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I think this is a really good question.

One perspective is that "financial innovations" are just technology. As technology they can be used or abused. Entrepreneurs have been encouraged to create them and to use them.

But is that correct? Another argument is that a social institution (evolved or created) can never truly be like technology. Money provides a function like a technology though it was not originally designed.

I'm unsure which view is right.

Does it really matter now which innovations produced wealth or not? Isn't the more interesting question which could create wealth under better conditions?

What is the market failure here that justifies intervention? I do not think it is asymmetric information between buyers and sellers of financial products. After all, wouldn't both buyers and sellers have incentive to obtain information about the financial risks involved with the product being traded?

Instead, I think Bernanke is arguing that there is something about the complexity of the financial instruments that prevents buyers and sellers from gaining the information they need to make "good decisions". Maybe investors have scarce cognitive resources?

Either way, the primary problem with this argument, that doesn't necc apply to the asymmetric information argument, is that regulators wont be able to determine which financial products are good or bad either!! They will face the same information problems that investors do, but have even less incentive to try understand complex financial instruments. Maybe Bernanke things regulators have more cognitive resources than investors?

More concise summary: Bernanke seems to think there is a market failure that is resulting in over investment. I think Bernanke is arguing that financial products are so complex, neither buyers or sellers can assess their true risk.

This is not so much an argument about asymmetric information as it is an argument about the limits of human cognition. Unfortunately, regulators would also face these same limits as well as the usual incentive problems regulators face.

IOW: Bernanke's argument should make us even LESS confident in proposed regulation.

Bernanke's arguments aren't so persuasive.

I wonder what Jeffrey Friedman would think about this? he talks about cognitive limits a lot.

The logical question is why are investors trying to do things beyond their own cognitive limits? Do they not know them? Perhaps they don't but in time they will be "taught" them by selective elimination of failures.

Good question. I am afraid too many people are going to throw the derivatives baby out with the financial mess bathwater.

It's true that MBS and CDS allowed firms to be much more exposed and hence are now in hotter water, but by the same token if only people had forgotten how to build houses, then we could have averted this catastrophe. Or if they had shut off all the electricity to Wall Street. etc.

"The logical question is why are investors trying to do things beyond their own cognitive limits? "

Most things we do are "beyond" our limits, in that we don't really deeply understand them - but they seem to work and we have some understanding & therefore go with it.

We can look at who is gaining & who is losing - bankers, and in this particular bubble, real estate flippers gained. The public was on the hook for the clean up. Bankers seem to blow things up every 5-10 years, and lose basically all the money & wealth generated in the system over that time. But they have been repeatably taught that this is a win-win for them: they get huge personal rewards, even in the blow up year. A lot of other people gain too. In a sense the system is a pyramid scheme where people on the bottom get hammered every once in a while. I have no problem with this, it is a choice where one can gain and looking at history one should see the risks and how the system operates. But when they make people not playing the pyramid scheme game pay - that is sad, and dangerous. Here we will see much more loss of wealth.

I have no problem with people gambling in Los Vegas, or on Wall Street, or on any scheme - I can say that this is unproductive overall, and I would rather put my money to more productive uses, but it is a choice for people to make for themselves. But once people in Vegas (wall street, etc.) start forcing the general public to pick up the tab...

In a sense value was gained, but for a subset of people, with the system as it is. If bankers & others where on the hook for the losses we would see much more prudent and stable systems - and wealth generation rather than "redistribution" and loss, since the rules of the game would not make it profitable to take large risks (as the risks would be real, "backed" with personal loss).

Good morning, I will have to write a paper for a conference here in Italy about the topic, so I was trying to clarify a couple of points. I'm sorry for the length of my "contribution", but the issue is cumbersome.

1. Innovation destroys habits and rules of thumbs: it is far more likely to make entrepreneurial errors while innovating than while performing simple price arbitraging in a well-known institutional setting: technological recipes and optimal financial structures are to be discovered anew, and bad information and bad incentives have a "leveraged" negative impact in these cases. In a traditional sector I may have a hint that a 20:1 leverage is excessive, but in a new market I have no historical data, just market prices. Innovation and crisis are thus tighly knit, because the latter increase the probability of entrepreneurial error.

2. Innovation can't be regulated in a static way: although a regulation might help avoiding some widespread failure (for example, regulating access to a common is preferable to the tragedy of the common, although internalizing social benefits and costs may be even better*), they can't play the role of entrepreneurs. Innovation is a task for entrepreneurs and not for bureaucrats, hence, a regulation that is good enough to avoid harm will be likely bad enough to outlaw the good.

3. As it all boils down to entrepreneurship, the question turns into something slightly different: which are the entrepreneurial incentives for good and bad innovation? Entrepreneurs innovate because they see profit opportunities, and they see profit opportunities because of the price system conveying information to them+. Here lies the problem with financial innovation: financial prices are distorted, so they give wrong information and wrong incentives.

4. An example: it is intuitively bad to fund a 30-year mortgage with 3-month commercial paper. The mere fact of believing that there will always be sufficiently liquid money markets, and sufficiently low short rates, to enable 120 rollovers in a row in 30 years is folly. However, if money markets are politically manipulated, and if policy activism is widespread, why bother? Monetary policy will shift financial risk from originators (those with weak financial positions) to every money holder (which in the long run will suffer price inflation).

5. I can summarize the problem by saying that entrepreneurship with distorted prices is distorted entrepreneurship: bad incentives create bad innovation, and bad actions pollute the significance of prices. Risk premia will be insignificant and the whole market will be induced to take on too much risk, both because of direct incentives and because of "economic calculation" distortions.

6. Opaqueness can be endogeneous: I don't need to check what's in my portfolio if markets are guaranteed to be liquid, as I just can liquidate everything as soon as I want. The opaqueness theory has the lemon market problem: markets with asymmetric information should not exist (a point made by Caplan in his book on bad democratic policies): what induce market agents to buy opaque instruments instead of undervaluing them to the point of making the market for them impossible? In a rational word, opaque instruments would be illiquid and undervalued. There are two possibilities: either rational agents have incentives to behave inefficiently (moral hazard, for instance), or they are irrational (behavioural finance); on the other hand, the "rational" inefficiency can be endogeneous (market-induced, like in credit channel models), or exogenous (Greenspan-induced). I'm on the blame-Greenspan camp.

7. The post seems to imply that the distinction between good and bad innovation coincides with the distinction between market-driven innovation and policy-driven innovation. I wouldn't be so optimistic, although this point makes totally sense in the present situation, in my opinion. I don't know if markets would work well without governments, I only know that they can't work with systematically distorted prices. We might have bad innovation and bad entrepreneurship also without Mr. Bernanke & Co, but we can't expect to have anything better with these policies. Nobody can distinguish good and bad innovation if markets are forced to convey false information. Regulators can't avoid with one hand the problems that monetary policy-makers create with the other: if incentives are to take on too much risk, regulation will be outmanouvered by skillful financial agents (OTC markets, SPVs, nonbank financial institutions...). Middle-of-the-road policies lead to socialism, and moral-hazard-induced regulation must spread throughout the financial market, from banks to nonbanks, because entrepreneurs will make bad innovations whenever they see fit.

8. The only way to stop the vicious circle is to eliminate the systematic distortion: let entrepreneurs pay their costs. Unfortunately, this is against the received wisdom about the working of financial markets, which are believed to need to be saved from their own failures, so there can't be real entrepreneurs. The Bernanke^ doctrine implies systemic moral hazard and time inconsistency: if policymakers promise to bail the system out, everybody will try to gain a free ride by taking on risk.

These are my confused ideas on the topic. I'm scared by the prospect of having to write a paper on it, but the deadline approaches. :-)

Pietro M.

* Obviously, government intervention would also eliminate incentives to address the problem.

+ It's obviously not whole of the story.

^ Bernanke 1983, "Nonmonetary effects..."

The way I would look at it is this:

There are two kinds of innovations: the useful and the predatory. The useful provides people with something that they value. This is how we would know that it is useful: someone is willing to pay for it.

The predatory innovation is the sort of innovation whose only "value" lies in exploiting the coercive power of the state in order to coerce money out of people. This can be done through "regulations" mandating using these products, or through taking excessive risks in the comfort of a safety net.

In a market that is as butchered with intervention as the US financial system, it is impossible to be able to look back and imagine what is useful and what is not, because the amount of interventions out there makes it impossible to guess whether the innovations were valuable because people willingly paid for them and benefited from them, or because they were handy regulation extortion mechanisms.

With such an extensive amount of innovations and extensive amount of interventions, I don't think anyone could predict what is good or not.

The only way to know would be to run a control experiment where one group of financial systems are butchered with regulations, interventions, safety nets and guarantees, while the other group is completely free. Anything that emerges only in the first group is worse than superfluous, it is downright theft.

This, obviously, is impossible. But a far better idea, of course, is to just get rid of all interventions in financial markets, and see what happens. If MBS's disappear, good riddance. If they stay around, that means they're worthwhile.

The logical consequence of this reasoning is that, if I'm better off fishing more, and all other fishermen are better off fishing more in the same lake, the best state of the world is when not a single fish remains.

That markets would be stable, or at least that their instability would be "optimal" (whatever it means), had not government been involved, is not a defensible proposition of economic theory.

No. Because there are no property rights to fish or the ocean.

Hence, this isn't a place where markets can function. Hence, the problem.

Whenever you have property rights and no governmet interventions, you have functioning markets and no problems. If you have no property rights and/or government intervention, you always have problems.

Very good question. So many prespectives are being considered to answer this question. I'm not an expert, but I enjoyed reading other people's comment about this question.


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