More and Better

After the wholesale discrediting of the strong form of the efficient markets hypothesis, Robert Shiller may be the most respected financial economist in the world at the moment. This is what he has to say on the last page of Justin Fox’s The Myth of the Rational Market:

Finance is a huge net positive for the economy. The countries that have better-developed financial markets really do better. . . . I think that we’re less than halfway through the development of financial markets. Maybe there’s no end to it.

I think Shiller’s first and second sentences are almost certainly true. There is a strong correlation between having a high material standard of living and having a relatively sophisticated financial system; think of the United States, Japan, and Germany as opposed to Zimbabwe, for example.  But you can’t infer that more financial market “development” is always better. (I’m not saying that Shiller necessarily believes that, but most of the defenders of financial innovation take it for granted.)

Just because something is good, it doesn’t necessarily follow that more of it is better. Take food, for example. It’s pretty obvious that over a wide range – say from 0 to 1500 calories per day – more food is better for you. For most people that range probably extends up to 2000 calories or a little more. After that, not so much.

I and others have made this point about financial innovation. You could make a similar argument about health care technology. To a point, using more technology – scans, implants, drugs, etc. – does correlate with better outcomes. Beyond that point, if the technology is being used instead of preventative medicine and old-fashioned doctoring, it doesn’t provide much incremental value, and may actually hurt. (If, in addition, the high use of technology is pushing up the cost of health care and making it unaffordable for millions of people, then it may really hurt.) Really all we’re talking about is the fact that marginal returns tend to diminish, and they can diminish to zero.

I’m not saying that we should put a lid on financial (or medical) innovation once and for all. As the economy changes over the next decades and centuries, the financial system we need will change as well. But this fallacy that more of a good thing must always be better is so simple and so deep-seated that it’s worth being aware of it.

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