One of the most remarkable aspects of the success of Wall Street in subordinating the real economy to its wishes and needs is the con job implicit in the application of the word “innovation” to what might more accurately be described as tax evasion, regulatory arbitrage, and chicanery. Martin Mayer once described innovation as “using new technology to do that which was forbidden under the old technology.”
Rob Johnson, former economist to the Senate Banking Committee, has a new article that parses how the financial services industry has managed to wrap itself in the mantle of progress, when if anything its new products have been a force for destruction rather than creation. We had a wave of new OTC derivative products sold, starting in the early 1990s, whose high profits for the most part depended on the fact that they allowed investors to game ratings or mask the economic substance of transactions or fob risk off on to people who really did not understand it. The industry managed to co-opt SEC chairman Arthur Levittt and fight a delaying action until the media got bored and went on to other matters, A collateralized debt obligation market blew up in the late 1990s only to be reborn in the new millennium in only slightly modified form to wreak havoc on a much greater scale. Abuses of off-balance-sheet vehicles by Enron did not lead to reforms that affected the financial services industry much, since huge carve outs were made so as to keep mortgage securitization alive. And I will admit to having been unable to keep up on the news as fully as I once did, but I don’t recall any of the proposed fixes for the securitization market calling for changes in deal structures and servicer contracts so as to make mortgage mods easier and more attractive.
Innovation. It is a lovely word that teases the mind with the notion of expansive possibilities… A win-win game. Just as Americans once expanded westward to relieve social tensions, we are now exhorted to have a rather imprecise faith in the notion of technological change to deliver us from our current troubles. Embracing that starship to unlimited possibility and deliverance requires a faith that cannot be easily refuted: Who, after all, is against progress?
David Noble, who has written so powerfully about this in his series of books including America by Design, Religion of Technology and Beyond the Promised Land, has explored this mythology of redemption and salvation through changes in technique and deference to undefined dreams of “possibility.” It is time to apply his perspective to the religion of financial innovation.
We have seen the financial sector, with its massive resources and access to the best minds of public relations, work to create what Stuart Ewen calls “spin.” ….we have been ever-so-persistently encouraged to draw the comparison between developments in financial products and the great leap forward in social uses of computers and the Internet, or advances in biomedical research. Former mathematicians, physicists, and computer scientists redirected their energies and Ph.D. tenacity to the domain of finance. Financial innovation was presented to us in a way that suggested that great things were happening for mankind. The presentations were usually vague. To understand them, we had only the power of our own imaginations, or perhaps, failing that, our awe in the face of this powerful expertise, confidently propelling us to a greater future.
Skeptical questioning–”Where are the benefits to be found?”–was frowned upon or ignored. ”Just doesn’t get it,” the whisperers would say. The skeptic was discredited with the insinuation that he or she was either 1) jealous of those who were making money and progress at the same time, or 2) had fallen down like a tired horse and just could not keep up with the new breed of thoroughbreds on Wall Street. After all, what kind of human spirit would get in the way of progress?
The reason I bring forward the notion of “spin” is that I sense that the great benefits of financial innovation were not self-evident, and that some form of intimidation or coercion was needed to keep the genie of doubt in its bottle. If a great Wall Street luminary were actually forcefully questioned, could he really convince grandma and you and me that he was making the world a better place? The point of the exercise, the spin, was to create deference to this process, to deter questioning and create social license, to make what those rocket scientists were doing appear as though their work was not merely profitable but something that would benefit us all. It was presented like a free option to the public: Wall Street pays these guys and “shazam!” They do things that make us all better off. No reason to get in the way of that, or even suggest that your Congressman or friendly bank regulator keep an eye on the proceedings. The subtle message was, “Get out of the way.” Such was the Kool-Aid poured into our glass by the financial press and pundits. That capital avoidance and tax avoidance and regulatory evasion were involved in offshore and off- balance-sheet methods was rarely emphasized, as the notion of innovation was paraded like a badge of valor.
Then we had the crisis. The side effects and spillovers and bailouts reminded us that what we had allowed to unfold was not a free option on progress but something that had a downside, too. It’s funny how a crisis changes your perceptions….
Despite these recent protestations, I am witnessing the lingering hangover of deference to so-called “innovation.” It permeates the debate on regulation. We hear that getting in the way of new technique may cause more problems than it solves. Or that the innovators can always outrun the regulators. Or, and this is my favorite, that nothing you do to stifle these new derivative products like credit default swaps will (ominous music in the background) lead to “systemic risk.” Systemic risk is the new stun-gun phrase to impart dread to those who would tamper with this delicate machine.
Malarky. This is all code for defer to the wishes of those who make money from these techniques.
Financial engineers on Wall Street are employed to make money for Wall Street firms and themselves. There is no hidden code that says they will design their products to align private and social benefits and costs. That is precisely where a healthy role for regulation and laws and enforcement can be envisioned. At the same time, it is important not to be romantic about that vision, though. Regulatory policy often does not live up to the romantic appeal, as theories of collective action and regulatory capture have illuminated.
My takeaway is distinctly unromantic. It is that, devoid of these religious-like connotations, innovation simply implies the use of a new method or technique. It can be harmful or it can be helpful. Let’s keep score. It can benefit us both, or it can harm us both, or it can make you better off and me worse off, or vice versa. That sober reality, and the notion that we are a society, sets the stage for critical thinking about these methods. If credit default swaps serve a purpose and are economically viable when proper capital and margin requirements are in place, then let the proponents bear the burden of proof in convincing us of the benefits to society according to some real social goals, rather than the vague myth of intangible progress. Protecting the profit margins of large investment firms is not a social goal.
We have a serious and real problem right now as a society that employs complex technique. Experts in the financial, nutrition, energy, and health realms have been found wanting when the curtain is pulled back and their behavior examined. Trust, particularly in financial expertise, has been shattered. Early in the 20th century, the so-called Progressive Era was an attempt to bridge the gap between the oligarchs of industry and the populists. Deference to expertise was said to be in the interest of all. Delay gratification and let the experts allocate capital so that in the future we would all be better off was the mantra. It had a religious-like psychic resonance. Experts on economics and social planning were custodians of our future, not unlike the role that priests played in earlier times. Restrain yourself now to achieve the promise of the afterlife. The linchpin was the experts vision and integrity. They were trusted to make sure we all got to economic heaven together.
We just got handed a big bill and the perpetrators that led to the bailouts are back getting large bonuses. If experts cannot be trusted and governments are unwilling to change the rules, then we will once again be heading toward popular reaction. The cooperative game is breaking down. The population showed us a hint of that over the AIG bonuses. A volcano that is still today may yet explode tomorrow.
As I watch the stories of this newest revelation on the wonders of financial innovation, so-called high frequency trading (HFT), I scratch my head and wonder how we got to this place: That most profound mystical deity which we are asked to worship, “the market,” can now be rigged so that a few get to see orders beforehand. As Charles Duhigg wrote last week in the New York Times, “While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee.”
This “innovation”–employing monster computing power and the apparent ability to buy your way to the front of the line–looks like old fashioned front-running to me. How can that contribute to the integrity of our marketplace? Bob Kuttner has written an illuminating piece on this subject. For my part, I just hope that our society can demystify (unspin?) this process. It is time to build a financial system that serves the real economy for the next generation. To do so, we may need to sweep aside some of the so-called innovations in financial practice that were born of this foolish era of market fundamentalism and its supervisory and enforcement laxity. Surely there are techniques that we should adopt. Yet in the aftermath of the crisis the burden of proof is on those who advocate them. Where are the benefits to society? What are the costs? To answer those questions, we must come out from the well spun power cloud of Wall Street and ask real questions. Regarding financial innovation, I am fond of the lyrics of Michael Stipe. It is time we start losing our religion.