Is there real innovation in banking and finance, or just endless, cyclical repetition of credit enthusiasms and mistakes?
James Grant, an acerbic chronicler of the foibles of financial markets, argues that, though science and engineering are progressive, finance is cyclical. Writing in the 1990s about the 1980s, he observed: "In technology, therefore, banking has almost never looked back. On the other hand, this progress has paid scant dividends in judgment. Surrounded by computer terminals, bankers in the 1980s committed some of the greatest howlers in American financial history."
And how about the bankers of the 21st century? Surrounded by vastly more computer power, supplied with reams of data and informed by Nobel Prize-winning financial theories, they made even more egregious mistakes. They created, as we all know so well, an amazing bubble, an international panic and a massively costly bust.
A while ago, the Financial Times had a contest to come up with the best word for the opposite of a "bubble." My entry was a "shrivel" — which did not win. The winning entry was a "bunge." This was drawn from "bungee cord," the idea being that you experience a terrifying free fall but do in the end reach bottom and bounce back. Financial innovation has a lot in common with this pattern.
In every boom, we hear about "creative" new financial products. For example, the Clinton administration's homeownership strategy in the 1990s called for "creative mortgages." An extreme example of this sort of "creativity" was the "option ARM" mortgage, on which you did not even pay all the interest due, thus, in effect, borrowing more every month — and this additional borrowing was booked as income by the lender!
Such products are not real innovations. They are merely new names for diminishing credit standards, running up leverage and increasing risk.
In the same fashion, "CDOs-squared" and "SIVs" were merely new names for lending long and borrowing short, as the "GSE" charters of Fannie Mae and Freddie Mac were for running at extreme leverage. All these ways of increasing old risks by new names bring the same inevitable, sad end. They are all illusory as innovations.
I propose to distinguish between illusory and real financial innovations. Real innovations turn ideas into institutions that endure. Real innovations occur much less frequently than cyclical illusory innovations, of course, because it is hard to do something truly new. Nonetheless, they do happen.
Here are some real innovations from fairly recent financial experience: interest rate swaps. TIPS (these inflation-indexed Treasury securities make it harder for the government to cheat savers through inflation, a worthy achievement), senior-subordinated securitizations, money market mutual funds, automated teller machines, general-purpose charge and debit cards and the 30-year, fixed-rate mortgage.
From further back in financial history, we have: mutual funds, deposit insurance, futures exchanges, stock exchanges and central banks.
True innovations shape and constrain but cannot prevent the next new ideas, and so on forever. The combination of true and illusory innovations ensures that financial markets are always in transition.
The constant challenge to bankers and all financial actors is to try to separate real innovations, which will last and be productive, from the illusory ones, which will tempt them once again to overexpand credit, triggering a credit collapse.
