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February 21, 2010
David Warsh, Proprietor


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Many Pieces, Many Hands

The books and papers pile up. So many pieces to the puzzle! Newspaper reporters provide detailed case studies of particular events – Fool’s Gold, by Gillian Tett, on the invention of credit default swaps; The Greatest Trade Ever, by Gregory Zuckerman, on how hedge fund manager John Paulson put those CDSs to use. Policy-makers give their accounts (From Asian to Global Financial Crisis , by Andrew Sheng; On the Brink , by Henry M. Paulson Jr.; Getting Off Track, by John Taylor). Theorists with formal models, meanwhile, seek to capture the mechanisms that underlie events.

A Columbia University conference last week showcased some of the most promising new attempts to explain what happened: A Macroeconomic Model with a Financial Sector, by Markus Brunnermeier (Princeton) AND Yuliy Sannikov (Princeton); Financial Intermediation and Credit Policy in Business Cycle Analysis; by Mark Gertler (New York University) and Nobohiro Kiyotaki (Princeton); Two Monetary Tools: Interest Rates and Haircuts, by Adam Ashcraft (Federal Reserve Bank of New York), Nicolai Gârleanu (Berkeley) and Lasse Pederson (NYU); and Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts, by Emmanuel Farhi (Harvard) and Jean Tirole.(Toulouse).

Synthesizers of various sorts seek to bridge the gaps.

John Lanchester, of the London Review of Books, is the most recent magazine journalist to produce a broad overview of the crisis. Others include John Cassidy, of The New Yorker (How Markets Fail); Justin Fox, of Harvard Business Review (The Myth of the Rational Market ); and Robert Samuelson, of Newsweek (The Great Inflation and Its Aftermath, revised and with a new introduction in paperback). Lanchester is a distinguished novelist, and in I.O.U. Why Everyone Owes Every One and No One Can Pay, he explains how he stopped gathering material for another novel more than two years ago in order to cover the crisis full time. He is a quick study (and a careful and appropriately grateful reader of Tett, Simon Johnson, Nicholas Nassim Taleb and Paul Krugman). There are lucid descriptions of many technical matters: of bank accounting, the logic of options, futures and swaps, the enthusiasm for value-at-risk accounting.

But Lanchester is also a story-teller of considerable skill; and what emerges is a narrative mainly of nations “yelling woo-hoo and tearing their regulatory clothes off.” Much of this had to do, he says, with the end of the Cold War. Before the Berlin Wall came down, Lanchester writes, “The jet engine of capitalism was harnessed to the ox cart of social justice, to much bleating from the advocates of pure capitalism, but with the effect that Western liberal democracies became the most admirable societies that the world has ever seen.” Afterwards, “the jet engine was unhooked from the ox cart and allowed to roar off at its own speed.” Now the joyride is over now – at least it should be. It’s time to rein in the banks, chuck out the flawed mathematical models, and assure that nothing like the current mess can ever happen again.

Robert Litan takes more or less the opposite view in “In Defense of Much, But Not All, Financial Innovation.” Litan is a senior fellow of the Brookings Institution. He is also vice president of the Ewing Marion Kauffman Foundation, famous for its commitment to entrepreneurship, so presumably he’s got something of an axe to grind. (I am speaking at a Kauffman meeting next month, for which I will receive a fee.) On the other hand, he is a highly regarded regulatory economist.

Condemnations of the role of financial innovation in the near market meltdown of 2008 have become widespread, Litan notes. New York Times columnist and Princeton professor Paul Krugman was typical when he wrote that it was “hard to think of any recent financial innovations that actually aided society, as opposed to being new, improved ways to blow bubbles, evade regulations and implement de facto Ponzi schemes.”

Litan undertook an inventory of innovations since the 1960s and concluded that, on balance, there had been more good ones than bad. Whether they had enabled the economy to grow faster by enhancing productivity was an open question, but, individually and collectively, they had improved access to credit and made life more convenient.

He classified his list of innovations according to the economic purpose that each served – enabling parties to pay one another, mobilizing savings, channeling savings towards productive investments and allocating risks to willing and able bearers – and summarized his findings in the following table, scoring each development under three different headings: access, convenience and contribution to growth.

Some innovations, he allowed, had been poorly designed (collateralized debt obligations, or CDOs; structured investment vehicles, or SIVs). Others often had been misused (credit default swaps, or CDSs; adjustable rate mortgages, or ARMs; home equity lines of credit, or HELOCs). All were susceptible to better design and improved regulation.

Whether you agree with his evaluations or not, the list makes interesting reading. So does the paper.

.                                                 Recent Financial Innovations: A Summary

.                                             Access.            Convenience.        Productivity/GDP

Payments

ATMs                                   ++.                           ++.                                 +

Credit card expansion.          ++.                           ++.                                  +

Debit cards                           ++.                           ++.                                  +

Saving

Money market funds           ++.                             ++.                                  0

Indexed mutual funds          ++.                             ++.                                  +

Exchange-traded funds        +.                                +.                                  0/+

Limited partnerships

Hedge Funds                        0.                                0.                                0/+

Private Equity                       0.                                0.                                   +

TIPS                                   ++.                             ++.                                0/+

(Treasury Inflation Protected Securities)

Investment

Credit scoring                          ++.                      ++.                                  0

ARMs                                     ++.                     N/A+.                               -/–

Home Equity Lines of Credit    ++.                     ++.                                -

Asset-backed securities             ++.                   ++.                       -/+ (see text)

CDOs*                                      ++.                  ++.                                  

SIVs*                                        ++.                   ++.                                  

Rise of Venture Capital                +.                     +.                                   ++

Risk-Bearing

Options/Futures Exchanges

And Pricing                                  +.                    +.                                  +/++

Interest/Currency Swaps            ++.                  ++.                                  +/++

Credit default swaps                     +.                   +.                                     +

*The positive scores here were temporary

Source: Analysis in Litan’s text.

Litan boldly concludes that its more financial innovation we need, not less – specifically. “macromarkets,” as advocated by Robert Shiller, of Yale University, designed to permit individuals to hedge against various currently uninsurable risks. Will consumers some day purchase home equity insurance, career risk insurance, the way they routinely buy health and home insurance today? Perhaps. No time soon.

Negotiations continue, in Congress, between lobbyists, among governments, behind the scenes.

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