Financial Innovation Again

What’s the most important financial “innovation” for regular consumers of the past 30 years? It has an obvious answer. No, it is not the ATM machine. I’ll give you the answer in a bit.

Felix and Tyler have a go around over whether or not financial innovation is any good. I seriously dislike the term financial innovation. It obscures the debate more than it clarifies anything. Finance is a way of connecting savings and borrowers, and as such is a system that is influenced by and in turn influences the real economy. It is difficult to separate the financial innovations of the 1970s – interest rate swaps, CBOE, currency swaps – from the collapse of Bretton Woods. It is not the stuff that consumers will see – indeed most of what we are calling innovation at the consumer level is really just a scheme to jack consumers with hidden fees or used as a tax dodge.

Innovation is usually thought of as taking a good or service and making it obviously better – cheaper, more productive, and/or more features. Finance doesn’t necessarily work that way. What are some guidelines for talking about financial innovation?

ATM

The ATM is not a financial innovation. There’s nothing interesting financially about it. As a baseline, a financial innovation has to involve finance. Instead of going to a teller at the bank to take out cash, you can go to a machine next to your restaurant. Financially, there is no difference between that machine and the bank hiring a teller to stand there next to the restaurant. Obviously a bank couldn’t afford that, but it can afford the machine due to breakthroughs in informational technologies. But in terms of cash flows, risks, etc. – the stuff of finance – there’s nothing interesting there. This is different than overdraft protection, or the minimum payment on a credit card, or an interest rate swap, which has actual effects on finance.

Is the subject at hand something a well-informed MBA should know about? Checking your balance or paying your bills online – an MBA shouldn’t be aware of the IT work that goes on into making sure that account information gets passed to your browser correctly; an MBA who will do accounting for a major company should know how an interest rate swap works. The second is financial innovation and the first isn’t. So anything that isn’t primarily about finance shouldn’t be lumped into finance.

Most Important Innovation

Did you figure out what the most important financial innovation for consumers is yet? No, it isn’t credit cards.

It is the 401(k), created in 1980. Some stats: In 1983, 62 percent of workers relied on a defined- benefit plan; by 2007, only 17 percent did, while 63 percent only had a 401(k) or similar defined-contribution plan. Assets in 401(k)s had jumped from $92 billion in 1984 to $3 trillion.

Notice how we normally talk about innovation in other markets doesn’t really apply here, nor does it help us understand what is going on. It’s the creation of a loophole in a tax bill; is the guy who saw this loophole for what it was like Thomas Edison discovering the light bulb? We can change it entirely with another tax bill. Is it an innovation over the pension? It isn’t obviously better than a pension (defined-benefit plan), like the Playstation 2 is obviously better than the Playstation 1.

One story about the rise of the 401(k) is that someone has to hold the risk bag, and instead of employers, or the government, it is going to be consumers. There’s a plus that consumers can directly manage their retirement finances, and a negative that consumers can directly manage their retirement finances. The risks have to go somewhere, and now they are going to be transfered to the individual rather than held at the government or corporate level.

Another story is that the pension system we had in place was workable for the Fordist economy of industrial oligarchies and strong labor unions. We had a system of how the real economy worked, and the financial system stepped up to provide investments regime suitable for it. Even this is a bit of a lie, as the pension system was, like the corporate-provided health care system, a middle-ground stalemate that the United States came to as a result of conflicts between labor and capitalists rather than something we all agreed on. As this system of the real economy was historically contingent, and as global competition kicked in it started to tear at the seams, corporations were no longer going to be strong enough to hold these risks. So the financial system had to evolve accordingly, and it did so by moving it back to the individuals with some weak corporate ties in matching.

Now notice that this has a strong dialectical relationship with the real economy. There are less incentives to stay with a company for 30 years, so workers are going to move company to company more. This will effect our neighborhoods, communities, labor arrangements, etc. There is more of an incentive to earn more money earlier in your life, as to take advantage of compounding interest, rather than later in your life, as your pension is tied to the last 5 years of earnings. This (may, it would be cool to see research on this) leads to workers investing more in labor and competitive education earlier in life, leading to less family formations in one’s 20s. This has real consequences for the economy itself. So it may be better to think of finance less as a light bulb that lasts 20% longer and more of a field that is influenced by, and in turn influences, the real economy.

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10 Responses to Financial Innovation Again

  1. Anaxagoras says:

    Self-managed 401(k)s, while qualifying as a financial innovation, and theoretically sound, have proven, and will continue to prove, disastrous, by giving participants the illusion they are “managing” their own investment accounts. Given the ability to switch money among funds at whim, participants are least qualified to create and execute a long term investment strategy, certainly, at least, compared with the professional money managers who formerly managed company defined benefit pensions. 401(k)s are the only thing which kept big mutual funds in business after the dot.com bubble collapse and are a source of huge fee income which the fund companies have a vested interest in maintaining, as well as the illusion that the participants are capable of managing their own accounts. Further evidence that financial innovation ultimately transfers risk to the level least able to undertake it.

  2. Brad Morrison says:

    In general, I despise the financial sector’s insistence on appropriating language from the trade sectors. “Financial products” is nothing more to me than part of the dodge to allow banks to sell investment vehicles.

    The innovation as of late, it appears, is to find a way to push the risk onto others, e.g., the recent discussion about how bonds are sold several times, with the tail end consisting of selling the risk.

    We should all know what happens when risk is bought, i.e., assumed. The new “owner” should keep reserves on hand in case the risky situation fails, but as we have so recently seen (AIG), this is regarded as the simpleton move. Why keep liquid or near-liquid assets on hand just to meet your end of a fiduciary agreement? Just make sure to maintain your “too big to fail” status–even if it’s just an ideological truth–with the Feds, and then wait for the bailouts. Ideally, the first wave will satisfy your bond- and stockholders, with successive waves of bailout actually shoring up your risk. Then repeat the process, e.g., drain your reserves to pay … executive bonuses?

    No, you simpleton. Pay _lobbyists_ to prevent transparency and other bothersome regulatory legislation. _Then_ pay the executives who courted the lobbyists.

  3. Chris says:

    Further evidence that financial innovation ultimately transfers risk to the level least able to undertake it.

    I would say instead that financial innovation ultimately transfers risk to the party least able to *understand* it.

    The person most likely to be willing to take on risk (especially cheaply) is the one who doesn’t know he is doing so. The market then seeks out this comparative “advantage” as an optimum. This explains the 401(k), the subprime loan, and the credit card.

    Some shrill extremists have harsh, judgmental words for a transaction in which one party is getting a raw deal and doesn’t know it, and the other party does know it and doesn’t tell him. But they can’t be allowed to stand in the way of glorious financial innovation!

    P.S. One party that *definitely* benefits from having individuals control their 401(k)s: brokers. The fragmentation of control and resulting churn that results from having millions of amateur pension fund managers instead of far fewer professionals is highly inefficient, but if you make a commission every time money changes hands, highly profitable. Brokers’ relationship to the market is like a casino’s relationship to a poker game: they don’t care who wins any given hand, as long as somebody keeps playing.

  4. Taunter says:

    If you don’t want to count the ATM as a machine, you are forced to count the interbank network BEHIND the ATM.

    In 1979 McFadden Act America, if I went on a trip from New York to Los Angeles I needed to bring enough cash to last me the duration. The branch/machine issue was the least of my problems; walking into a Bank of America office wasn’t going to do me much good accessing by Citibank account. If something happened I might be able to write a check to a nice hotel or not nice check-cashing establishment, but even these places had difficulty processing an out of state check.

    In 1979, if I went on a trip from New York to Paris I needed to go to Citibank in New York and buy traveler’s checks (for a fee). When I got to Paris I got a lousy exchange rate (and another fee) when I went to BNP to get francs. If I ran out of traveler’s checks, my best bet for getting additional money was literally having someone in the US send it to me by Western Union.

    Today I can withdraw money seamlessly anywhere. I can walk up to an ATM in Beijing and withdraw renminbi that aren’t even freely convertible.

    These changes required information technology…and a market. Banks needed to see a mutual interest in having interoperable networks (for what it’s worth, Citibank refused for years to join a network, thinking it was only helping smaller banks), a payment scheme needed to be devised, state and national banking regulations amended. The Diebold or NCR hardware on the front end is just the most obvious piece of the puzzle; the miracle is that anything in northern Brazil, after a trivial piece of authentication, is able to make the decision “yes, go ahead and give this person money.”

  5. crocodilechuck says:

    Taunter is correct; Peter Drucker himself nominated consumer credit (incl. access to cleared funds) as the only inovation in modern finance.

  6. John Laudun says:

    I am curious if others also see this as the beginning in a fundamental shift in how companies were managed and led to some of the problems today. With the advent of the 401ks and 403bs, there was a lot of money being dumped into the stock market, and a lot more attention as well. Surely this led to what Wired wanted to call “the long boom” of the 1990s when some thought the stock market would simply keep growing and growing.

    Of course, it didn’t.

    But all that money chasing equity consistently drove stock prices up and soon executives were managing for stock price. (And the logic that they would be reimbursed in stocks made sense.) Within two decades, everything was about stock price and not about other measures, and we seem to be stuck in that logic today.

  7. Fidelity Castro says:

    As the first poster mentions, it is an illusion that most consumers are controlling their retirement investments.

    One of the biggest problems facing 401ks is actually a LACK of choices among funds. Companies like Paychex have partnered with Fidelity and a few other behemoths who essentially control most of the money coming out of 401ks.

  8. Chris says:

    the miracle is that anything in northern Brazil, after a trivial piece of authentication, is able to make the decision “yes, go ahead and give this person money.”

    Doesn’t the trivial piece of authentication include two-way lightspeed communication with your actual bank in your home country? I’m sure if that could have been done cheaply in Brazil in 1950, or even in 1850, that Brazilian bankers would have let you use your money. In fact, that’s pretty much what Western Union *was* doing, but technology made it less convenient.

    I don’t think “look, bankers can use computers and phones!” counts as *financial* innovation – it’s innovation from other industries penetrating the financial sector (or in this case just the banking sector – strictly speaking what you’re doing isn’t a financial transaction at all).

  9. Mike says:

    Good points Taunter. I’ll have to reconsider this. It’s very interesting from a legal and regulatory issue with the points you bring up. But is it interesting from a finance point? Are there changes to cash flows, risks, returns? Yes with the international markets. Yes probably with a short term inter-bank lending POV. But “a person can get to his checking account easier” still strikes me as more tech than finance.

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