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?
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.