People tend to generally assume that the word innovation always carries a positive connotation. While for the most part they may be right, this isn’t always the case. Innovation has the ability to fuel prosperity, but unfortunately it sometimes comes at the expense of the common man. The concept follows that of the distribution of wealth; where one man is rich only because another is poor. I recently came across a blog post by Yves Smith on NakedCapitalism.com titled “On Good and Bad Financial Innovation”, in which Smith explores the world of devious financial innovation. Although the entire post reads like a satire on capitalism and its inabilities to efficiently function unregulated on a mass scale.
“Given the propensity of financial firms to take advantage of widows and orphans, a caveat emptor posture and investment in attaining a higher level of expertise seems prudent.”
Yves starts the topic by dissecting the perspectives of Ben Bernanke and Ryan Avent on the topic of financial innovation. Ryan Avent pointed out that in a recent speech Ben Bernanke had a tough time coming up with examples of good financial innovation that related to the current crisis. Bernanke took the generic route by citing credit cards and securitization. However what we generally have in mind these days are the complex financial derivatives that are the helm of the banking crisis.
The major problem that Yves identifies is the extension of access to credit. He quotes Kwak,
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 home buyers 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…. 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.
Now sure hedging has its benefits, and is an essential tool that allows risk sharing or risk transfer. It is by far the root that is at the bottom of all these complex products. So even though hedging is a great tool, excess use of it can create probleme. First people who actually understand and make use of these credit default swaps should be using them. Take for example a recent case study done by the Motley Fool. When you purchase a corprate bond it has a certain risk attached to it, so it seems like a smart move to have Goldman Sachs insure your risky bond incase of a default. By purchasing this insurance policy you have basically transferred risk for an insurance premium. You have made a solid investment move for which you can now pat yourself on the back for. However you are not my concern, my concern is the man who is being sold a credit default swap but has no idea what he just bought. He purchased it because he believes that the guy selling it to him is smarter than he is, overlooking the fact that he is also the man inheriting the commission. This man has just bought from Goldman Sachs an insurance policy on his U.S. Treasury bond. That is by far the dumbest investment I have ever heard of. So the logic is that there could exist some catastrophic event that would have within it the power to wipe out the entire American Government, but would leave Goldman Sachs left standing to pay you your insurance money.
The first is that these new products were sufficiently complex and opaque that risks were too often dumped on the hapless who didn’t know what they were buying. We’ve seen everything from German Landesbanken, Norwegian villages, Australian pension funds, Jefferson County and a host of other municipalities buying products or entering into swaps they didn’t understand.
Needless to say Yves points out something that has scared us for a very long time. It metaphorically questions the fate of Capitalism and its ability to sustain itself. Today we are combatting our problems through disguised socialism, so the question comes to mind. What’s next for a country that has set economical, political, and social precedents that most of the world has followed? To even attempt to make such an impossible inference would mean that i was suddenly overcome with the illusion of grandeur. However I will say this much, since we have officially started our path through a lightless tunnel, it will be rather interesting to see what comes out the other end.
“Today we are combating our problems through disguised socialism,”
what on earth does this mean? You have such a strong analysis of whats going on – it would be a shame to then let it unravel into meaningless aspersions.
I dont agree that it’s a meaningless statement. The Obama administration has nearly doubled the national deficit in a few months. Banks are on the verge of nationalization. The Federal reserve is constantly printing money to keep up with the stimulus bill, China isn’t giving us any money. If a lesser country had done this, inflation would have wiped out their economy overnight. So yes i do believe that the government is implementing socialist methods. But we don’t say it because in America socialism is a bad word.
what is your definition of socialism? anything that involves state spending? in my understanding of what socialism is (and what capitalism is) there is nothing un-capitalist about deficit spending, nor is their anything uncapitalist about temporary nationalizations. Social democratic states have been doing this (the US included – even though the US is barely social democratic anymore) for ages.
Socialism is about wealth redistribution – creating a more equitable society through non-market means – according to this standard – government bailouts of wall street are far from socialist.
Perhaps my definiton of socialism is a bit tainted, but the point i was trying to get across is that we are seeing a departure from the completely unregulated free market system. I mean why are the financials being bailed out after investing so negligibly. I forgot who said it, but i was once read this great quote that said Capitalism without bankruptcy is like Christianity without hell. I mean rather than letting these insolvent banks fail and the market bottoming out and properly stabalizing the government is making a quick fix at our expense. You can’t help but wonder that the Obama administration favors a boom bust cycle just to make sure his entire presidency isn’t clouded by a prolonged recession. Why not let the good banks Wells Fargo and Chase gain recognition for their efficient business models. Maybe i’m just naive but thats my understanding of it. Maybe it was the wrong choice of words