The End of Financial Innovation? – The American Spectator | USA News and PoliticsThe American Spectator | USA News and Politics
Modern market economies are marked by a relentless quest for efficiency. In every area of economic endeavor, along all segments of the value chain, and within each function of increasingly complex commercial organizations, greater efficiency equates to increased profits and higher valuations. To be inefficient is to court extinction.
But can there be such a thing as too much efficiency? A place just beyond the peak of a normal distribution, beyond which diminishing and ultimately negative returns result from its continued pursuit? The state of financial innovation today may be at just such a pass.
Financial innovation has historically been an undisputed good: as the funding of enterprise has advanced from the crude to the mind-numbingly complex, funding for promising projects has been plentiful and companies’ cost of capital has fallen. This hasn’t occurred in a vacuum — free-market capitalism (and the financial innovation that has fueled it) arose and flourished under discrete conditions critical to its success.
These factors included democratic polities (or “soft” autocracies on the road to eventual liberalization); high-trust environments ensuing from some combination of cultural factors (such as the Chinese commercial diaspora operating throughout East Asia for millennia) and legal regimes allowing for the enforcement of binding contracts; state policies supportive of peaceful trade with one’s neighbors; hard (physical) and soft (education and civic) infrastructure providing the requisite backbone for commercial activity; and, most importantly, a cultural, ideological, religious, and civic context complementary to economic advancement, the profit motive and private wealth creation, the admixture of which with the other conditions has proved stronger than the natural human inclination of envy towards the material success of others.
Along with creating the environment in which free markets could develop, these conditions in turn spurred financial creativity and efficiency. While enterprise has existed throughout recorded history, the progression from more primitive forms of commercial organization and financing — initially funded with founder capital, through to the growth in bank lending, the rise of joint stock companies, merchant banking, and liquid capital markets, to our now highly complex, globally integrated financial architecture — has expanded the availability and efficiency of capital and promoted the formation, funding, and profitable operation of modern corporations.
The idea that a company or economy may be “too efficient” — whether in general, or from a funding perspective — seems counterintuitive. If something is good — such as widely available, flexible, and low-cost “efficient” capital — isn’t more of it even better?
While this question could be posed of all economic endeavors, financial innovation is particularly salient as it is both more readily observed and broadly consequential than (say) supply chain management or other commercial activities. Expanding the availability of capital and reducing its cost would seem to be objectively good. Capital efficiency is realized through the reduction or elimination of “friction” costs, which are a drag on profitability and value creation; these would seem to be objectively bad. But might there be a benefit to friction costs?
In a technical (say, engineering) sense, efficiency often translates as speed. Financial “speed,” if not properly governed, may overtake the conditions initially conducive to its development. But it is necessary to draw a contrast between false efficiencies (that which do not deliver the benefits promised) and striving for efficiency beyond the inflection point at which it becomes debased.
Not all progress or innovation actually delivers. Any system can misfire even while remaining on the upward slope of the bell curve of efficiency. One need only consider the forced sterilizations and lobotomies of the early and mid-20th century — a period of otherwise impressive medical advances in treating disease and injury — that not everything seen as “progressive” actually constitutes progress. Such “innovations” are now rightly seen as monstrous and maladjusted.
But even legitimate progress, if it creates negative externalities, may subvert confidence in its relevant ecosystem, vitiate the very conditions necessary for continued advancement, and do damage far greater than any benefits realized. In the financial sphere, this damage often manifests as instability, which can threaten the organizations, markets, and societies initially profiting from financial innovation.
Recent financial innovations in the U.S and other developed economies include the democratization of capital, the rise of active markets for corporate control, rapid growth in alternative investment strategies (particularly private equity), borderless and highly integrated global capital markets, and the institutionalization of previously inaccessible and illiquid asset classes. While typically seen as salutary, these developments may incorporate undesirable externalities or contribute to systemic risk.
The great financial crisis of 2008 offers one illustration of innovation gone awry, implicating several of the advancements just noted. The financial market contagion ensuing from the bursting of a housing bubble was accelerated by the securitization of loans against homes in the form of mortgage-backed securities. While the availability and cost of home mortgages used to finance the acquisition of residential real estate — generally recognized as a good thing — benefited from these innovations, the subsequent housing market crash and broader economic and financial consequences of the financial crisis weakened citizens’ faith in the stability and fairness of the global financial system.
While the great financial crisis is an extreme example of innovation gone haywire, myriad less catastrophic examples exist of innovation-related harm. The democratization of equity markets following the deregulation of stock commissions in 1975 interposed additional rent extractors into the marketplace (investment advisors, proxy services, etc.) and increased individual investors’ allocations to traded “screen price” securities, with unnerving consequences in the stock market crashes of 1987, 2000, 2008, and 2020.
Similarly, the liberalization of markets for corporate control spurred an M+A frenzy. While a boon for sellers, the related headquarters moves, job losses, and rootlessness of distant corporate masters are colorably a net loss for society when such externalities are properly accounted for. And while the institutionalization of residential real estate ownership is in its early days, it’s hard to see how the depersonalization of the landlord–tenant relationship and greater distance between owner and “user” won’t risk destabilizing communities in a manner similar to the soulless workforce rationalization typically associated with corporate mergers.
There are two risks in pushing financial efficiency to the descending slope of the bell curve. The first is seen in the direct negative externalities noted above, suggesting that a fulsome cost/benefit accounting that internalizes these costs might discourage harmful “innovation.” The second, and far more dangerous, is that faith in the financial system is so depleted by serial market failures, grotesque and kakistocratic wealth concentration, and two-tiered rule enforcement that populist policies that imperil the golden goose of a market economy garner widespread, bipartisan support.
As a fervent believer that free-market economies are vastly superior at improving the material well-being of the human race, I’m instinctively uneasy with offering a critique of innovations conceived to improve economic efficiency. But the failure to consider the broader consequences of such initiatives, and exercise self-regulatory constraint accordingly, hazards inviting the sort of governmental intervention that is almost certain to do more harm than good.
Richard Shinder is the managing partner of Theatine Partners, a financial consultancy.