Financial "innovation"

I just finished reading Panic by Micheal Lewis, which is a collection of pieces that track financial panics starting with the 1987 stock market crash and leading all the way up through to today's housing bubble crisis.

I'll have more to say on it later, but one pattern that seemed to repeat itself involves the dubious activity of "financial innovation"--i.e., Wall Street geniuses inventing some complex new financial instrument that supposedly squeezes more efficiency out of investments, creating greater returns--but in reality just does a good job of hiding risk, fueling a speculative bubble. Here is how the pattern plays out:

1. Some Wall Street geniuses invent some new financial instrument.

2. The instrument is so complex that no one can accurately and independently assess its level of risk--and so they take the Wall Street geniuses' word for it that the financial instrument really does offer better returns for the same amount of risk--that it is a true "innovation". I mean, they're geniuses, right? Look how much math they know!

3. As people buy into the financial instrument, its value increases, creating a cycle of self-validation: the higher it rises, the more solid the "evidence" that the geniuses' theory was right, which leads to more investors hopping on board, which raises the value of the financial instrument higher, and so on.

4. The financial instruments take off on what is in reality a speculative bubble, but what is thought to be the fruits of true financial innovation. Everyone gets richer and richer, and increases their leverage to get richer still ("leverage" means borrowing money to invest, so that you can make even more money. For example, suppose I knew that a horse was a sure thing in a race, but I only had $100. If the payout is 2x, the most I could gross would be $200. But if I borrowed $1 million from my rich uncle, I could gross $2 million, pay back the loan, and go home with a cool $1 million. Of course, if I bet on the wrong horse, then I'm horribly screwed: I go home with a whopping debt of $1 million owed to my uncle).

5. Eventually the risk hidden in the financial instrument (the risk that nobody could see because the financial instrument's complexity obscured it) rears its ugly head, and investors get wiped out. But everyone is now so overleveraged, that the demise of the financial instrument causes a domino effect, where everyone suddenly finds themselves in extreme debt (like the debt I owed to my uncle when my horse lost) that they cannot pay, and all their creditors are suddenly not going to get the money back that they lent out. Markets threaten to seize up as no one can raise money to pay off their debts, because there are no buyers, because everyone is selling at the same time. Eventually, Wall Street is bailed out and upbraided by Senators with spectacles slid half-way down their noses, new financial regulations are solemnly put into place, a few CEOs are fired, and Wall Street returns to business as usual.

6. Go to step 1.

Or at least, something like that. But the real point is that what is happening is a kind of manufactured uncertainty is introduced into the market, which becomes the vehicle for a classic speculative bubble--and when the bubble pops, it threatens to take everything down with it.

But this is particularly troubling, because the whole justification of the financial sector is that, supposedly, it does a better job of any system yet conceived of directing capital to the most useful and efficient places--which benefits us all, by giving the world cheaper goods, new inventions, and steady employment. Fair enough. But if Wall Street is spending its energies chasing mirages and throwing huge amounts of capital into one bubble after the next, then it's not doing a good job at all of allocating resources: it's just kind of arbitrarily sloshing them around. So it's like: what's the point?

(By the way, it's worth noting that Matt Yglesias has often pivoted off the inevitability of Wall Street hijinks to make an argument for more redistribution: basically, the grand deal is made that we'll allow Wall Street (and the investor class in general) to be sickeningly rich and we'll suffer its panics when they come and we'll bail it out if need be, but in return, we get to levy high taxes on the rich that pay for universal health care, child care, and education. I think it's pretty reasonable.)

(Photo lifted from this article, which it turns out is definitely worth reading if you found this post at all interesting.)