Debate On Financial Innovation: Scholes And Putnam's Reyonlds Vs. Grantham And Bookstaber; Innovation Loses

By now you have certainly heard the opinion of one Paul Volcker who claims that the only useful financial innovation over the past 20 years has been the ATM machine. Now please indulge this video, in which Jeremy Grantham and Rick Bookstaber debate popular opinion that financial innovation boosts economic growth, as defended by Myron Scholes and Putnam's Robert Reynolds, and support the case (judged by a popular vote before and after the debate) that financial innovation in recent decades has done nothing but make the financial sector become a "large, heavy, and growing bloodsucker on the economy's back." (and yes, such brilliant developments as HFT, Flash trading, and all other "market efficiency and liquidity enhancing" gimmicks most certainly fall under the innovation umbrella).

Must watch video.

Comments

[Anal_yst]

Having tried to talk some sense into Dr. Bookstaber myself, I appreciate this vid like whoa.  Alas...

[Anonymous]

Same here. Bookstaber is a failed quant with a chip on his shoulder.

[Anonymous]

Why do financial intermediaries draw a greater proportion of GDP to their consumption than their physical economy counterparts?

(1) Gov't compels them to invest or speculate by tax policy. 401K's deliver funds to financiers in order that citizens may avoid great tax penalty AND may provide for retirement.
(2) Gov't policy of inflation makes savings a negative gain proposition. Persons must put money at risk in order to avoid depradation over time. Gov't seeks to put stored capital to highest-best use through allocation of intermediaries. It presumes financiers can target efficiently and are incorrupt actors (both fallacious).
(3) Restrictions on leverage being loosened, hedge funds or their equivalents can use tremendous leverage to make what would normally be tiny returns, magnify into windfall.

Conversely they introduce massive systemic risk and make such outlandish gambles that although their (and investor) capital might be wiped out--it goes further to wiping out domino-like the entire system.
(4) Finance has gained access to political establishment and can access the public treasury to make themselves whole when their gambles go awry. MSM complicity also insulates them from risk consequences.
(5) Through networks, proximity to price exchange, proximity to decision making, even access to trading information just momentarily before such info goes into trade, agents are able to front-run, game, steer, manipulate, defraud other actors without sufficient information.
(6) Fractional reserve banking models allow initiated players to CREATE money and leverage whereby they make windfall gain through interest service and principal repayment, or if structured correctly, through assumption of collateral in event of default.
(7) Financiers act in some concert with the governing structures of their industry i.e. Fed Reserve, Treasury. In helping to implement policy which may be contrary to natural incentives or free market expectations, they are rewarded for such loyalty by covert runs at the public purse. They are made aware in advance of changes in money supply, changes in interest rates, or other minutiae of command "nudges" which other rational financial actors would not conceive, nor prepare for. In short, they win due to corruption.

Why is this system not sustainable?

Because the arts of financiers have grown so adept at stripping value from the system beyond legitimate claims through standard banking or investing that their returns claim most (if not all) the annual accumulations of capital AND drive productive assets into default (which they then claim through foreclosure).

In short, finance has recently come to gather almost all productive increase and is also cannibalizing capital.

Usury must ever fail. Risk requires a return over the risk-free rate. The compounding demand outstrips natural growth to such a degree that if the gap is not reconciled, depressions occur. Depressions long procrastinated or momentarily foiled by monetary, fiscal, or accounting-gimmick policy, assure a devastating collapse. This may be one of those times, in which case it is a COMPLETE RESET.

[BigBagHolder]

Point is kinda moot as energy and investment already headed to other sectors about 2 years ago.  Clean tech, energy tech, iPhone apps, healthcare... all getting the talent again (like in early 90s after that real estate crash).

This does bode well for economy.

Best policy thing would be to move up "capital gains tax".  Why tax income at 30-40% and cap gains at 15%?  I want to incent all working/income roughly equally.

Cap gains back to 20%.  To de-emphasize finance (and high-end tax dodging).

[Anonymous]

i agree with corresponding reductions of labor
taxes to be anacted....that is a huge factor keeping
unemployment high.....

if blobama wanted to create jobs he would slash
employment taxes and raise cap gains....

i am a huge opponent of taxes - especially
income and sales - but in best of worst worlds
my recommendations would be the most sensible
at this point....

the fire economy is out of control.

[Bearish News]

Grantham owned that debate, I was there. The audience poll shifted from like 75-25% for, to  25-75% against.

His best line was about money managers (he's one of the biggest), something to the effect of "All we do is shuffle money around and think up ways to increase fees".

[no cnbc cretin]

Dude, this video is really old. I saw this like late last year. I liked the ending though.

[Anonymous]

it's not old to me....thanks for posting it...

[Ruth]

I'll take FlashTrading for $100, Alex.  Um, yes, sorry, I meant $100Bazillion, ok Brazillion whatever.

[Eternal Student]

Check out the book "The Great Financial Crisis - Causes and Consequences" by John Foster and Fred Magdoff. You'll see that a framework for what's been going on was published back in the 1960's, along with some papers that were published in 2005 and 2006 which predicted what happened in the housing and stock markets. And predicted the current question of "where do you put your money now"?

According to them, we're currently in what looks to be the tail end of a "financialization phase", where people "make money" off of pushing paper around (as I would paraphrase it). This doesn't end well.

[Budd Fox]

For God sake...the bona fide hedgers OWN the damn underlying. The volume of trades in oil derivatives and commodities is so inflated that has NOT anything to do anymore with hedging...that is BS!!!!

[Arthor Bearing]

If you want to understand the effect of banks on the market, analogize it to the effects of cancer on a human body. "Adding liquidity" is another word for pilfering- financing would be done by private investors if there were no banks, banks ONLY damage the economy, and then manipulate the post hoc ergo propter hoc fallacy to take credit for any economic growth (more likely due to new information technologies and expanding international markets). Some day soon a doctor is going to come along and do his utmost to kill the cancer, and to be perfectly frank I don't wish for any of you to be spared.

http://arthorbearing.com/2010/01/institutional-investment-must-die/

[hbjork1]

To each his own.  The cancer analogy doesn't do it for me.  If we have to kill something, the concept of killing fraud and erronious assertion, I like much better. 

Banks are useful.   Mortgage brokers that encourage fasification of financal data and banks that give loans which are then bundled and sold are not.  

Eric Hofer would say these are times of change.  Word meanings change.  I can no longer talk about that time when "my heart was young and gay" with risk of misunderstanding.  But the meaning of "fraud" has not changed for at least several hundred years.  

Through the decades I thought fraud was a crime punishable by law. 

[Anonymous]

I don't know why anyone cares what Scholes thinks anymore.

Volcker hit it on the head recently.

A long time ago, another "old man" Galbraith wrote "FInance is a field that does not lend itself to innovation. What passes for innovation in Finance is leverage packaged up in new forms".

[Anonymous]

Complexity and leverage ratchet up the risk, no doubt about it. This is one of Taleb's main arguments too.

Was the 80's junk bond revolution a financial innovation or did some clever middlemen simply match willing buyers (who were willing to take on the risk/reward) with willing sellers (who needed the $ to start companies and projects) ?? Because there is a pretty good case to be made that all kinds of quality-of-life-improving products came to be only because of junk bonds. Just asking.

Also...so this debate pre-dates the Obama election? And Jeremy is urging us to vote for "Change" and "income equality?"

There's nothing more annoying than a rich guy who wants to pull the ladder up into the tree house AFTER he's comfortably up there himself and too old to worry about the consequences. I know financial "innovation" can't make us all rich but "income equality?" What the fuck Jeremy?

[Anonymous]

you raise some valid points but i am not sure
how cause and effect can be isolated to answer
your first point.....

i would argue that tax reform more than milikanism
and pickensism heralded the unleashing of innovation...

remember that a boat load of capital had been tied
up in ancient investments because the marginal
tax rates were so confiscatory that investors
stayed in stale investments...this was up to c. 1982...

[Sisyphus]

OT. 

***** Privacy Alert ***** Friends in the industry have informed me that major U.S. banks have been instructed to submit Form 104s for cash withdraws lower than the $10,000 threshold required by the Bank Secrecy Act. 

Limit cash withdraws to LESS THAN $2,500 per 24 hour period if you want to avoid being reported to the government.

http://fdralloveragain.blogspot.com/2010/01/privacy-alert.html

[omi]

HFT is good for getting filled and intraday trading.

[ED]

"Financial innovation is the grease that keeps things moving"..?

The grease/fat off the backs of the taxpayer more like.

God bless the whales.

[MikeNYC]

Bookstabers last book, Clif Notes(2) version:

"Boy we really blew the risk management on that one! BOOM! Wow - man you shoulda seen that sucker blow. Hooo-WEEEE!

And then a couple a years later, well, buddy...let's just say we missed ANOTHER ticking time bomb! Ssshhhhhheeeeeeee-BOOM!!!! Damn. Heh-heh. Who woulda thought?

But then this other one time (at band camp) we really dialed up the risk, like, super high? And sheeeooot if that thing didn't blow sky high, just like the water heater on Mythbusters!!!! (and I mean the myth revisited one - right thru the roof!!)"

I swear to friggin god, this guy shouldn't be allowed within 1000 yards of an IB. He seems to have been ringside for every calamity of the past 30 years (often with a risk management role.) And amazingly, offers no personal mea culpas, and seems to laugh at his own dancing from bomb site to bomb site.

It's not just the major characters, the ones making the headlines, that got us to where we are. It's also minor malevolent malfeasants like Bookstaber. I feel like I need to take a shower after just looking at that unctuous bastard. Blech.

hey, RB, before you take another fuckin job somewhere, how about you do a little refresher. Start here. I'm sure it'll be an eye opener:

http://en.wikipedia.org/wiki/Risk_management

[Psquared]

It is funny how you know something intuitively and it turns out to be true. I can remember the mid to late 90s when everyone thought they were a genius because they put money into "index" funds. The monkey throwing darts did just as well.

At the time I remember thinking, what value was created by buying and selling stocks? (Or mutual funds.) How does it create economic growth? It does not build anything, manufacture anything, design anything, nor does it create anything. It only takes something that represents value "on paper" and increase its value. If those profits were directed into other areas of investment I might think differently but there is no evidence that happens.

Trading IBM stock does not promote hiring by IBM - at least not directly. It does not increase R&D it only makes investors and brokers wealthy, "on paper."

There is no trickle down from the stock market and Reagan was wrong.

[heatbarrier]

Take securitization, fundamentally good innovation. But surely 50-tranche MBS is no good and dangerous, so how do you call this? Degeneration?   Only a handful of innovations during the past 30 years need to be preserved IMO.

[sickboy]

Disappointed that both Bookstaber and Grantham were to polite to bring up LTCM to Myron Scholes

I mean LT frikkin CM!!!

Am I missing something here?

In '98 a bunch "smartest people in the business" leverage their capital hundred fold...no two hundred, no even more... 

Smart risk management techniques then, resulted in JPM, GS, Citi/Sallies, Barcap etc...all running the same trades, so they too could be the smartest asses in the room too. Then Russia default results in all those arbitrage/basis trades exposing huge flaw in thinking.

Result, massive aglomeration of risk, resulting in a near cosmic inflection point where the system was ready to explode/implode.

Financial innovators/investment banks/hedge funds/private equity...have learnt nothing. To their credit, the private sector resolved that crisis with much smaller cost to tax payers.

However, similar to today, liquidity traps and the firesale response to huge miscalculated risk taking where idfentical to then.

Financial innovation has its needs and should be restricted to hedging real world risks only.

[Anonymous]

Burning your hand on the stove is the kind of mistake you only make once.

At some level, by bailing out failed financial institutions -beyond FDIC type guarantees- that lesson is never learned and real limits aren't defined. It's that simple.

Grantham says that if the government didn't ride in like the cavalry to save the day we would all be slammed back into the stone age. I think things would have sorted themselves out sooner rather than later. Pain? yes but compared to the moral hazard and slow death we've set ourselves up for now we're going to get the worst of both worlds.

Now that the government has taken on and/or obfuscated the risk of the too-big-to-fail financial institutions who is going to bail them out down the road?

[Anonymous]

Someone should let Myron Scholes know that throwing in "second law of thermodynamics" only intimidates econ graduate students, it doesn't work on anyone with half a brain and some education in physics.

I find the whole Scholes performance despicable, only in the "science" of economics can you take an equation a couple of centuries old, build a "model" around it with assumptions that effectively make it a tautology, and end up getting a "nobel" for it.

Oh wait, the finance industry is even better when it comes to rewarding self-serving pompous asses. You can earn hefty consulting fees while bringing down one giant institution (Salomon Brothers), charge 2 & 20 to lose all your client's money by using the dumbest amount of leverage possible while almost cause financial armageddon (LTCM), and still go on to do it again with a new hedge fund (Platinum Grove) and lose 40% of your investor's money.

Scholes is a good person to trot out ("Nobel" prize clutched firmly in hand) when your broker's about to hand you the largest margin call imaginable. Maybe you'll get lucky and the credit officer will be young enough not to know about LTCM and give you a few more days.

The best he can say is "Obviously, you prefer not to have lost money for investors."

http://www.bloomberg.com/apps/news?pid=20670001&sid=aWQVwbD5Hfxw
http://www.nytimes.com/2009/05/17/magazine/17wwln-q4-t.html

[Anonymous]

Someone should let Myron Scholes know that throwing in "second law of thermodynamics" only intimidates econ graduate students, it doesn't work on anyone with half a brain and some education in physics.

I find the whole Scholes performance despicable, only in the "science" of economics can you take an equation a couple of centuries old, build a "model" around it with assumptions that effectively make it a tautology, and end up getting a "nobel" for it.

Oh wait, the finance industry is even better when it comes to rewarding self-serving pompous asses. You can earn hefty consulting fees while bringing down one giant institution (Salomon Brothers), charge 2 & 20 to lose all your client's money by using the dumbest amount of leverage possible while almost cause financial armageddon (LTCM), and still go on to do it again with a new hedge fund (Platinum Grove) and lose 40% of your investor's money.

Scholes is a good person to trot out ("Nobel" prize clutched firmly in hand) when your broker's about to hand you the largest margin call imaginable. Maybe you'll get lucky and the credit officer will be young enough not to know about LTCM and give you a few more days.

The best he can say is "Obviously, you prefer not to have lost money for investors."

http://www.bloomberg.com/apps/news?pid=20670001&sid=aWQVwbD5Hfxw
http://www.nytimes.com/2009/05/17/magazine/17wwln-q4-t.html

[Anonymous]

Interesting article