Financial Innovation for Beginners

Kevin Drum pointed me to Ryan Avent’s insightful review of Ben Bernanke’s recent speech on financial innovation. (How’s that for the Internets in action?) Bernanke’s brief was simple: to defend financial innovation in general while acknowledging that at the margin it can be counterproductive and may need to be more closely regulated. “I don’t think anyone wants to go back to the 1970s,” he said in a line that was clearly supposed to make his point. Unfortunately for Bernanke, Avent was listening closely. His rejoinder:

neither could Bernanke point to a truly helpful piece of financial innovation developed after that decade. His examples of successful financial products? Credit cards, for one, which date from the 1950s. Policies facilitating the flow of credit to lower income borrowers was another, for which he credited the Community Reinvestment Act of 1977. And, of course, securitization and the secondary mortgage markets developed by Fannie Mae and Freddie Mac in…the 1970s.

With one exception:

Tasked with defending deregulation as a source of financial innovation, Bernanke reached for subprime lending.

This helped at least partially crystallize some thoughts I have had floating around about financial innovation for a while.

Where I come from (career-wise at least), innovation meant that you invented something that people wanted, or you figured out a cheaper way to make something that people wanted, or you figured out a way to improve something that people wanted. Think of the iPod, or floss with a thin coating that makes it slide between your teeth more easily, or those little plastic things that keep the tips of your shoelaces together. These are things that make our lives, in aggregate, unequivocally better.

Financial innovation, however, comes in two forms. There are financial innovations that make our lives easier. One is the automated teller machine (ATM). ATMs are great. They mean that you don’t have to wait in line at bank teller windows or rearrange your schedule to go to the bank when it is open, and most importantly you can get cash at any hour if you need it . . . almost anywhere in the world. I would pay real cash money to use ATMs if I had to (and occasionally I do, if it’s not at my bank). Another example is the debit card, which saves me the trouble of dealing with cash altogether. There are corporate versions of these innovations, like corporate purchasing cards, which help automate the process by which employees buy stuff for their companies and get reimbursed for it. These types of innovations increase the quality of service and reduce costs – it’s hard to argue with that.

The other kind of financial innovation has to do with extending access to credit. Here I think it’s less clear that innovation is unequivocally good.

It is certainly possible for a society to be below the optimal level of access to credit. Consider the idyllic banking paradise that gets mentioned a lot these days, in which people deposited their savings with local banks which, in turn, lent money out to trustworthy local homebuyers and held onto those mortgages to maturity. The good thing about this model is it encouraged responsible underwriting. The bad thing is that it isn’t very good at moving capital (money) from one part of the country to the other. Imagine in Iowa no one needs a mortgage, so the banks have no place to lend and can only pay their depositors 0.1% interest. In Florida lots of people need mortgages, so the banks offer 4% on savings accounts, but they still can’t attract enough cash and people who would buy houses can’t. (Or, alternatively, people who would take out loans to expand their businesses can’t.)

Securitization is one innovation that helped overcome this problem and increased access to credit, and I think securitization on balance is a good thing. But it’s not in the same category as the iPod, or better floss, or better shoelaces, which are things that make people’s lives better directly. Securitization is something that increases access to credit, which may or may not be good, depending on the context.

The effect of securitization should be to moderate differences in interest rates – mortgage rates can come down as money moves into Florida, but they may go up as money leaves Iowa – and perhaps to lower them overall by making more money available to the market as a whole. If we were in a situation where too few people were getting mortgages, this is a good thing. But it is also possible for too many people to be getting mortgages, as we now know. Something similar happened with venture capital and startups over the last fifteen years. After the IPO rush of the late 1990s, billions of dollars of new money piled into the VC industry; that money flowed to thousands of companies that should never have gotten funded, resulting in lost money for investors and lost time and effort for thousands of generally bright and well-meaning entrepreneurs. Even credit cards – which I think most people would say are on balance a good thing, and which I personally use multiple times almost every day – can sometimes be a bad thing: they can prompt people to make unwise purchases they might otherwise not have made, with negative consequences for themselves.

In short, financial innovations whose sole function is to increase access to credit do not in and of themselves make the world a better place. They can help by providing the credit that people need to make the world a better place, but they can also make it possible for people to do irrational and economically destructive things. So when people say that innovation is the source of all progress, that may be true – but not all types of innovation are equal.

You can stop reading here if you want; I’ve made my main point.

The story I’ve told so far is a little simplistic: real innovation is good, some financial innovation is good, but some financial innovation just pushes money around, which could be good or bad. What’s simplistic is the clear line between “unequivocally good” and “double-edged” types of innovation; many innovations are double-edged to some degree.

Imagine we invented a new way to make a whole new class of light, strong, flexible, and cheap materials that made it possible to manufacture millions of different products more cheaply, vastly increasing the material wealth of middle-class households. Wait a second – we did that. They’re called plastics. In the process, we accelerated the depletion of our natural resources including fossil fuels; we created an enormous amount of garbage that is now collecting in giant pools in the middle of our oceans; we poisoned our waterways; and we may be poisoning ourselves as toxins leach from our containers into our food.

The point of this caveat is that many innovations, even “real” innovations, can have negative aspects. (And if those negative aspects are externalities, they will not get incorporated into the aggregate societal decision to produce and consume the resulting products.) So it is never appropriate to say that innovation is always unequivocally good. Still, however, there is a difference between better shoelaces and option ARM mortgages – or between ATMs and option ARM mortgages. The former is a product or service that provides utility directly; the latter is a financial product that enables people to use their money in ways they could not use it previously, with consequences that can be good or bad.

(For a complete list of Beginners articles, see Financial Crisis for Beginners.)

Originally published at the Baseline Scenario and reproduced here with the author’s permission.

2 Responses to "Financial Innovation for Beginners"

  1. Anonymous   April 19, 2009 at 1:42 pm

    Credit cards were introduced in the 1920s by some individual companies such as oil companies and hotel chains for use only at their businesses. Unlike today, they were probably issued exclusively to people who were good credit risks. Diners Club introduced the first universal-use credit card in the 1950s.

  2. Charlie   April 20, 2009 at 11:59 am

    I’m not sure that your argument is as clear as you would like. In an economic sense, all technological innovation leads to a more economically efficient allocation of resources, which simply means lowering the cost of an action. Sometimes it’s the facility of tying shoelaces, and sometimes it’s the portability of water. Others it is the cost of borrowing.Unfortunately, we never know a priori whether the innovation will be on net good or bad. More directly, negative externalities could arise from shoelaces too.In the absence of omniscience or a suitable brightline for good and bad innovation, would it not be more efficient to wait and see which is the case, and then tax the negative externalities as they arise?