sails. Here Shiller’s faith in more information, more complete databases and more muscular computing power sometimes feels like the toils of an intrepid explorer who refuses to give up the ghost.
All innovation -technological or financial- is liable to failure – why would things be any different when people are stepping into dark. No activity is exempt. The difference is that the consequences of failure are extraordinarily high in some areas -nuclear power, aircraft design, financial engineering to name a few (check out the literature on high-reliability organisations). They cannot be tamed by trial and error learning when the potential for catastrophic losses means that the first error will also be the last trial.
Denying the similarities between technological and financial innovation analytically (no doubt unintentionally) cuts off the one of the great routes that has contributed to progress and confidence in these areas – regulation. Why shouldn’t new financial instruments be subject to an ex ante approval process like the FDA does for new drugs? Nobody would tolerate the banking equivalent of holding more capital in those sectors.
nathan s
September 28, 2009 at 7:08 pm
Reply
- nathan s: “I would agree with Shiller that economic change -specialisation, the division of labour and diversity of preferences- moves to greater complexity. This is true of all human artefacts – for instance the emergence of a new language -from pidgin to creole- is characterised by a movement from clarity to complexity – human interaction would fall apart if it relied on blunt instructions rather than on a panoply of qualifications and conditions.”
To invoke evolution again, the reason that evolution appears to move towards greater complexity is that it started with simplicity. In reality evolution also has moves towards simplicity. (BTW, this is the answer to the “intelligent design” argument from “irreducible complexity”. First there was an increase in complexity, and then a reduction in complexity to a point where further reduction would destroy the new functionality.) We see the same in language evolution. English has lost the inflections that its cousin, German, maintains. And we see it in finance. Puts and calls are simplifications of stocks. Their simplicity allows them to be used to build complex combinations that would be impossible with stocks.
“Denying the similarities between technological and financial innovation analytically (no doubt unintentionally) cuts off the one of the great routes that has contributed to progress and confidence in these areas – regulation. Why shouldn’t new financial instruments be subject to an ex ante approval process like the FDA does for new drugs? Nobody would tolerate the banking equivalent of holding more capital in those sectors.”
As I have said, new financial instruments, like new designer drugs, should be regulated upon creation, for similar reasons. :)
Min
September 28, 2009 at 8:30 pm
Reply “
Source
Eric Duchin 11:43 am on October 30, 2009 Permalink |
Brilliant! Love the idea. Funding based on attitude, character, vision, and heart is mostly passed on by others. Business plans with numbers are not always easily created when an idea brews within. Now just need to find me am investor! :)
(we had lunch together at the Feast—perfect example of people who could use PIC’s!)