Where do you want to be when a crisis strikes? The answer is clearly `not head office’. It was noticeable that the bankers who did well after the ’98 Russian crisis were often those who had senior positions in Asia or Latin America, and who were perceived to have acted like good corporate citizens (i.e. cut like Jack the Ripper when told to). The same thing happened after the 2001 Nasdaq crisis, and now FT alphaville reports that it is happening again:
Citigroup has just become the third big US bank (at least) in under four months to decide to pull its Japan chief out of the country… Douglas Peterson, Citi’s top executive in Japan, will shortly move to New York to become chief operating officer of Citi’s North American commercial and retail banking operations.
Being a big fish in a smallish office is often a bum deal as you are out of the HQ power loop. But it can certainly prove to be a blessing when more or less everyone back home is implicated in massive losses.
There has been a fair amount of discussion recently about financial innovation. Willem Buiter has suggested that new financial products should have a licensing regime akin to drugs, and Felix Salmon has written provocatively on the link (or lack thereof) betweeen innovation and economic growth. This should be read in the context of David Warsh’s work on Knowledge and the Wealth of Nations, a work that this post from Science Blogs reminded me of.
So, what do we know? First that certain infrastructures help innovations generate wealth. The ability to profit from a good idea helps, as does the ability to finance development. Hence patents and joint stock companies. Education is necessary, and law which gives certainty of ownership is also helpful.
Next, we know that most innovation does not produce growth. A lot of it isn’t harmful, but there are many, many dead ends. Markets are sometimes (but not always) good at sorting out which ideas are useful.
Now to specifically financial innovation. The point of financial innovation is to produce products which meet specific needs better (more cheaply, more accurately), and thus often to lower the cost of finance. Some innovations have worked out: a good example would be the convertible bond, which allows companies to monetise the volatility in their stock price. Others have been more or less useless but benign. Credit spread options are a good example here: in the early days of credit derivatives, these were a competitor with CDS as standard credit risk transfer products. CDS turned out to work rather better, and so credit spread options faded into illiquidity without doing anyone any harm.
Are there genuinely harmful wholesale financial products? I am still not sure that there are. I certainly can’t think of one*. If firms are required to keep enough capital against the risk of a product; to value it properly; and to document it carefully, then why should trading be constrained? Isn’t product licensing just a route to a less efficient economy?
*Tradable emissions permits come pretty close though.
Update. There is a nice rebuttal of the `innovation causes crises’ meme from the Economics of Contempt here.
From Market Pipeline:
If paying the bankers (a lot) less or taxing them (a lot) would certainly be more desirable from a moral point of view … would it be harmful in terms of economic efficiency, as many economists suggest? Is there a risk of discouraging the most talented to work hard and innovate in finance? Probably. But it would almost certainly be a good thing. A study on Harvard graduates showed that those who work in finance earn almost 3 times more than others. The temptation for young talent to work in this sector is enormous – 15% of 1990 Harvard graduates are working in finance, compared with only 5% of the class of 1975. More generally, the massive deregulation of the financial sector, which began in the 1980s, and the opportunity to make extraordinary profits have been accompanied by an increase in the number and qualifications of employees in this sector. Again, according to Philippon and Resheff, one has to go back to 1929 to see such a gap between the average education of an employee in the financial sector and one in the rest of the economy. The complex financial products, but also the evolution of standards in the social sectors over the past 30 years, have made the financial sector particularly attractive to any graduate, intelligent as he or she may be.
What the crisis has made bluntly apparent is that all this intelligence is not employed in a particularly productive way.
It is hard to disagree with this. If some of those 10% extra Harvard graduates in finance had gone into alternative energy, or transport planning, or medicine, would they have done more good (however you want to define it)? One’s visceral reaction is that they would, especially once you factor in all the unproductive professions that go along side finance: tax lawyers, particularly.
Good banks lending on rational terms are important. New financial products can help investors and borrowers meet on terms that are better for both. But just as we don’t need many of the ‘innovations’ that are foisted upon us by politicians — ID cards spring to mind — so investors should have been sensible enough to say no thank you to the worst excesses of financial creativity. No one needed a Libor squared swap in 1994: similarly no one needed a CPDO or CDO squared in the 2000s. Just say no to pointless, counterproductive innovation. It will help the innovators do something more useful with their lives.