Thursday, February 25, 2010

Joseph Stiglitz on financial innovation

Here's an extract from an online debate organised by The Economist magazine entitled "This house believes that financial innovation boosts economic growth". It's the case opposing the motion, written by Joseph Stiglitz, a former chief economist at the World Bank and Nobel laureate. Stiglitz calls for financial services to fulfil their economic function but believes most recent innovations in finance had the exact opposite effect, while plenty of good financial innovations were suppressed by the industry. Here is his summary of where it all went wrong:

A good financial system is essential for a well-functioning economy. A good financial system allocates capital to its most productive use, and manages risk in ways that enable higher risk activities to be undertaken for higher return. By reducing risks faced by individuals and firms, e.g. through insurance products, a good financial system contributes to greater security and societal well-being, in ways that may not even be fully reflected in GDP statistics.

Another responsibility of the financial system is to run the payments mechanism, without which a modern economy could not function.

A good financial system does all of this efficiently, that is, at low transactions costs. It is essential to realise that, for the most part, the financial system is not an end in itself, but a means to an end, and the measure of the success of the financial system must therefore relate to its success in accomplishing these broader societal functions. Innovations in the financial system that help it perform these tasks better and at lower cost almost surely lead to increased societal well-being, and to the extent that our GDP measures capture these benefits, in higher measured growth. There are some financial innovations, such as the venture capital firms, that have facilitated the flow of funds to new enterprises. Few are questioning the virtue of these innovations.

The question about financial innovation is, however, somewhat different: it is whether most of the innovations that have been widely touted, such as credit default swaps, have in fact enhanced economic performance. What is evident is that they contributed to the current economic crises, and added greatly to the burden on taxpayers. The AIG bailout alone—linked directly to these innovations—cost taxpayers almost $180 billion, a sum that is hard to fathom. There is also ample evidence that they have been useful in accounting, regulatory and tax arbitrage, activities that may enhance the profits of the companies employing them, but not necessarily the efficiency of the economy. They have helped governments and firms hide their financial doings from taxpayers and investors. And those benefiting from such deception have been willing to pay amply for it, with large profits to the innovators, even if society as a whole loses.

Paul Volcker put the matter clearly when he said, "I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy."

I agree. Indeed, as the international Commission on the Measurement of Economic Performance and Social Progress notes, even the mild growth observed in America during the period of so-called rapid innovation before the crisis was a charade: the 40% of corporate profits attributable to the financial sector were largely a mirage, an accounting fiction, offset by the losses in subsequent years; and the value of investment, much of it in real estate, was distorted by the bubble prices to which the financial innovation contributed.

We should not be surprised that the so-called innovation did not yield the real growth benefits promised. The financial sector is rife with incentives (at both the organisational and individual levels) for excessive risk-taking and short-sighted behaviour. There are major misalignments between private rewards and social returns. There are pervasive externalities and agency problems. We have seen the consequences in the Great Recession which the financial sector brought upon the world's economy. But the consequences are also reflected in the nature of innovation, which, for the most part, was not directed at enhancing the ability of the financial sector to perform its social functions, even though the innovations may have enhanced the private rewards of finance executives. (Indeed, it is not even clear that shareholders and bondholders benefited; we do know that the rest of society—homeowners, taxpayers and workers—suffered.)

Some of the innovations, had they been appropriately used, might have enabled the better management of risk. But, as Warren Buffett has pointed out, the derivatives were financial weapons of mass destruction. They were easier to abuse than to use well. And there were incentives for abuse. They made it easier too to engage in non-transparent transactions; and lack of transparency never helps markets to function better. Some of the financial products increased the problems of information asymmetry, exacerbating problems of moral hazard. Indeed, much of the growth of some of these products can be attributed to these information problems, and perhaps to the deliberate exploitation of the uninformed: it is hard otherwise to explain the expansion of products that, it should have been clear, were so toxic.

What has disturbed me is the resistance of some within the financial sector to innovations which would improve the ability of the financial sector to perform its core functions. For instance, modern technology allows the creation of an efficient electronics payments mechanism, where the transfer of funds, say, from a customer's account to the retailer's would cost at most pennies. Yet in most countries, the fees can be orders of magnitude greater. As a member of President Clinton's Council of Economic Advisers, I saw the resistance to the introduction of inflation-indexed bonds that protect individuals' savings for their retirement from the uncertainties of inflation decades later. The financial sector's complaint was that individuals just bought and held these securities; for the retirees, who wanted to minimise transactions costs, that was good; for the financial sector, that wanted to maximise transactions costs, it was not. There are mortgage products (such as those prevalent in Denmark) which would have helped ordinary families manage the risk associated with their most important asset, their home. But in few countries have they been introduced; in many countries, the financial sector has resisted their introduction.

The right kind of innovation obviously would help the financial sector fulfil its core functions; and if the financial sector fulfilled those functions better, and at lower cost, almost surely it would contribute to growth and societal well-being. But, for the most part, that is not the kind of innovation that we have had.

Regulatory reform is important not just to ensure that the economy does not have another crisis. Better regulations, including regulations that help align private rewards and social returns, could and probably would direct the sector's creativity in ways that lead to more socially productive innovation.

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