Has Financial Innovation led to increase in capital stock?

Adam Posen and Marc Hinterschweiger of Peterson Institute say:

This mantra of Wall Street investors and financial economists alike implied that expansion in the use of newer derivatives and the like would lead to an expansion in the country’s capital stock, and that these financial products would be useful to nonfinancial companies, not just to banks.

The growth of derivatives and real-sector investment in the United States tell a different story (figure 1). Between 2003 and 2008, US gross fixed capital increased by about 25 percent, a reasonable number during an economic expansion, but hardly a boom. During the same five-year period, the global amount of over-the-counter (OTC) derivatives increased by 300 percent, while derivatives held by the 25 largest US commercial banks rose by 170 percent. Clearly, growth in new financial products has outpaced fixed capital formation both globally and in the United States by a large margin.

An interesting way to analyse benefit of financial innovation. As I had said in my previous report- time to reassess financial innovation. Further:

Another way to assess the presumptive benefits for the real economy of these products is to analyze who made use of derivative instruments. Figure 2 shows the share of OTC derivatives by counterparty as of June 2008 (78 percent of all global derivatives for which such a level of detail is available are included). Reporting dealers, mainly banks and investment banks, accounted for 41 percent of all counterparties (double-counting is eliminated). Other financial institutions acted as counterparties in almost half of all cases. Only 11 percent of all counterparties were nonfinancial costumers.

Hence, almost 90 percent of all derivative contracts took place between financial institutions. Had their usage by financial institutions generated either a boom in productive lending or a more resilient financial system, then, even if unused by nonfinancial companies directly, these new products could still have been productive. Since we have clearly seen the opposite over this time period, it is a revealing indicator that the nonfinancial companies for whom these products were prescribed did not themselves use them.

This is precisely what I also found in my report on CDS (written too early in may 2008). Needless to say the report was not much appreciated.

Finally

In fact, given the gap between these products’ claims and their actual usage and impact, one has to wonder whether recent financial products are like the recalled weight-loss supplement Hydroxycut, the repeatedly crashing DC-10 aircraft, or the Chernobyl nuclear reactor design. If so, even if many financial innovations are beneficial, all of them need to be monitored over the long term, as well as scrutinized before issuance, by regulators for their safety and effectiveness.

That deserves an ouch. Modern finance people surely need to hunt for answers.

Increasing financial regulation or limiting usage of implicit safety net?

I had written a post on 13 January 2009 where I criticised Fed Regional Presidents for not being active. Since then, it has been amazing amount of action by Regional Fed Presidents. Jeff Lacker dissented against Fed’s credit easing policy in FOMC meeting and spokeon the need to revisit Fed-Treasury Accord, Charles Plosser of Philadelphia also on the Fed-Treasury accord, Thomas Hoenig of Kansas has spoken in numerous speeches on the need to let “Too Big to Fail firms” fail, James Bullard of St Louis on the need to have appropriate exit strategy from numerous Fed policies.

Now, in another interesting speech Jeff Lacker says:

As the tumultuous events unfolded in financial markets, the U.S. Treasury, the Federal Reserve and the other federal banking agencies responded with an array of measures to attempt to limit the damage to the financial system and the broader economy. These measures included lending and asset purchases by the Federal Reserve, as well as capital infusions, debt guarantees and expanded deposit insurance from the government. These tools represent an expansion of what we in the United States call the “financial safety net” – the array of programs that use government and central bank funds to support financial institutions

Looking back on the crisis thus far, however, I believe that a strong case can be made that the financial safety net, especially those parts that were more implicit and perceived than explicit and written into the laws, played a significant role in the accumulation of risks that ultimately led to the turmoil we are still experiencing. While deployment of the financial safety net is often viewed as an essential response to the financial crisis, I believe we need to give serious thought to the extent to which the safety net was actually a significant cause of the crisis.

He explains the difference between explicit and implicit fin safety net:

Some of the financial safety net is explicit, and some is implicit. The explicit part includes federal deposit insurance and access for banks to the Fed’s discount window lending facilities. The implicit parts are harder to measure, though probably more significant for understanding the risk-taking incentives of financial market participants. These include, most importantly, the broadly held perception that some institutions are “too big to fail” – that is, the failure of such institutions would be seen by government officials as so disruptive to the financial system that intervention is required in order to mitigate the losses born by their creditors. This belief has built up over the years in response to a series of events and government actions involving large financial institutions. While the explicit parts of the safety net historically have been confined mostly to banks and other deposit-taking institutions, the very nature of the implicit safety net means that it is hard to rule out such treatment for large non-bank financial companies.

This is pretty much the moral hazard problem as well. I remember, Lacker has spoken on on moral hazard on numerous occasions as well. It is amazing to see so may Fed members getting increasingly disconnected with US policies.

But all above words are well-known. The difference this time is the words were spoken and believed by minority and now becoming a majority. What is interesting are the final words:

An expansive and expanding safety net leaves us with two broad choices for addressing our financial stability problems: put an ever-growing blanket of regulation over financial institutions and markets; or set credible limits on the implicit safety net through limiting discretionary protection, coupled with a regulatory regime well calibrated to the extent of the explicit safety net. I prefer the latter.

He revisits the issue/debate with an interesting perspective. Most debate/reports have focused on whether to have more or less financial regulation.

He says we actually have 2 choices – increase regulation or lower implicit safety net. Actually all may prefer latter but this crisis has made implicit safety net so large that more regulation seems to be the only way left. As he himself points, this has increased over the years.  Haldane of BoE in a speechnoted the same problem in UK as well. Bernanke and others have actually asked for a seperate body to regulate non-banking firms that are too big to fail.

A good brief history of monetary policy

Frederick Mishkin has presented a superb history of monetary policy in the sample chapter of his book – Monetary Policy Strategy. Much of it is already known so  is a useful quick read.