Dinosaur Comics is awesome.
(The all caps at the end is great. This is also a good one.)
I tend to focus a lot on retail and consumer issues with Financial Innovation on this blog. To paraphrase T-Rex, it’s fairly easy to discuss, since a general audience will have a feel for it, I can try and solve it at night while I’m blogging, and a lot of it is obnoxious and duplicitous in a way you want to punch in the nose. I think it also links up with a lot of other interests I have, such as labor, inequality, access, etc., as well as seeing the implications for the ‘financialization’ of our economy.
Economics of Contempt (EoC) is mad at the level of discourse over financial innovation, calling out people by name. Since I want to make sure that when people call out others for “playing to the crowd” my name gets mentioned, I’ll throw in some thoughts.
Shorter EoC: It’s all the ratings agencies’ fault. CDOs as a fake alchemy of creating safe bonds from risky bonds? “the rating agencies were handing out AA and AAA ratings to tranches with lower and lower subordination levels.” Securitization creating a problem where the underwriters of risk were not holding the risk? “The weak link in this chain was, again, the rating agencies…It was the rating agencies that absolved the lenders from sensible underwriting by slapping AAA ratings on securitizations with laughably bad mortgages underlying them.” I assume if we got to CDS contracts in that entry, we would have heard that the real problem was AIG’s rating allowed them to not post collateral for their CDS book. And so forth.
– You should experience a bit of vertigo reading the argument ‘financial innovation would have been great for us except for all those people who told us it was great for us’, akin to it being the 1950s and hearing someone say ‘smoking would be really healthy for us except for all those doctors paid by the cigarette companies who told us it was healthy to smoke.’
– The ratings agencies deserve a large share of the blame. Especially with that CDS issue I mentioned! I hope we find a good way to rate the quality of credit debt, though it wouldn’t surprise me if the smartest way turns out to be having the Fed backstop CDS contracts with a CDS rate set away from market prices.
However putting all the blame on the ratings agencies strikes me as a far over-reach, and something very convenient for Wall Street. And as far as I understand, there’s no smoking gun; the ratings agencies conflict was well known, as it had been for a long time. Declining subordination levels were well known and on the top of every CDO contract – indeed if we had to start discussing attachment points every time we got into this discussion, the blogosphere would be twice as big.
If the innovation in question could be easily derailed by the ratings agencies, we have to stop and seriously consider if it is a matter of innovation instead of confidence selling at that point. If innovation is a matter of making investments more transparent or efficient I’m not sold. And it’s not necessarily about making investments less risky as opposed to making us understand the risk better – what attachment point is what likely to be breached. I’m not sure if the current science of setting attachment points has us there yet.
One level up
But again I talk about consumer/retail here too much. EoC has a list of financial innovations (zero-coupon bonds for one, from 1981 I think and I take for granted, I’d like to hear more about the history) one-level up, so to speak, that more directly impact those within financial markets. Zero-coupon bonds are awesome for insurance companies, for instance, since they don’t have to worry about re-investment risk with interest (duration). So I’m happy to give that to him as a win, though I’ve stated our increased ability to handle interest rate risk, and the instruments like this that came of it in the 1980s, is a genuine innovation, though an achievement I associate with a previous world of finance.
One thing I worry about at this level is that most innovation is zero-sum. The buy side and sell side have been at war forever; they both brings a knife, the sell side innovates and brings a gun, so the buy side has to innovate as well and bring a gun. They are still in check, though it isn’t clear that capital is getting allocated more efficiently. I hope EoC continues forward with this level.
Another level up
I think the real questions for us is how big do we want the financial market to be, and what effects does the current size of the financial market have on our economy. I think this is why the term innovation has such a negative connotation in this context – as others have pointed out, innovation should be consistent with this market share either declining or value for consumers increasing. Instead we are seeing both turn out the other way. It almost seems like the actions of the financial sector are becoming indistinguishable from rent-seeking on the real economy.
Whether or not an insurance company can adjust their coupons this way or that way is tangential to this bigger problem for the real economy, and ultimately for all of us.