financial innovation

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pages: 280 words: 79,029

Smart Money: How High-Stakes Financial Innovation Is Reshaping Our WorldÑFor the Better by Andrew Palmer

Affordable Care Act / Obamacare, algorithmic trading, Andrei Shleifer, asset-backed security, availability heuristic, bank run, banking crisis, Black-Scholes formula, bonus culture, break the buck, Bretton Woods, call centre, Carmen Reinhart, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, computerized trading, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Graeber, diversification, diversified portfolio, Edmond Halley, Edward Glaeser, endogenous growth, Eugene Fama: efficient market hypothesis, eurozone crisis, family office, financial deregulation, financial innovation, fixed income, Flash crash, Google Glasses, Gordon Gekko, high net worth, housing crisis, Hyman Minsky, implied volatility, income inequality, index fund, information asymmetry, Innovator's Dilemma, interest rate swap, Kenneth Rogoff, Kickstarter, late fees, London Interbank Offered Rate, Long Term Capital Management, longitudinal study, loss aversion, margin call, Mark Zuckerberg, McMansion, money market fund, mortgage debt, mortgage tax deduction, Myron Scholes, negative equity, Network effects, Northern Rock, obamacare, payday loans, peer-to-peer lending, Peter Thiel, principal–agent problem, profit maximization, quantitative trading / quantitative finance, railway mania, randomized controlled trial, Richard Feynman, Richard Thaler, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, short selling, Silicon Valley, Silicon Valley startup, Skype, South Sea Bubble, sovereign wealth fund, statistical model, Thales of Miletus, transaction costs, Tunguska event, unbanked and underbanked, underbanked, Vanguard fund, web application

François Velde and David Weir, “The Financial Market and Government Debt Policy in France, 1746–1793,” Journal of Economic History (March 1992). 15. For more on the role of technology in propelling financial innovation, see Stelios Michalopoulos, Luc Laeven, and Ross Levine, “Financial Innovation and Endogenous Growth” (NBER Working Paper 51356, September 2009). 16. Richard Sylla, “A Historical Primer on the Business of Credit Ratings” (paper prepared for a conference of the World Bank, Washington, DC, March 2001). 17. Andrew Odlyzko, “Collective Hallucinations and Inefficient Markets: The British Railway Mania of the 1840s,” SSRN Electronic Journal (2010). 18. Peter Tufano, “Business Failure, Judicial Intervention and Financial Innovation: Restructuring US Railroads in the Nineteenth Century,” Business History Review (1997). 19. Robert Shiller, “The Invention of Inflation-Indexed Bonds in America” (NBER Working Paper 10183, December 2003).

Oscar Gelderblom and Joost Jonker, “Completing a Financial Revolution: The Finance of the Dutch East India Trade and the Rise of the Amsterdam Capital Market, 1595–1612,” Journal of Economic History (2004). 4. Peter Tufano, “Financial Innovation and First-Mover Advantages,” Journal of Financial Economics (1989); Peter Tufano, “Financial Innovation,” Handbook of the Economics of Finance (2003). 5. “The Dojima Rice Market and the Origins of Futures Trading” (Harvard Business School Case Study, November 2010). 6. Minos Zombanakis, “The Life and Good Times of Libor,” Financial World (June 2012). 7. Nicola Gennaioli, Andrei Shleifer, and Robert Vishny, “Neglected Risks, Financial Innovation and Financial Fragility,” Journal of Financial Economics (2012). 8. “Financial Globalisation: Retreat or Reset?” (McKinsey Global Institute, February 2013). 9.

The thread running through the financial crisis of 2007–2008 was bad information—about the quality of borrowers, about who had exposure to whom, about how a default in one place would affect other loans—and it brought down every type of institution, simple and complex.2 The second misconception concerns the benefits of financial creativity. Few areas of human activity now have a worse image than “financial innovation.” The financial crisis of 2007–2008 brought a host of arcane financial processes and products to wider attention. Paul Volcker, one former chairman of the Federal Reserve whose postcrisis reputation remains intact, has implied that no financial innovation of the past twenty-five years matches up to the automatic teller machine in terms of usefulness. Paul Krugman, a Nobel Prize–winning economist-cum-polemicist, has written that it is hard to think of any major recent financial breakthroughs that aided society.3 A conference held by the Economist in New York in late 2013 debated whether talented graduates should head to Google or Goldman Sachs.


pages: 695 words: 194,693

Money Changes Everything: How Finance Made Civilization Possible by William N. Goetzmann

Albert Einstein, Andrei Shleifer, asset allocation, asset-backed security, banking crisis, Benoit Mandelbrot, Black Swan, Black-Scholes formula, Bretton Woods, Brownian motion, business cycle, capital asset pricing model, Cass Sunstein, collective bargaining, colonial exploitation, compound rate of return, conceptual framework, corporate governance, Credit Default Swap, David Ricardo: comparative advantage, debt deflation, delayed gratification, Detroit bankruptcy, disintermediation, diversified portfolio, double entry bookkeeping, Edmond Halley, en.wikipedia.org, equity premium, financial independence, financial innovation, financial intermediation, fixed income, frictionless, frictionless market, full employment, high net worth, income inequality, index fund, invention of the steam engine, invention of writing, invisible hand, James Watt: steam engine, joint-stock company, joint-stock limited liability company, laissez-faire capitalism, Louis Bachelier, mandelbrot fractal, market bubble, means of production, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, Myron Scholes, new economy, passive investing, Paul Lévy, Ponzi scheme, price stability, principal–agent problem, profit maximization, profit motive, quantitative trading / quantitative finance, random walk, Richard Thaler, Robert Shiller, Robert Shiller, shareholder value, short selling, South Sea Bubble, sovereign wealth fund, spice trade, stochastic process, the scientific method, The Wealth of Nations by Adam Smith, Thomas Malthus, time value of money, too big to fail, trade liberalization, trade route, transatlantic slave trade, tulip mania, wage slave

“Records from a Seventh Century Pawn Shop,” in William N. Goetzmann and K. Geert Rouwenhorst (eds.), The Origins of Value: The Financial Innovations That Created Modern Capital Markets. Oxford: Oxford University Press, pp. 56–64. 4. Goetzmann, William N., and K. Geert Rouwenhorst. 2005. The Origins of Value: The Financial Innovations That Created Modern Capital Markets. Oxford: Oxford University Press, p. 62. 5. Elman, Benjamin A. 2013. Civil Examinations and Meritocracy in Late Imperial China. Cambridge, MA: Harvard University Press, p. 176. 6. Von Glahn, Richard, “The Origins of Paper Money in China,” in William N. Goetzmann and K. Geert Rouwenhorst (eds.), The Origins of Value: The Financial Innovations That Created Modern Capital Markets. Oxford: Oxford University Press, pp. 65–90. 7. For an excellent account of the role of government enterprise in the Song, see Smith, Paul J. 1991.

Ukhov, Andrey. 2003. Financial Innovation and Russian Government Debt before 1918. Yale ICF Working Paper 03–20, May 5. Van De Mieroop, Marc. 1986. “Tūram-ilī: An Ur III merchant.” Journal of Cuneiform Studies 38(1): 1–80. ———. 1992. Society and Enterprise in Old Babylonian Ur. Berlin: Dietrich Reimer Verlag. ———. 1997. The Ancient Mesopotamian City. Oxford: Oxford University Press. ———. 2005. “The Invention of Interest: Sumerian Loans,” in William N. Goetzmann and K. Geert Rouwenhorst (eds.), The Origins of Value: The Financial Innovations That Created Modern Capital Markets. Oxford: Oxford University Press, pp. 17–30. ———. 2014. “Silver as a Financial Tool in Ancient Egypt and Mesopotamia,” in Peter Bernholz and Roland Vaubel (eds.), Explaining Monetary and Financial Innovation: A Historical Analysis.

“China would of herself have developed slowly into a capitalist society even without the impact of foreign capitalism,” proclaimed Mao Zedong [毛澤東] in 1939.1 Was Mao correct? Left to its own, without the incursion of Western powers in the nineteenth century, would China ever have become a capitalist power? China has a long history of financial innovation. The Chinese invented metallic coinage, paper money, bills of exchange, transferable rights certificates, sophisticated accounting and management systems, and securitized lending. Examples of wealthy entrepreneurs, financial institutions, private partnerships, and business organizations can be found throughout China’s history. Given all these financial innovations, why were the first global corporations European in origin, not Chinese? I argue in Part II of this book that the answer is rooted fundamentally in the relationship between government and private enterprise in Chinese history.


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13 Bankers: The Wall Street Takeover and the Next Financial Meltdown by Simon Johnson, James Kwak

American ideology, Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, banking crisis, Bernie Madoff, Bonfire of the Vanities, bonus culture, break the buck, business cycle, buy and hold, capital controls, Carmen Reinhart, central bank independence, Charles Lindbergh, collapse of Lehman Brothers, collateralized debt obligation, commoditize, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Edward Glaeser, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, financial intermediation, financial repression, fixed income, George Akerlof, Gordon Gekko, greed is good, Home mortgage interest deduction, Hyman Minsky, income per capita, information asymmetry, interest rate derivative, interest rate swap, Kenneth Rogoff, laissez-faire capitalism, late fees, light touch regulation, Long Term Capital Management, market bubble, market fundamentalism, Martin Wolf, money market fund, moral hazard, mortgage tax deduction, Myron Scholes, Paul Samuelson, Ponzi scheme, price stability, profit maximization, race to the bottom, regulatory arbitrage, rent-seeking, Robert Bork, Robert Shiller, Robert Shiller, Ronald Reagan, Saturday Night Live, Satyajit Das, sovereign wealth fund, The Myth of the Rational Market, too big to fail, transaction costs, value at risk, yield curve

Eventually even Greenspan was forced to admit his mistake in a congressional hearing.55 The recent orgy of financial innovation turned out so badly because financial innovation is not like technological innovation. There are financial innovations that do benefit society, such as the debit card. And derivatives, as discussed earlier, can be useful tools to help companies hedge their operational risks. But there is no law of physics or economics that dictates that all financial innovations are beneficial, simply because someone can be convinced to buy them. The core function of finance is financial intermediation—moving money from a place where it is not currently needed to a place where it is needed. The key questions for any financial innovation are whether it increases financial intermediation and whether that is a good thing.

Finance had become a complex, highly quantitative field that only the Wall Street bankers and their backers in academia (including multiple Nobel Prize winners) had mastered, and people who questioned them could be dismissed as ignorant Luddites. No conspiracy was necessary. Even Summers, a brilliant and notoriously skeptical academic economist (later to become treasury secretary and eventually President Obama’s chief economic counselor), was won over by the siren song of financial innovation and deregulation. By 1998, it was part of the worldview of the Washington elite that what was good for Wall Street was good for America. The aftermath is well known. Although Born’s concept paper did not cause a financial crisis, the failure to regulate not only derivatives, but many other financial innovations, made possible a decade-long financial frenzy that ultimately created the worst financial crisis and deepest recession the world has endured since World War II. Free from the threat of regulation, OTC derivatives grew to over $680 trillion in face value and over $20 trillion in market value by 2008.

Particularly severe episodes of wrongdoing often lead to the implementation of new rules that at least close the particular barn door that had been left open in the past; the most important example was the new regulatory scheme created during the Great Depression. The failures and scandals of the late 1980s and 1990s were closely linked to recent deregulatory policies or financial innovations: expansion of savings and loans into new businesses; junk bonds and leveraged buyouts; quantitative arbitrage trading; and over-the-counter derivatives. Someone familiar with the history of the financial system might have expected this record of disaster to lead to greater skepticism of financial innovation and closer oversight of the industry. Instead, the 1990s witnessed the final dismantling of the regulatory system constructed in the 1930s. The Riegle-Neal Act of 1994 practically eliminated restrictions on interstate banking, allowing bank holding companies to acquire banks in any state and allowing banks to open branches in new states.


pages: 218 words: 62,889

Sabotage: The Financial System's Nasty Business by Anastasia Nesvetailova, Ronen Palan

algorithmic trading, bank run, banking crisis, barriers to entry, Basel III, Bernie Sanders, big-box store, bitcoin, Black-Scholes formula, blockchain, Blythe Masters, bonus culture, Bretton Woods, business process, collateralized debt obligation, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, distributed ledger, diversification, Double Irish / Dutch Sandwich, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, financial repression, fixed income, gig economy, Gordon Gekko, high net worth, Hyman Minsky, information asymmetry, interest rate derivative, interest rate swap, Joseph Schumpeter, Kenneth Arrow, litecoin, London Interbank Offered Rate, London Whale, Long Term Capital Management, margin call, market fundamentalism, mortgage debt, new economy, Northern Rock, offshore financial centre, Paul Samuelson, peer-to-peer lending, plutocrats, Plutocrats, Ponzi scheme, price mechanism, regulatory arbitrage, rent-seeking, reserve currency, Ross Ulbricht, shareholder value, short selling, smart contracts, sovereign wealth fund, Thorstein Veblen, too big to fail

Commonly known as the paradox of aggregation,30 the phenomenon has many facets, with a direct implication for our understanding of the role of financial innovation. First, new financial products and processes tend to be shrouded in complexity, meaning that the full spectrum of information about them may never be available to buyer, client or the regulator.31 Second, always and everywhere, financial innovations are transactions in futurity. This means that buyers often discover an unwanted or risky element far too late, and it may be impossible to correct the outcome due to the conditions of the contract. Third, financial innovations increasingly span several markets, making oversight and regulation of the process extremely challenging. Historically, regulatory arbitrage has been feeding a lot of financial and legal innovation. These three elements, we argue, make financial innovation not only the ideal tactic of moneymaking but also a perfect tool in the Veblenian arsenal of sabotage.

So did the innovation of the personal computer and the smartphone, and most medical innovations. We know comparatively little about financial innovation: in fact, there is only a thin academic literature on the concept, with most studies published after 2009. A wide definition comes from the regulators, who describe financial innovation as the introduction of ‘something new that reduces costs, reduces risks or provides an improved product/service/instrument that better satisfies participants’ demands’ within a financial system.2 Who can object to that? What could possibly be wrong with improving services to clients? Alas, somehow innovation, at least in finance, often leaves a bitter aftertaste, not least among the many who have been sabotaged by the ‘innovation’. One sceptic recently described financial innovation as, simply, regulatory arbitrage.3 Or, put differently, a technique for sabotaging the public welfare and the government.

Collectively, they need to do exactly what Veblen observed more than a hundred years ago: they make money by sabotaging their clients, their competitors, their governments and, ultimately, the market itself. 3 BE FIRST, BE SMARTER AND CHEAT Sabotage by Financial Innovation Another character from the movie Margin Call, John Tuld, beautifully played by Jeremy Irons and based apparently on a composite of the real-life personalities of John Thain of Merrill Lynch and Lehman’s Dick Fuld, lectures his board at a critical point of reckoning for his bank: ‘There are three ways to make a living in this business… Be first, be smarter or cheat.’1 But what if you don’t have to choose between the three ways? A combination of the three tactics, according to John Tuld, would probably constitute the Holy Grail of truly big money in finance. Alas, it appears that such a Holy Grail does exist, and it is linked to the phenomenon of financial innovation. ‘Innovation’ has a nice ring to it. ‘New’ is probably the most popular word in advertising campaigns.


Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages by Carlota Pérez

agricultural Revolution, Big bang: deregulation of the City of London, Bob Noyce, Bretton Woods, business cycle, capital controls, commoditize, Corn Laws, creative destruction, David Ricardo: comparative advantage, deindustrialization, distributed generation, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, Hyman Minsky, informal economy, joint-stock company, Joseph Schumpeter, knowledge economy, late capitalism, market fundamentalism, new economy, nuclear winter, offshore financial centre, post-industrial society, profit motive, railway mania, Robert Shiller, Robert Shiller, Sand Hill Road, Silicon Valley, Simon Kuznets, South Sea Bubble, Thomas Kuhn: the structure of scientific revolutions, Thorstein Veblen, trade route, tulip mania, Upton Sinclair, Washington Consensus

So Irruption witnesses the maximum variety and intensity in financial innovation. Table 13.2 Phase The shifting behavior of financial capital from phase to phase of each surge Prevalent types of innovation A B C D E Prevalent characteristics of finance during the phase F Irruption ❐ ❐ ❐ ❐ ❐ ❐ Maximum intensity of real financial innovation ❐ ❐ ❐ Escape control, attract funds, speculate, inflate assets Synergy ❐ ❐ ❐ Adaptive innovations to accompany growth Maturity ❐ ❐ ❐ Accompany outspreading, escape control and manipulate Frenzy In fact, the whole of the installation period is one of intense experimentation and innovation not only in technology but also in financial practices. The intense connection with the technological revolution from the very early phase builds up a reservoir of appropriate financial innovations capable of dealing with the various peculiar aspects of each paradigm for the whole duration of the surge.

In turn, it is the characteristics of the specific revolution that will determine the nature of the problems to solve by the innovations in both those spheres and, through the principles of the paradigm, the manner in which to solve them. A. Financial Innovations from Phase to Phase The process of switching from a production-led economy in the deployment period to a finance-led economy in the installation period (and vice versa), profoundly affects the direction and intensity of innovation in the financial sphere itself. In fact, as has been discussed throughout Part II, in each of the phases the behavior of finance capital is strongly influenced by the changing quantity and quality of opportunities for augmenting paper wealth. Sometimes the paper values represent real wealth; at others they may be just a perverse form of redistribution. Generally there is a changing mix of both. The same variety will appear in relation to the nature of innovations. Table 13.1 proposes a typology of financial innovations, classifying them according to their main purposes and ranking them from the most useful for the ‘real’ economy to the least useful.

Table 13.1 proposes a typology of financial innovations, classifying them according to their main purposes and ranking them from the most useful for the ‘real’ economy to the least useful. The top ones provide the life-blood for entrepreneurship and production; the lowest ones take blood out of the economy through manipulating paper wealth. 138 The Changing Nature of Financial and Institutional Innovations Table 13.1 139 A tentative typology of financial innovations Type and purpose of financial innovations A Instruments to provide capital for new products or services For radical innovations (bank loans, venture capital and others) To enable large investments and/or spread risks (joint stocks, bank syndicates and so on) To accommodate the financial requirements of new infrastructures (for both construction and operation) To facilitate investment or trade in novel goods or services B Instruments to help growth or expansion For incremental innovations or production expansion (like bonds) To facilitate government funding in different circumstances (war, colonial conquest, infrastructural investment, welfare spending) For moving (or creating) production capacity abroad C Modernization of the financial services themselves Incorporation of new technologies (communications, transport, security, printing and so on) Development of better forms of organization and service to clients (from telegraph transfers, through personal checking accounts and high street banking to automatic tellers and E-banking) Introduction of new financial instruments or methods (from checks to virtual money, local, national and international services and various types of loans and mortgages) D Profit-taking and spreading investment and risk Instruments to attract small investors (various forms of mutual funds, certificates of deposit, bonds, IPOs, ‘junk bonds’) New instruments to encourage and facilitate big risk taking (derivatives, hedge funds and similar) E Instruments to refinance obligations or mobilize assets To reschedule debts or restructure existing obligations (re-engineering, Brady Bonds, swaps and others) To buy active production assets (acquisitions, incorporations, mergers, takeovers, junk bonds) To acquire and mobilize ‘rent’-type assets (real estate, valuables, futures and similar) F Questionable innovations Discovering and taking advantage of legal loopholes (fiscal havens, off-the-record deals and so on) Discovering and taking advantage of incomplete information: ‘making money from money’ (foreign exchange arbitrage, leads and lags and similar) Making money without money (from pyramid schemes to insider trading and outright swindles) 140 Technological Revolutions and Financial Capital Type A and B innovations are those related to the basic role of finance as an intermediary in relation to production investment, either to initiate activities (A), or for growth, expansion and extension (B).


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Never Let a Serious Crisis Go to Waste: How Neoliberalism Survived the Financial Meltdown by Philip Mirowski

"Robert Solow", Alvin Roth, Andrei Shleifer, asset-backed security, bank run, barriers to entry, Basel III, Berlin Wall, Bernie Madoff, Bernie Sanders, Black Swan, blue-collar work, Bretton Woods, Brownian motion, business cycle, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, constrained optimization, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, dark matter, David Brooks, David Graeber, debt deflation, deindustrialization, do-ocracy, Edward Glaeser, Eugene Fama: efficient market hypothesis, experimental economics, facts on the ground, Fall of the Berlin Wall, financial deregulation, financial innovation, Flash crash, full employment, George Akerlof, Goldman Sachs: Vampire Squid, Hernando de Soto, housing crisis, Hyman Minsky, illegal immigration, income inequality, incomplete markets, information asymmetry, invisible hand, Jean Tirole, joint-stock company, Kenneth Arrow, Kenneth Rogoff, Kickstarter, knowledge economy, l'esprit de l'escalier, labor-force participation, liberal capitalism, liquidity trap, loose coupling, manufacturing employment, market clearing, market design, market fundamentalism, Martin Wolf, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, Naomi Klein, Nash equilibrium, night-watchman state, Northern Rock, Occupy movement, offshore financial centre, oil shock, Pareto efficiency, Paul Samuelson, payday loans, Philip Mirowski, Ponzi scheme, precariat, prediction markets, price mechanism, profit motive, quantitative easing, race to the bottom, random walk, rent-seeking, Richard Thaler, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, savings glut, school choice, sealed-bid auction, Silicon Valley, South Sea Bubble, Steven Levy, technoutopianism, The Chicago School, The Great Moderation, the map is not the territory, The Myth of the Rational Market, the scientific method, The Wisdom of Crowds, theory of mind, Thomas Kuhn: the structure of scientific revolutions, Thorstein Veblen, Tobin tax, too big to fail, transaction costs, Vilfredo Pareto, War on Poverty, Washington Consensus, We are the 99%, working poor

Of course, MacKenzie realized that the narrative of “technological error” seems on its face implausible (pp. 1830–32); but by focusing so intently upon the narrowly confined world of the low-level analysts and traders, he misses most of the action surveyed in this volume. 43 Shiller, Finance and the Good Society, p. 13. 44 In Norris, “The Crisis Is Over, but Where’s the Fix?” 45 See Litan, “In Defense of Much, but Not All, Financial Innovation” and The Derivatives Dealer’s Club and Derivates Markets Reform; Litan and Wallison, Competitive Equity; Eichengreen, “The Crisis in Financial Innovation”; Shiller, “Radical Financial Innovation,” “In Defense of Financial Innovation,” and Finance and the Good Society. 46 Shiller, “Radical Financial Innovation” and “In Defense of Financial Innovation.” 47 Shiller, Interview on Finance and the Good Society. 48 Ibid. 49 Ibid. 50 The fact that Shiller has a conflict of interest in promoting the Case-Shiller index and his other financial contraptions is revealed by the mission statement of his company, at www.macromarkets.com/index.shtml.

The prospect of the government serving as market-maker of last resort presumably cannot be extended indefinitely, which brings us to the final long-game component of the full-spectrum brace of policies: the crisis analogue of geoengineering for neoliberals is the equally science-fiction prospect of financial innovation as the mode of ultimate deliverance from economic stagnation. Just as with geoengineering, the policy consists more of insubstantial promise than in demonstrated capabilities; but it plays an important pivotal political role nonetheless. The prophets of financial innovation are at pains to portray the invention of new pecuniary instruments, practices, and products as on a par with the science-based innovation of new physical technologies; in other words, it is the very apotheosis of the market coming to terms with an evolving nature. Indeed, one of the first people to promote the notion of financial innovation as a phenomenon commensurate with technological change was the Chicago neoliberal economist Merton Miller, again demonstrating direct affiliations with the thought collective.40 Miller himself admitted that much of the motive for this innovation was to avoid or circumvent prior regulations; but later discussions tended instead to stress purported improvements in general welfare, on the same footing as welfare gains from enhanced solar cells or combustion engines.

See, for instance, Chang, “The Revival—and the Retreat—of the State?” 39 See MacKenzie and Demos, “Credit Default Swap Trading Drops.” This estimate may be limited in its geographic range, and is probably too low. 40 Miller, “Financial Innovation.” 41 Some examples of the “social studies of finance” are MacKenzie, An Engine, Not a Camera; MacKenzie et al., Do Economists Make Markets?; and Preda and Knorr-Cetina, Handbook of the Sociology of Finance. The critique of the role of science studies in helping reify this interpretation of financial innovation can be found in Engelen et al., “Reconceptualizing Financial Innovation.” 42 I refer here to a paper by Donald MacKenzie (“The Credit Crisis as a Problem in the Sociology of Knowledge”), who argues that a shift in cultures of evaluation within the ratings agencies, from older corporate collateralized debt obligations to the newer CDOs composed of mortgage-backed securities, accounted for a number of “slips” when it came to evaluation of the dangers posed by the latter.


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The Devil's Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . And Are Ready to Do It Again by Nicholas Dunbar

asset-backed security, bank run, banking crisis, Basel III, Black Swan, Black-Scholes formula, bonus culture, break the buck, buy and hold, capital asset pricing model, Carmen Reinhart, Cass Sunstein, collateralized debt obligation, commoditize, Credit Default Swap, credit default swaps / collateralized debt obligations, delayed gratification, diversification, Edmond Halley, facts on the ground, financial innovation, fixed income, George Akerlof, implied volatility, index fund, interest rate derivative, interest rate swap, Isaac Newton, John Meriwether, Kenneth Rogoff, Kickstarter, Long Term Capital Management, margin call, market bubble, money market fund, Myron Scholes, Nick Leeson, Northern Rock, offshore financial centre, Paul Samuelson, price mechanism, regulatory arbitrage, rent-seeking, Richard Thaler, risk tolerance, risk/return, Ronald Reagan, shareholder value, short selling, statistical model, The Chicago School, Thomas Bayes, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, yield curve, zero-sum game

Extine would politely send them on their way, but Smith was intrigued by their pitches for commercial paper issued by unfamiliar finance companies with odd names like Rhineland, Tango, McKinley Funding, and Mainsail II.2 The ratings agencies wrote approvingly about these IOUs, which were known as asset-backed commercial paper (ABCP). Little did he know that he was about to be a guinea pig for the latest tricks of love-to-win investment bankers and their ratings agency accomplices. Driven by short-term gains, they found in people like Smith the ultimate twist in a challenge that had spurred financial innovation for centuries. The assurance of liquidity that Extine and Smith craved—the idea that their investments could be redeemed, dollar for dollar, whenever cash was needed—was nothing new. It was behind one of the oldest financial innovations of all, the invention of banking. How do banks get away with taking depositors’ cash and lending it out to borrowers who won’t pay the money back for years? Like the Cowardly Lion, the Scarecrow, and the Tin Man getting green spectacles from the Wizard of Oz, the depositors happily walk around thinking their cash is available whenever they want it.

Next came their easy seduction of traditional bankers and consumers, which led to a corruption of the ratings agencies, all of which was encouraged—either openly or through benign neglect—by the regulatory agencies charged with monitoring these people. Add several trillion dollars, and you have a recipe for disaster. It took a final, crucial ingredient—a catalyst, an ingenious and insidious financial innovation that made it all possible. A helpful tool that upended the distinction between banking and markets. An enabler of a massive shift of power toward love-to-win traders that traditionalists barely understood despite their insistence that they too were “sophisticated.” A mechanism for replicating reality and synthesizing financial robots that allowed complexity to go viral. It’s time to meet our first derivatives.

Back in the late 1990s, such back-and-forths may have been good fodder for academic debate but didn’t seem to matter much in the real world. But business pressures suddenly put the two worlds at odds. There was the pressure on senior bankers such as Chase’s Marc Shapiro and J.P. Morgan’s Peter Hancock to shift credit risk off their balance sheets, and the pressure on investment banks to respond to the threat of commercial banks’ breaking into the securities business. But what really rocked both of these worlds was a radical financial innovation: credit derivatives. Imagine a bank looking to make corporate loans or to own bonds—but without the credit risk. How does it strip out the risk? Easy: think of the loan as two separate parts. Pretend the loan is made to a borrower as safe as the government, which will repay the money without fail, and pays a “risk-free” rate of interest in compensation. Then there is an “insurance policy” or indemnity, for which the risky borrower pays an additional premium to compensate the lender for the possibility of not repaying the loan (although they might have to hand over some collateral).


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Financial Market Meltdown: Everything You Need to Know to Understand and Survive the Global Credit Crisis by Kevin Mellyn

asset-backed security, bank run, banking crisis, Bernie Madoff, bonus culture, Bretton Woods, business cycle, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, disintermediation, diversification, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Francis Fukuyama: the end of history, George Santayana, global reserve currency, Home mortgage interest deduction, Isaac Newton, joint-stock company, Kickstarter, liquidity trap, London Interbank Offered Rate, long peace, margin call, market clearing, mass immigration, money market fund, moral hazard, mortgage tax deduction, Northern Rock, offshore financial centre, paradox of thrift, pattern recognition, pension reform, pets.com, plutocrats, Plutocrats, Ponzi scheme, profit maximization, pushing on a string, reserve currency, risk tolerance, risk-adjusted returns, road to serfdom, Ronald Reagan, shareholder value, Silicon Valley, South Sea Bubble, statistical model, The Great Moderation, the new new thing, the payments system, too big to fail, value at risk, very high income, War on Poverty, Y2K, yield curve

As soon as both banks and Wall Street realized that the securitization ‘‘financial sausage machine’’ could be tweaked to manufacture marketable debt securities out of almost any type of loan, a wholesale migration of credit from bank balance sheets into the financial 57 58 FINANCIAL MARKET MELTDOWN markets was set off. In the late twentieth century, the big brains in finance all thought that financial market intermediation had permanently gained the upper hand on bank balance sheet intermediation through the ‘‘financial innovation’’ that started with mortgages. They were wrong. It turns out that the asset securitization model provided the explosives to blow up the global economy. 3 t FINANCIAL INNOVATION MADE EASY ‘‘The business of banking ought to be simple; if it is hard it is wrong. The only securities which a banker, using money that he may be asked at short notice to repay, ought to touch, are those which are easily saleable and easily intelligible.’’ —Walter Bagehot, The Economist, January 9, 1869.

Box 1911 Santa Barbara, California 93116-1911 This book is printed on acid-free paper Manufactured in the United States of America To my wife Judy, who has always patiently supported my writing ventures and both typed the handwritten drafts of the text and suggested important changes in direction and tone throughout the project, and to my historian daughter Elizabeth who offered great encouragement and good advice to her dad. CONTENTS t INTRODUCTION: Money, Markets, Manias, and You ix CHAPTER 1: A Tour of the Financial World and Its Inhabitants CHAPTER 2: The Financial Market Made Simple 29 CHAPTER 3: Financial Innovation Made Easy 59 CHAPTER 4: How We Got Here 75 CHAPTER 5: The Fed Demystified 101 CHAPTER 6: The Limits of Financial Regulation 117 CHAPTER 7: The Natural History of Financial Folly 135 CHAPTER 8: What Should Be Done? 161 Conclusion 179 Index 191 vii 1 INTRODUCTION Money, Markets, Manias, and You t The purpose of this book is to help you understand what is happening in the global financial economy, why it is happening, and what can be done about it.

If things turn out as badly as it looks like they might, people will also wonder why somebody didn’t stop it in its tracks. The answer is, in part, because ‘‘innovation’’ is genuinely viewed as a good thing in our culture— change is a good word. The other answer is that this was a quarter century of remarkably benign financial circumstances. Above all, it was a great party, and lots of people got very rich. Financial Innovation Made Easy BANKS DISCOVER CONSUMER LENDING The early 1980s witnessed something that has been called the retail banking revolution. This started in the United States and spread to the United Kingdom and other rich countries. Traditionally, banks only looked to consumers like you and me for deposits. Classic banking turned our OPM into ‘‘working capital’’ for business and industry. Lending money to consumers was always left to retailers, finance companies, and savings banks.


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Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe by Greg Ip

Affordable Care Act / Obamacare, Air France Flight 447, air freight, airport security, Asian financial crisis, asset-backed security, bank run, banking crisis, break the buck, Bretton Woods, business cycle, capital controls, central bank independence, cloud computing, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, Daniel Kahneman / Amos Tversky, diversified portfolio, double helix, endowment effect, Exxon Valdez, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, global supply chain, hindsight bias, Hyman Minsky, Joseph Schumpeter, Kenneth Rogoff, lateral thinking, London Whale, Long Term Capital Management, market bubble, money market fund, moral hazard, Myron Scholes, Network effects, new economy, offshore financial centre, paradox of thrift, pets.com, Ponzi scheme, quantitative easing, Ralph Nader, Richard Thaler, risk tolerance, Ronald Reagan, Sam Peltzman, savings glut, technology bubble, The Great Moderation, too big to fail, transaction costs, union organizing, Unsafe at Any Speed, value at risk, William Langewiesche, zero-sum game

Attendees included Ben Bernanke and Mervyn King, future heads of the Fed and Bank of England, respectively, and Paul Krugman, future Nobel laureate. None needed convincing that finance had become more treacherous. The puzzle was why the economy kept humming. Larry Summers, who would later serve as Treasury secretary to Bill Clinton and adviser to Barack Obama, had a theory. Technological and financial innovation, he told the group, had indeed made finance more bubble-prone. He sketched out a scenario of how a crisis and deep recession could recur. Still, he concluded, since the Great Depression, the federal government had erected firewalls between the financial system and the real economy where ordinary people worked and invested: the vast federal budget, deposit insurance, and, most important, an activist Federal Reserve: “It is now nearly inconceivable that there would be no active lender of last resort in time of crisis.”

As a graduate student at Harvard he worked closely with both Schumpeter, a leading scholar of the Austrian school, and Alvin Hansen, Keynes’s most influential disciple. Minsky agreed with Keynes that the economy needed a big, active government to avoid depressions. But he also thought Keynesian models gave short shrift to the financial system. They assumed that the central bank had full control of the money supply, credit, and interest rates. Minsky argued that the volume of money and credit didn’t depend just on the central bank but on financial innovation. If, to control inflation, the Fed restricted the growth of lending by banks, then Wall Street’s innovators would come up with mechanisms to go around banks and get credit to those who wanted to borrow. Innovation, he predicted, proceeded through three stages: the first, “hedge” stage, when it served business’s legitimate need to manage risk; the second, “speculative” phase, when it served mostly to finance rising asset prices; and a final, “Ponzi” stage, when investors had to borrow more simply to pay the interest on past borrowings.

So securities firms began using mortgage-backed securities that were designed to be as safe as Treasurys, and had the same top AAA rating. In 2008 lenders were nervous enough about AAA-rated MBSs to refuse to refinance repo loans that used them. Bear Stearns collapsed in 2008 largely because it couldn’t refinance its maturing repo loans, which, given the lessons learned from Drexel, simply wasn’t supposed to happen. Drexel’s experience amply illustrated how a financial innovation that seemed at the time to reduce risk once it became widespread enough, did the opposite, and raised risk throughout the system. Another example was the use of mortgage-backed securities. Because American banks tended to be regional, they were acutely vulnerable to localized housing busts. Deep downturns in Massachusetts and Texas had sent many local banks over the edge. MBSs made it possible to pool loans from around the country, diluting the effect of a housing bust in any region on the overall portfolio.


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Taming the Sun: Innovations to Harness Solar Energy and Power the Planet by Varun Sivaram

addicted to oil, Albert Einstein, asset-backed security, autonomous vehicles, bitcoin, blockchain, carbon footprint, cleantech, collateralized debt obligation, Colonization of Mars, decarbonisation, demand response, disruptive innovation, distributed generation, diversified portfolio, Donald Trump, Elon Musk, energy security, energy transition, financial innovation, fixed income, global supply chain, global village, Google Earth, hive mind, hydrogen economy, index fund, Indoor air pollution, Intergovernmental Panel on Climate Change (IPCC), Internet of things, M-Pesa, market clearing, market design, mass immigration, megacity, mobile money, Negawatt, off grid, oil shock, peer-to-peer lending, performance metric, renewable energy transition, Richard Feynman, ride hailing / ride sharing, Ronald Reagan, Silicon Valley, Silicon Valley startup, smart grid, smart meter, sovereign wealth fund, Tesla Model S, time value of money, undersea cable, wikimedia commons

., regulations that govern power utilities).d Notes a. Adam B. Jaffe, Richard G. Newell, and Robert N. Stavins, “Technological Change and the Environment,” in K-G Maler and J. R. Vincent (eds.), Handbook of Environmental Economics, Volume 1 (Amsterdam, Netherlands: Elsevier Science B.V., 2003): 461–516. b. This is based on the Financial Times Lexicon definition of financial innovation, http://lexicon.ft.com/Term?term=financial-innovation. c. See Karan Girotra and Serguei Netessine, “Four Paths to Business Model Innovation,” Harvard Business Review (July/August 2014): https://hbr.org/2014/07/four-paths-to-business-model-innovation. d. See Theocharis D. Tsoutsos and Yeoryios A. Stamboulis, “The Sustainable Diffusion of Renewable Energy Technologies as an Example of an Innovation-Focused Policy,” Technovation 25 (2005): doi:10.1016/j.technovation.2003.12.003.

Given these characteristics, solar power lines up well with the needs of deep-pocketed institutional investors around the world. All of this suggests that it is only a matter of time before new approaches dramatically expand the pool of capital available to fund solar power. The financial innovation needed to expand this pool of capital does not require reinventing the wheel. Under Schumpeter’s paradigm (see box 3.1 in chapter 3), an innovation is an invention that has been brought to market. So adapting novel financial instruments from other sectors and popularizing them for the first time in the solar sector exemplifies financial innovation. According to New York’s energy czar, Richard Kauffman, there is plenty of inspiration to be drawn from other sectors of the economy to augment funding sources for solar projects: Projects in the [United States] rely upon an old-fashioned and anachronistic form of financing that is different than how other parts of the U.S. economy are financed.

But the drop makes it harder for emerging technologies that might not be cost-competitive before economies of scale kick in at mass production to break into the market in the long run. What’s more, the financial innovation discussed in chapters 4 and 5 could aid this lock-in. Silicon solar projects might soon be able to tap into public capital markets and access cheap finance, thanks to the existence of decades of performance data and thirty-year manufacturer warranties. That ability would add another cost advantage to silicon over emerging technology competitors that public investors, having just gotten comfortable with silicon technology, would be loath to bet on. As a result, financial innovation could act as a barrier, rather than a bridge, to technological innovation. Public policy can exacerbate lock-in as well. In the nuclear case, by applying rules that were customized for light water reactors, U.S. nuclear regulators have made it very difficult for firms to deploy new reactor designs.


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Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe by Gillian Tett

accounting loophole / creative accounting, asset-backed security, bank run, banking crisis, Black-Scholes formula, Blythe Masters, break the buck, Bretton Woods, business climate, business cycle, buy and hold, collateralized debt obligation, commoditize, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, easy for humans, difficult for computers, financial innovation, fixed income, housing crisis, interest rate derivative, interest rate swap, Kickstarter, locking in a profit, Long Term Capital Management, McMansion, money market fund, mortgage debt, North Sea oil, Northern Rock, Renaissance Technologies, risk tolerance, Robert Shiller, Robert Shiller, Satyajit Das, short selling, sovereign wealth fund, statistical model, The Great Moderation, too big to fail, value at risk, yield curve

Morgan management was resisting strongly, and Hancock sketched out its alternative vision for revitalizing the bank, maintaining its hallowed role as an independent player. Morgan would continue harnessing the power of financial innovation, such as derivatives, to make itself into a sharp, focused investment bank that could continually serve its clients with new products. His listeners were unmoved. At the end of the meeting, another electronic vote was conducted, and the proportion in the crowd who believed in the bank’s strategy had not risen at all. Most of the staff—the junior staff at least—shared Hancock’s belief in the power of financial innovation. But they also knew that the rest of Wall Street was making much higher returns from the internet and financial merger boom than J.P. Morgan was producing with derivatives, and the senior managers came across as increasingly out of touch.

The first of these results was what attracted Hancock and his team to the pursuit. It would be the second feature that would come to dominate the business a decade later, eventually leading to a worldwide financial catastrophe. [ TWO ] DANCING AROUND THE REGULATORS There was a critical juncture, around the time that Peter Hancock’s team seized on the idea of credit derivatives, when financial innovation might have followed a subtly different path. In the few years leading up to Hancock’s Boca off-site, regulators and many prominent banking experts grew concerned about the boom in derivatives and the proliferation of exotic new types. They fiercely debated whether regulations should be imposed. Peter Hancock found himself at the heart of this debate. In 1991, three years before the Boca Raton meeting, he had received an unexpected summons from Morgan CEO Dennis Weatherstone.

If they had just managed to stay independent for a few more months, the share price of Chase would have crashed. Events would have turned out quite differently. They felt as if the fates were laughing at them. But even as they reeled from the carnage, the innovation cycle was about to heat up again, and with the wonders of dot-coms soundly repudiated, attention would turn anew to the marvelous potential of credit derivatives and other forms of financial innovation. On January 3, 2001, the US Federal Reserve suddenly announced a 50-basis-point cut in interest rates, reducing them to 6 percent. That news stunned the markets almost as much as the internet collapse. In the prior eight years, Alan Greenspan had made a virtue out of running monetary policy in a calm, controlled manner, decreasing rates steadily but slowly at just 25 basis points a shot.


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The Ascent of Money: A Financial History of the World by Niall Ferguson

Admiral Zheng, Andrei Shleifer, Asian financial crisis, asset allocation, asset-backed security, Atahualpa, bank run, banking crisis, banks create money, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, BRICs, British Empire, business cycle, capital asset pricing model, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, collateralized debt obligation, colonial exploitation, commoditize, Corn Laws, corporate governance, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, deglobalization, diversification, diversified portfolio, double entry bookkeeping, Edmond Halley, Edward Glaeser, Edward Lloyd's coffeehouse, financial innovation, financial intermediation, fixed income, floating exchange rates, Fractional reserve banking, Francisco Pizarro, full employment, German hyperinflation, Hernando de Soto, high net worth, hindsight bias, Home mortgage interest deduction, Hyman Minsky, income inequality, information asymmetry, interest rate swap, Intergovernmental Panel on Climate Change (IPCC), Isaac Newton, iterative process, John Meriwether, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, knowledge economy, labour mobility, Landlord’s Game, liberal capitalism, London Interbank Offered Rate, Long Term Capital Management, market bubble, market fundamentalism, means of production, Mikhail Gorbachev, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, mortgage tax deduction, Myron Scholes, Naomi Klein, negative equity, Nelson Mandela, Nick Leeson, Northern Rock, Parag Khanna, pension reform, price anchoring, price stability, principal–agent problem, probability theory / Blaise Pascal / Pierre de Fermat, profit motive, quantitative hedge fund, RAND corporation, random walk, rent control, rent-seeking, reserve currency, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, seigniorage, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spice trade, stocks for the long run, structural adjustment programs, technology bubble, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Bayes, Thomas Malthus, Thorstein Veblen, too big to fail, transaction costs, undersea cable, value at risk, Washington Consensus, Yom Kippur War

Despite our deeply rooted prejudices against ‘filthy lucre’, however, money is the root of most progress. To adapt a phrase from Jacob Bronowski (whose marvellous television history of scientific progress I watched avidly as a schoolboy), the ascent of money has been essential to the ascent of man. Far from being the work of mere leeches intent on sucking the life’s blood out of indebted families or gambling with the savings of widows and orphans, financial innovation has been an indispensable factor in man’s advance from wretched subsistence to the giddy heights of material prosperity that so many people know today. The evolution of credit and debt was as important as any technological innovation in the rise of civilization, from ancient Babylon to present-day Hong Kong. Banks and the bond market provided the material basis for the splendours of the Italian Renaissance.

In the five years to 31 July 2007, all but two of the world’s equity markets delivered double-digit returns on an annualized basis. Emerging market bonds also rose strongly and real estate markets, especially in the English-speaking world, saw remarkable capital appreciation. Whether they put their money into commodities, works of art, vintage wine or exotic asset-backed securities, investors made money. How were these wonders to be explained? According to one school of thought, the latest financial innovations had brought about a fundamental improvement in the efficiency of the global capital market, allowing risk to be allocated to those best able to bear it. Enthusiasts spoke of the death of volatility. Self-satisfied bankers held conferences with titles like ‘The Evolution of Excellence’. In November 2006 I found myself at one such conference in the characteristically luxurious venue of Lyford Cay in the Bahamas.

By making their bank bigger and more diversified than any previous financial institution, they found a way of spreading their risks. And by engaging in currency trading as well as lending, they reduced their vulnerability to defaults. The Italian banking system became the model for those North European nations that would achieve the greatest commercial success in the coming centuries, notably the Dutch and the English, but also the Swedes. It was in Amsterdam, London and Stockholm that the next decisive wave of financial innovation occurred, as the forerunners of modern central banks made their first appearance. The seventeenth century saw the foundation of three distinctly novel institutions that, in their different ways, were intended to serve a public as well as a private financial function. The Amsterdam Exchange Bank (Wisselbank) was set up in 1609 to resolve the practical problems created for merchants by the circulation of multiple currencies in the United Provinces, where there were no fewer than fourteen different mints and copious quantities of foreign coins.


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Why Wall Street Matters by William D. Cohan

Apple II, asset-backed security, bank run, Bernie Sanders, Blythe Masters, bonus culture, break the buck, buttonwood tree, corporate governance, corporate raider, creative destruction, Credit Default Swap, Donald Trump, Exxon Valdez, financial innovation, financial repression, Fractional reserve banking, Gordon Gekko, greed is good, income inequality, Joseph Schumpeter, London Interbank Offered Rate, margin call, money market fund, moral hazard, Potemkin village, quantitative easing, secular stagnation, Snapchat, South Sea Bubble, Steve Jobs, Steve Wozniak, too big to fail, WikiLeaks

If a banker or trader creates and sells a squirrelly financial product or makes a terrible and risky bet knowing full well when he or she did it that it was likely to go wrong, then there is little question, if convicted, that the expensive art should be sold off the walls in his or her home and that the home itself should be sold and the proceeds given to the victims. There should be no equivocating on this point. But then, we also must reward Wall Street for financial innovation because it is financial innovation that has led to what I call the “democratization of capital,” the ability of more and more people to get access to capital at a fair price—whether in the form of a mortgage, an auto loan, or a credit card. These are important innovations that Wall Street has pioneered. They have given us the country and way of life that if it were suddenly stripped away, we would demand back.

But that is more a failure of public relations than anything else. The truth is that financial innovation is good for all of us. It leads to a lower cost of capital. It provides access to capital more broadly to more people when once upon a time capital was available only to the well heeled. It leads to most people being able to have their own credit card, or many of them—an unsecured line of credit that can be used to buy almost anything. It leads to most Americans being able to get a mortgage to buy a home, or a loan to buy a car or boat, or to borrow money to pay for a college education. It is also leading to a possible new revolution in finance—the so-called fintech industry—where the Internet supposedly eliminates the middlemen and matches investors directly with borrowers. Before the era of financial innovation, spurred on by the IPOs of Wall Street investment banks, it was not possible for an ordinary American to have a credit card or a low-priced mortgage or a car loan.

“We are essentially on a fairly dangerous battlefield with very little ammunition.” What we need on Wall Street is smart regulation, not political, retaliatory regulation. What Tarullo is doing in trying to prevent another financial crisis is unwinding decades of financial innovations that have actually benefited the American people by allowing them access to capital at lower prices than would otherwise have been possible. Tarullo is no doubt sincere in his mission to make financial markets safer, but at what cost? We need a way to reward bankers, traders, and executives for taking prudent financial risks and developing new financial innovations while also holding them accountable for their bad behavior. The days of socializing the risks and privatizing the gains, which should have come to an end after the 2008 financial crisis, have to be stopped.


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The Globalization Paradox: Democracy and the Future of the World Economy by Dani Rodrik

affirmative action, Asian financial crisis, bank run, banking crisis, bilateral investment treaty, borderless world, Bretton Woods, British Empire, business cycle, capital controls, Carmen Reinhart, central bank independence, collective bargaining, colonial rule, Corn Laws, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, currency manipulation / currency intervention, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, Doha Development Round, en.wikipedia.org, endogenous growth, eurozone crisis, financial deregulation, financial innovation, floating exchange rates, frictionless, frictionless market, full employment, George Akerlof, guest worker program, Hernando de Soto, immigration reform, income inequality, income per capita, industrial cluster, information asymmetry, joint-stock company, Kenneth Rogoff, land reform, liberal capitalism, light touch regulation, Long Term Capital Management, low skilled workers, margin call, market bubble, market fundamentalism, Martin Wolf, mass immigration, Mexican peso crisis / tequila crisis, microcredit, Monroe Doctrine, moral hazard, night-watchman state, non-tariff barriers, offshore financial centre, oil shock, open borders, open economy, Paul Samuelson, price stability, profit maximization, race to the bottom, regulatory arbitrage, savings glut, Silicon Valley, special drawing rights, special economic zone, The Wealth of Nations by Adam Smith, Thomas L Friedman, Tobin tax, too big to fail, trade liberalization, trade route, transaction costs, tulip mania, Washington Consensus, World Values Survey

Indeed, the mortal blow to the “collateral benefits” argument was struck by the subprime mortgage meltdown, which demonstrated finance’s remarkable ability to undermine governance—and to do so in the richest and oldest democracy in the world. In its wake, it would be very difficult to argue that banking interests contribute to better institutions. The Seductions of Financial Innovation In the aftermath of the subprime mortgage meltdown no one has to break a sweat to be a finance skeptic. But we should give hedgehog economists their due. To most of us, their narrative on the financial innovation that led to the crisis seemed quite compelling when we first heard it. Everyone wanted credit markets to serve the cause of home ownership, so we started by introducing real competition into the mortgage lending business. We allowed non-banks to make home loans and let them offer creative, more affordable mortgages to prospective homeowners who were not well served by conventional lenders.

And just in case anyone was still nervous, we created derivatives that allowed investors to purchase insurance against default by issuers of those securities. If we had wanted to showcase the benefits of financial innovation, we could not have devised a better set of arrangements. Thanks to them, millions of poorer and hitherto excluded families were made homeowners, investors made high returns, and financial intermediaries pocketed the fees and commissions. It might have worked like a dream—and until the crisis struck, many financiers, economists, and policy makers thought that it did. The narrative they all relied on was appealing. Financial innovation can allow people to access credit in ways they could not before by pooling risk and passing it on to those in the best position to bear it. If some people and institutions make mistakes and get over-stretched in the process, they will pay the price for it.

The crisis that engulfed financial markets in 2007 buried Wall Street and humbled the United States. The gigantic multi-trillion-dollar bailout of troubled financial institutions which the U.S. Treasury and Federal Reserve had to mount makes emerging market crises look like footnotes by comparison. And the benefits of financial innovation? They were hard to see amidst the rubble. As Paul Volcker would say afterwards in all seriousness, the automated teller machine had brought far more gains to most people than any asset-backed bond.19 Or as Ben Bernanke put it, much more diplomatically, “One would be forgiven for concluding that the assumed benefits of financial innovation are not all they were cracked up to be.”20 Where exactly did it all go wrong? The subprime mortgage crisis demonstrated once again how difficult it is to tame finance, an industry which is both the lifeline of all modern economies and the gravest threat to their stability.


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Finance and the Good Society by Robert J. Shiller

Alvin Roth, bank run, banking crisis, barriers to entry, Bernie Madoff, buy and hold, capital asset pricing model, capital controls, Carmen Reinhart, Cass Sunstein, cognitive dissonance, collateralized debt obligation, collective bargaining, computer age, corporate governance, Daniel Kahneman / Amos Tversky, Deng Xiaoping, diversification, diversified portfolio, Donald Trump, Edward Glaeser, eurozone crisis, experimental economics, financial innovation, financial thriller, fixed income, full employment, fundamental attribution error, George Akerlof, income inequality, information asymmetry, invisible hand, joint-stock company, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, land reform, loss aversion, Louis Bachelier, Mahatma Gandhi, Mark Zuckerberg, market bubble, market design, means of production, microcredit, moral hazard, mortgage debt, Myron Scholes, Nelson Mandela, Occupy movement, passive investing, Ponzi scheme, prediction markets, profit maximization, quantitative easing, random walk, regulatory arbitrage, Richard Thaler, Right to Buy, road to serfdom, Robert Shiller, Robert Shiller, Ronald Reagan, selection bias, self-driving car, shareholder value, Sharpe ratio, short selling, Simon Kuznets, Skype, Steven Pinker, telemarketer, Thales and the olive presses, Thales of Miletus, The Market for Lemons, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, Vanguard fund, young professional, zero-sum game, Zipcar

Arjun Jayadev and Samuel Bowles have estimated that 19.7% of the U.S. labor force in 2002—supervisors, security personnel, members of the military—was involved in guarding in some form.17 The high percentage of our citizens paid to guard us and our installations and possessions is at its essence surely more troubling than the percentage engaged in the substantially productive activities of nance. Yet relatively few of us seem bothered by this statistic. Financial Capitalism and the Challenge of Financial Innovation While nancial capitalism inevitably must be made to serve the good society, it cannot be summarized in simple terms. This is so because it represents a bewilderingly broad and cross-cutting array of institutions, instruments, and markets, each element of which evolved through a process of invention not unlike the processes that produced our automobiles and airplanes, and through which they continue to evolve. Financial innovation is an underappreciated phenomenon. According to Google Ngrams, the term nancial innovation was hardly ever used until the late 1970s and 1980s. The term seems to have been applied rst to the controversial nancial futures markets that developed around that time.

By 2007 this decline had brought prices of home mortgage securities down far enough to create a crisis for investors in these securities. It was called the subprime crisis because the price falls were especially striking among mortgages issued to subprime borrowers, that is, home buyers who are judged more likely to default because of factors including their past payment and employment histories. Financial innovations related to these subprime loans were blamed for the crisis. But the crisis did not remain con ned to subprime mortgages; that was only the initial shock in a vast catastrophe. The consequence was a drop in real estate prices and the collapse of nancial institutions, not only in the United States but also in Europe and elsewhere. By the spring of 2009 the crisis was so severe that it was described as the biggest nancial calamity since the Great Depression of the 1930s—bigger than the Asian nancial crisis of the 1990s and bigger than the oil-price-induced crises of 1974–75 and 1981–82.

The Inexorable Spread of Financial Capitalism At the time of this writing we are still stuck in the severe nancial crisis that began in 2007. As such we tend to associate nance with recent problems, such as the mortgage and debt hangovers in the United States and Europe, and with the legal and regulatory errors that preceded these events. But we should not lose sight of the bigger picture. The more important story is the proliferation and transformation of successful nancial ideas. Financial innovations emanating from Amsterdam, London, and New York are developing further in Buenos Aires, Dubai, and Tokyo. The socialist market economy, with its increasingly advanced nancial structures, was introduced to China by Deng Xiaoping starting in 1978, adapting to the Chinese environment the examples of other highly successful Chinese-speaking cities: Hong Kong, Singapore, and Taipei. The economic liberalization of India, which allowed freer application of modern nance, was inaugurated in 1991 under Prime Minister P.


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Other People's Money: Masters of the Universe or Servants of the People? by John Kay

Affordable Care Act / Obamacare, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, buy and hold, call centre, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, cognitive dissonance, corporate governance, Credit Default Swap, cross-subsidies, dematerialisation, disruptive innovation, diversification, diversified portfolio, Edward Lloyd's coffeehouse, Elon Musk, Eugene Fama: efficient market hypothesis, eurozone crisis, financial innovation, financial intermediation, financial thriller, fixed income, Flash crash, forward guidance, Fractional reserve banking, full employment, George Akerlof, German hyperinflation, Goldman Sachs: Vampire Squid, Growth in a Time of Debt, income inequality, index fund, inflation targeting, information asymmetry, intangible asset, interest rate derivative, interest rate swap, invention of the wheel, Irish property bubble, Isaac Newton, John Meriwether, light touch regulation, London Whale, Long Term Capital Management, loose coupling, low cost airline, low cost carrier, M-Pesa, market design, millennium bug, mittelstand, money market fund, moral hazard, mortgage debt, Myron Scholes, NetJets, new economy, Nick Leeson, Northern Rock, obamacare, Occupy movement, offshore financial centre, oil shock, passive investing, Paul Samuelson, peer-to-peer lending, performance metric, Peter Thiel, Piper Alpha, Ponzi scheme, price mechanism, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, railway mania, Ralph Waldo Emerson, random walk, regulatory arbitrage, Renaissance Technologies, rent control, risk tolerance, road to serfdom, Robert Shiller, Robert Shiller, Ronald Reagan, Schrödinger's Cat, shareholder value, Silicon Valley, Simon Kuznets, South Sea Bubble, sovereign wealth fund, Spread Networks laid a new fibre optics cable between New York and Chicago, Steve Jobs, Steve Wozniak, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Tobin tax, too big to fail, transaction costs, tulip mania, Upton Sinclair, Vanguard fund, Washington Consensus, We are the 99%, Yom Kippur War

The ineffectiveness and inefficiency of this process contributed directly to the dismal economic performance of these states. A country can be prosperous only if it has a well-functioning financial system, but that does not imply that the larger the financial system a country has, the more prosperous it is likely to be. It is possible to have too much of a good thing. Financial innovation was critical to the creation of an industrial society; it does not follow that every modern financial innovation contributes to economic growth. Many good ideas become bad ideas when pursued to excess. And so it is with finance. The finance sector today plays a major role in politics: it is the most powerful industrial lobby and a major provider of campaign finance. News bulletins report daily on what is happening in ‘the markets’ – by which they mean securities markets.

Third, finance enables us to manage our personal finances across our lifetimes and between generations. Fourth, finance helps both individuals and businesses to manage the risks inevitably associated with everyday life and economic activity. These four functions – the payments system, the matching of borrowers and lenders, the management of our household financial affairs and the control of risk – are the services that finance does, or at least can, provide. The utility of financial innovation is measured by the degree to which it advances the goals of making payments, allocating capital, managing personal finances and handling risk. The economic significance of the finance industry is often described in other ways: by the number of jobs it provides, the incomes that are earned from it, even the tax revenue derived from it. There is a good deal of confusion here, discussed in Chapter 9.

Banks specialised in what I will call the deposit channel, diverting short-term savings into relatively low-risk activities. There has always been a need for a parallel investment channel, to facilitate the deployment of longer-term savings. In 1812, with Britain at war with both Napoleon and the USA, some public-spirited Edinburgh gentlemen founded the Scottish Widows’ Fund to make provision for their dependants. Scotland has played a disproportionately large role in the history of financial innovation for a small country on Europe’s periphery. The Bank and the Royal Bank of Scotland are among the oldest surviving institutions in the deposit channel (even if their survival was a close call). The Bank of England, which saved them, was also founded by a Scot. My parents and teachers, believing my destiny was to be an actuary, sent me to work at Scottish Widows in the school holidays. I reported to a building in St Andrew’s Square that faced the imposing headquarters of the Royal Bank.


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Extreme Money: Masters of the Universe and the Cult of Risk by Satyajit Das

affirmative action, Albert Einstein, algorithmic trading, Andy Kessler, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Basel III, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, BRICs, British Empire, business cycle, capital asset pricing model, Carmen Reinhart, carried interest, Celtic Tiger, clean water, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, debt deflation, Deng Xiaoping, deskilling, discrete time, diversification, diversified portfolio, Doomsday Clock, Edward Thorp, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, eurozone crisis, Everybody Ought to Be Rich, Fall of the Berlin Wall, financial independence, financial innovation, financial thriller, fixed income, full employment, global reserve currency, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, happiness index / gross national happiness, haute cuisine, high net worth, Hyman Minsky, index fund, information asymmetry, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, job automation, Johann Wolfgang von Goethe, John Meriwether, joint-stock company, Jones Act, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, Kevin Kelly, laissez-faire capitalism, load shedding, locking in a profit, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Martin Wolf, mega-rich, merger arbitrage, Mikhail Gorbachev, Milgram experiment, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Myron Scholes, Naomi Klein, negative equity, NetJets, Network effects, new economy, Nick Leeson, Nixon shock, Northern Rock, nuclear winter, oil shock, Own Your Own Home, Paul Samuelson, pets.com, Philip Mirowski, plutocrats, Plutocrats, Ponzi scheme, price anchoring, price stability, profit maximization, quantitative easing, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Ray Kurzweil, regulatory arbitrage, rent control, rent-seeking, reserve currency, Richard Feynman, Richard Thaler, Right to Buy, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, Rod Stewart played at Stephen Schwarzman birthday party, rolodex, Ronald Reagan, Ronald Reagan: Tear down this wall, Satyajit Das, savings glut, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, Slavoj Žižek, South Sea Bubble, special economic zone, statistical model, Stephen Hawking, Steve Jobs, survivorship bias, The Chicago School, The Great Moderation, the market place, the medium is the message, The Myth of the Rational Market, The Nature of the Firm, the new new thing, The Predators' Ball, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, trickle-down economics, Turing test, Upton Sinclair, value at risk, Yogi Berra, zero-coupon bond, zero-sum game

Much of the activity did not generate true value or represent direct additions to the goods and services produced in the economy. It increased debt and the circulation of money, as well as trading and speculation. In 2009 Paul Volcker, a former chairman of the Federal Reserve, questioned the role of finance: “I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth—one shred of evidence.... [U.S. financial services increased its share of value-added from 2 percent to 6.5 percent] Is that a reflection of your financial innovation, or just a reflection of what you’re paid?”2 The only financial innovation over the past 20 years that impressed Volcker was the automated teller machine. In the financial centers, high rewards enjoyed by people associated with finance trickled down. Entire cities and districts became gentrified, with bustling streets, chi-chi restaurants, trendy bars, and luxury label retailers.

Louis Aunchincloss in his 1954 novel A World of Profit, quoted in Robert Sobel (1993) Dangerous Dreamers: The Financial Innovators from Charles Merrill to Michael Milken, John Wiley, New York: 29. 2. ©Lucy Prebble, Enron, and Methuen Drama, an imprint of Bloomsbury Publishing Plc., London: 106. 3. John Lanchester (2010) Whoops! Why Everyone Owes Everyone and No One Can Pay, Allen Lane, London. 4. John Kenneth Galbraith “The 1929 parallel” (January 1987) Atlantic Monthly: 62. 5. Thomas Philippon and Ariell Reshef “Wages and human capital in the financial industry: 1909–2006” (December 2008), Working Paper, New York University and University of Virginia. 6. Quoted in Gillian Tett “Silos and silences: why so few people spotted the problems in complex credit and what that implies for the future” (July 2010) Financial System Review—Derivatives: Financial Innovation and Stability, Banque de France: 122. 7.

The top 1 percent of households accounted for more than 30 percent of net worth, greater than the entire bottom 90 percent of households put together. Writer Robert Frank observed that the wealthy inhabited a different country—Richistan.3 Gains from recent economic growth flowed disproportionately to the wealthy, who benefited from market-friendly governments, favorable tax regimes, protection of property rights, globalization, and technological change, and financial innovation and deregulation. The top 10 percent of earners received the majority of the benefits of the productivity miracle of 1996–2005.4 Wealthy plutocrats both powered and benefited from economic growth. The Forbes 400 richest people in 2006 controlled $1,250 billion, up $92 billion from 1982. To make it on to the list in 2006 you had to have a billion, compared to $75 million in 1982. This money was invested, making more money to fund consumption or simply to attest to wealth.


pages: 369 words: 94,588

The Enigma of Capital: And the Crises of Capitalism by David Harvey

accounting loophole / creative accounting, anti-communist, Asian financial crisis, bank run, banking crisis, Bernie Madoff, Big bang: deregulation of the City of London, Bretton Woods, British Empire, business climate, call centre, capital controls, creative destruction, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, deskilling, equal pay for equal work, European colonialism, failed state, financial innovation, Frank Gehry, full employment, global reserve currency, Google Earth, Guggenheim Bilbao, Gunnar Myrdal, illegal immigration, indoor plumbing, interest rate swap, invention of the steam engine, Jane Jacobs, joint-stock company, Joseph Schumpeter, Just-in-time delivery, land reform, liquidity trap, Long Term Capital Management, market bubble, means of production, megacity, microcredit, moral hazard, mortgage debt, Myron Scholes, new economy, New Urbanism, Northern Rock, oil shale / tar sands, peak oil, Pearl River Delta, place-making, Ponzi scheme, precariat, reserve currency, Ronald Reagan, sharing economy, Silicon Valley, special drawing rights, special economic zone, statistical arbitrage, structural adjustment programs, the built environment, the market place, The Wealth of Nations by Adam Smith, Thomas L Friedman, Thomas Malthus, Thorstein Veblen, too big to fail, trickle-down economics, urban renewal, urban sprawl, white flight, women in the workforce

The demand problem was temporarily bridged with respect to housing by debt-financing the developers as well as the buyers. The financial institutions collectively controlled both the supply of, and demand for, housing! The same story occurred with all forms of consumer credit on everything from automobiles and lawnmowers to loading down with Christmas gifts at Toys ‘R’ Us and Wal-Mart. All this indebtedness was obviously risky, but that could be taken care of by the wondrous financial innovations of securitisation that supposedly spread the risk around and even created the illusion that risk had disappeared. Fictitious financial capital took control and nobody wanted to stop it because everyone who mattered seemed to be making lots of money. In the US, political contributions from Wall Street soared. Remember Bill Clinton’s famous rhetorical question as he took office? ‘You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of fucking bond traders?’

Meanwhile, Bankers Trust, without checking his figures, put out reassuring statements on its profitability to prop up its share value. Krieger’s figures turned out to be faulty by $80 million but, rather than admit its profitability had disappeared, the bank tried all manner of ‘creative’ accounting practices to cover over the discrepancy before finally having to admit that it had been wrong. Notice the elements in this tale. First, unregulated over-the-counter trading permits all sorts of financial innovation and shady practices which nevertheless make a lot of money. Secondly, the bank supports such practices, even though they don’t understand them (the mathematics in particular), because they are often so profitable relative to their core business and hence improve share value. Third, creative accounting enters the picture, and fourth, the valuation of assets for accounting practices is extremely uncertain in volatile markets.

Global shifts in production capacity accompanied by highly competitive technological innovations, many of which were labour-saving, contributed further to the disciplining of global labour. The United States still retained immense financial power, even as it lost its earlier dominance (though not significance) in the realm of production. Increasingly, the US relied upon the extraction of rents, either on the basis of its advantages in technological and financial innovation or from intellectual property rights. But this meant that finance should not be burdened by excessive regulation. The crash of the US financial sector in 2008–9 has jeopardised US hegemony. The ability of the US to launch a go-it-alone debt-financed recovery plan is limited politically by staunch conservative opposition at home as well as by the huge debt-overhang accumulated from the 1990s on.


pages: 76 words: 20,238

The Great Stagnation by Tyler Cowen

Asian financial crisis, Bernie Madoff, en.wikipedia.org, endogenous growth, financial innovation, Flynn Effect, income inequality, indoor plumbing, life extension, liquidity trap, Long Term Capital Management, Mark Zuckerberg, meta analysis, meta-analysis, Peter Thiel, RAND corporation, school choice, Tyler Cowen: Great Stagnation, urban renewal

Contemporary innovation often takes the form of expanding positions of economic and political privilege, extracting resources from the government by lobbying, seeking the sometimes extreme protections of intellectual property laws, and producing goods that are exclusive or status related rather than universal, private rather than public; think twenty-five seasons of new, fall season Gucci handbags. The dubious financial innovations connected to our recent financial crisis are another (perhaps less obvious) example of discoveries that benefit some individuals but are not public goods more generally. A lot of the gains from recent financial innovations are captured by a relatively small number of individuals. Top American earners are increasingly concentrated in the financial sector of the economy. For 2004, nonfinancial executives of publicly traded companies comprised less than 6 percent of the top 0.01 percent income bracket.

In that same year, the top twenty-five hedge fund managers combined earned more than all of the CEOs from the entire S&P 500. The number of Wall Street investors earning over $100 million a year was nine times higher than the public-company executives earning that amount. When I look back at the last decade, I think the following: There are some very wealthy people, but a lot of their incomes are from financial innovations that do not translate to gains for the average American citizen. The slowdown in ideas production mirrors the well-known rise in income inequality. Labor and capital are fairly plentiful in today’s global economy, and so their returns have been somewhat stagnant. Valuable new ideas have become quite scarce, and so the small number of people who hold the rights to new ideas—whether it be the useful Facebook or the more dubious forms of mortgage-backed securities—earned higher relative returns than in earlier periods.

GDP, and that figure had been rising throughout the 2000-2004 “productivity boom” period. I know what the numbers say, but what was the financial sector really producing during those years? The published figures do not pick up the problematic nature of financial sector growth, which of course culminated in a major crash. What we measured as value creation actually may have been value destruction, namely too many homes and too much financial innovation of the wrong kind. Keep in mind that median income growth has been slow, and stock prices—the valuation of capital—haven’t made lasting progress in a long time. As of the fall of 2010, the S&P 500 is more or less back where it had been in the mid-1990s. As economist Michael Mandel puts it, if neither labor nor capital is reaping much gain, can we really trust the productivity numbers?


pages: 586 words: 159,901

Wall Street: How It Works And for Whom by Doug Henwood

accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, affirmative action, Andrei Shleifer, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, borderless world, Bretton Woods, British Empire, business cycle, capital asset pricing model, capital controls, central bank independence, computerized trading, corporate governance, corporate raider, correlation coefficient, correlation does not imply causation, credit crunch, currency manipulation / currency intervention, David Ricardo: comparative advantage, debt deflation, declining real wages, deindustrialization, dematerialisation, diversification, diversified portfolio, Donald Trump, equity premium, Eugene Fama: efficient market hypothesis, experimental subject, facts on the ground, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, George Akerlof, George Gilder, hiring and firing, Hyman Minsky, implied volatility, index arbitrage, index fund, information asymmetry, interest rate swap, Internet Archive, invisible hand, Irwin Jacobs, Isaac Newton, joint-stock company, Joseph Schumpeter, kremlinology, labor-force participation, late capitalism, law of one price, liberal capitalism, liquidationism / Banker’s doctrine / the Treasury view, London Interbank Offered Rate, Louis Bachelier, market bubble, Mexican peso crisis / tequila crisis, microcredit, minimum wage unemployment, money market fund, moral hazard, mortgage debt, mortgage tax deduction, Myron Scholes, oil shock, Paul Samuelson, payday loans, pension reform, plutocrats, Plutocrats, price mechanism, price stability, prisoner's dilemma, profit maximization, publication bias, Ralph Nader, random walk, reserve currency, Richard Thaler, risk tolerance, Robert Gordon, Robert Shiller, Robert Shiller, selection bias, shareholder value, short selling, Slavoj Žižek, South Sea Bubble, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, The Market for Lemons, The Nature of the Firm, The Predators' Ball, The Wealth of Nations by Adam Smith, transaction costs, transcontinental railway, women in the workforce, yield curve, zero-coupon bond

But that can't be the only reason; clearly there's a demand, not always fully thought through, for whizbang new tools to "manage risk," have a fling, or indulge some other lust for moneymaking. John D. Finnerty, who compiled the Whitmanic catalogue of financial innovations since the 1960s reproduced on page 51, listed 10 stimuli to such creative enterprise. They include risk reduction or the shifting of risk towards one party or the other, reduction of agency costs (lender supervision of management) and issuance costs, tax angles, compliance with or evasion of regulation, changes in the level and volatility of interest and exchange rates, "academic and other research that result in advances in financial theories," accounting gimmickry, and technological advances. This little survey of financial innovation would be incomplete without notice paid to the ease with which nearly anything can be absorbed into the circuit of money.

Most of the nearly 100 instruments shown nearby are merely hybrid products assembled from several basic building blocks — conversion of fixed to floating interest rates or vice versa; maturity transformation (turning long-term obligations into shorter-term ones, or the reverse) instruments crafted to move in the direction opposite some other price (inverse floaters, which pay less as interest rates rise and more as they fall); the creation of hermaphrodite securities (bond-stock warrant, bond-gold, bond-an-other country's currency, bond-stock future); tax, accounting, and regulatory footwork; the splitting of income streams ("stripped" bonds, ones divided into interest and principal sub-bonds, and then perhaps divided again between high- and low-risk); the swapping of income streams (interest rate swaps); the pooling of funds or of obligations into larger wholes to diversify against individual risks (mutual funds, securitization); schemes for increasing leverage (options, futures, payment-in-kind securities) or controlling volatility (options, futures, swaps). From these elements, however, infinitely strange creatures can be made. Or, "Rather than developing new generic instruments," "financial innovation since the mid-1980s has tended to take the form of novel combinations of existing products to support complex and highly sophisticated investment strategies.... At the same time, a growing range of 'custom-tailored' investment products has been developed to maximise possibilities for matching actual portfolio structures to theoretically-based invesment models" (Bank for International Settlements 1993, P- 86). The more reality INSTRUMENTS financial innovations adjustable rate convertible notes • adjustable rate preferred stock • adjustable/variable rate mortgages • All-Saver certificates • Annericus trust • annuity notes • auction rate capital notes • auction rate notes/debentures • auction rate preferred stock • bull and bear CDs • capped floating rate notes • collateralized connmercial paper • collateralized nnortgage obligations/real estate mortgage investment conduits • collateralized preferred stock • commercial real estate-backed bonds • commodity-linked bonds • convertible adjustable preferred stock • convertible exchangeable preferred stock • convertible mortgages/reduction option loans • convertible reset debentures • currency swaps • deep discount/zero coupon bonds • deferred interest debentures • direct public sale of securities • dividend reinvestment plan • dollar BILS • dual currency bonds • employee stock ownership plan (ESOP) • Eurocurrency bonds • Euronotes/Euro-commercial paper • exchangeable auction rate preferred stock • exchangeable remarketed preferred stock • exchangeable variable rate notes • exchange-traded options • extendible notes • financial futures • floating rate/adjustable rate notes • floating rate extendible notes • floating rate, rating sensitive notes • floating rate tax-exempt notes • foreign-currency-denominated bonds • foreign currency futures and options • forward rate agreements • gold loans • high-yield (junk) bonds • increasing rate notes • indexed currency option notes/ principal exchange linked securities • indexed floating rate preferred stock • indexed sinking fund debentures • interest rate caps/collars/floors • interest rate futures • interest rate reset notes • interest rate swaps • letter of credit/surety bond support • mandatory convertible/equity contract notes • master limited partnership • medium-term notes • money market notes • mortgage-backed bonds • mortgage pass-through securities • negotiable CDs • noncallable long-term bonds • options on futures contracts • paired common stock • participating bonds • pay-in-kind debentures • perpetual bonds • poison put bonds • puttable/adjustable tender bonds • puttable common stock • puttable convertible bonds • puttable-extendible notes • real estate-backed bonds • real yield securities • receivable-backed securities • remarketed preferred stock • remarketed reset notes • serial zero-coupon bonds • shelf registration process • single-point adjustable rate stock • Standard & Poor's indexed notes • state rate auction preferred stock • step-up put bonds • stock index futures and options • stripped mortgage-backed securities • stripped municipal securities • stripped U.S.

"Andre could peel people like bananas," said Rohatyn (Reich 1983, p. 19). But financial innovations are more than mere bankers' fancy; hard issues of power and risk are settled through them. Floating rate instruments shift the risk of rising interest rates from lender to borrower. Adjustable rate notes protect bondholders against imprudent or capital-risking actions by management, like taking on gobs of new debt. Looser regulations on issuance like shelf registration, which allows corporations to file general prospectuses to be kept on file, rather than prepare custom prospectuses for a specific stock or bond issue, allow firms to hawk their paper when the market looks friendly. Joseph Schumpeter (1939, vol. 2, p. 613), writing during a decade when financial innovation was deeply out of fashion, observed that "it is one of the most characteristic features of the financial side of capitalist evolution so to 'mobilize' all, even the longest, maturities as to make any commitment to a promise of future balances amenable to being in turn financed by any sort of funds and especially by funds available for short time, even overnight, only.


pages: 733 words: 179,391

Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo

"Robert Solow", Albert Einstein, Alfred Russel Wallace, algorithmic trading, Andrei Shleifer, Arthur Eddington, Asian financial crisis, asset allocation, asset-backed security, backtesting, bank run, barriers to entry, Berlin Wall, Bernie Madoff, bitcoin, Bonfire of the Vanities, bonus culture, break the buck, Brownian motion, business cycle, business process, butterfly effect, buy and hold, capital asset pricing model, Captain Sullenberger Hudson, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computerized trading, corporate governance, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, Daniel Kahneman / Amos Tversky, delayed gratification, Diane Coyle, diversification, diversified portfolio, double helix, easy for humans, difficult for computers, Ernest Rutherford, Eugene Fama: efficient market hypothesis, experimental economics, experimental subject, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, Fractional reserve banking, framing effect, Gordon Gekko, greed is good, Hans Rosling, Henri Poincaré, high net worth, housing crisis, incomplete markets, index fund, interest rate derivative, invention of the telegraph, Isaac Newton, James Watt: steam engine, job satisfaction, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, Joseph Schumpeter, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, longitudinal study, loss aversion, Louis Pasteur, mandelbrot fractal, margin call, Mark Zuckerberg, market fundamentalism, martingale, merger arbitrage, meta analysis, meta-analysis, Milgram experiment, money market fund, moral hazard, Myron Scholes, Nick Leeson, old-boy network, out of africa, p-value, paper trading, passive investing, Paul Lévy, Paul Samuelson, Ponzi scheme, predatory finance, prediction markets, price discovery process, profit maximization, profit motive, quantitative hedge fund, quantitative trading / quantitative finance, RAND corporation, random walk, randomized controlled trial, Renaissance Technologies, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, Robert Shiller, Robert Shiller, Sam Peltzman, Shai Danziger, short selling, sovereign wealth fund, Stanford marshmallow experiment, Stanford prison experiment, statistical arbitrage, Steven Pinker, stochastic process, stocks for the long run, survivorship bias, Thales and the olive presses, The Great Moderation, the scientific method, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, theory of mind, Thomas Malthus, Thorstein Veblen, Tobin tax, too big to fail, transaction costs, Triangle Shirtwaist Factory, ultimatum game, Upton Sinclair, US Airways Flight 1549, Walter Mischel, Watson beat the top human players on Jeopardy!, WikiLeaks, Yogi Berra, zero-sum game

Such an idealized market is unlikely to ever exist in practice, but it’s still a useful abstraction whose performance can be approximated under certain conditions (and I’ll offer some examples shortly). To understand what those conditions are, we look to the one corner of the economy where competition is “red in tooth and claw”: the hedge fund industry. CHAPTER 7 The Galapagos Islands of Finance QUANTUM MECHANICS For three hundred years, London has been one of the world’s great financial centers, a paragon of financial innovation and stability. Nevertheless, in 1992, the forces of evolutionary change were hard at work in that historic city. The fall of Communism in Eastern Europe had shocked the international financial environment. This geopolitical surprise appeared to open up a new path for the greater economic integration of the nations of Europe—including the United Kingdom. After a decade of skepticism about the proposed unified European currency (not yet called the euro), Britain had become a new member of the European Exchange Rate Mechanism, bringing its currency into sync with the other currencies of Europe.

THE DEMOCRATIZATION OF INVESTING Passive investing—the idea that you can’t beat the market and should invest in index funds—is now such an important part of the traditional investment paradigm, it’s hard to appreciate just how revolutionary the idea of an index fund once was. These days, however, there seem to be nearly as many indexes as there are stocks. Where did the idea of the index come from, and where is it going? The Adaptive Markets Hypothesis can also explain the evolving nature of passive investing and indexation. As with many financial innovations, the genealogy of passive investing can be traced to academic research, in this case two different programs. We already described one of them: the CAPM, developed by Bill Sharpe (and simultaneously by John Lintner, Jan Mossin, and Jack Treynor). The other is, of course, the Efficient Markets Hypothesis. The CAPM allowed investors to construct an efficient portfolio simply by holding a basket of all stocks in proportion to their market capitalization—in other words, a portfolio that simulated the whole stock market (Principle 3).

But the transition from equal weighting to market-cap weighting occurred through trial and error, not because the market for new financial products was particularly efficient. The emergence of the multitrillion-dollar index fund industry was an evolutionary process driven by competition, innovation, and natural selection. This is the Adaptive Markets Hypothesis at work. NEW SPECIES OF INDEX FUNDS The success of the index mutual fund, beginning with the Vanguard Index Trust, led to an evolutionary explosion of financial innovation. Three different stock market index futures debuted in 1982, based on the New York Stock Exchange (NYSE) Composite, the S&P 500, and the Value Line index, respectively. Indexes for each asset class emerged, and additional index funds to track them: the first bond index fund for retail investors in 1986, the first international share index funds in 1990, and the first exchange-traded fund in 1993.


pages: 333 words: 76,990

The Long Good Buy: Analysing Cycles in Markets by Peter Oppenheimer

"Robert Solow", asset allocation, banking crisis, banks create money, barriers to entry, Berlin Wall, Big bang: deregulation of the City of London, Bretton Woods, business cycle, buy and hold, Cass Sunstein, central bank independence, collective bargaining, computer age, credit crunch, debt deflation, decarbonisation, diversification, dividend-yielding stocks, equity premium, Fall of the Berlin Wall, financial innovation, fixed income, Flash crash, forward guidance, Francis Fukuyama: the end of history, George Akerlof, housing crisis, index fund, invention of the printing press, Isaac Newton, James Watt: steam engine, joint-stock company, Joseph Schumpeter, Kickstarter, liberal capitalism, light touch regulation, liquidity trap, Live Aid, market bubble, Mikhail Gorbachev, mortgage debt, negative equity, Network effects, new economy, Nikolai Kondratiev, Nixon shock, oil shock, open economy, price stability, private sector deleveraging, Productivity paradox, quantitative easing, railway mania, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, secular stagnation, Simon Kuznets, South Sea Bubble, special economic zone, stocks for the long run, technology bubble, The Great Moderation, too big to fail, total factor productivity, trade route, tulip mania, yield curve

The cost of a three-minute telephone call from New York to London fell from $4.37 in 1990 (in 2000 dollars) to $0.40 in 2000.19 Deregulation and Financial Innovation Light touch regulation, or deregulation, is often an ingredient in the buildup of financial bubbles. In the railway boom of the early 19th century in Great Britain, for example, the repeal of the Bubble Act in 1825, introduced after the collapse of the South Sea bubble in 1720, was an important development. Aimed at controlling the formation of new companies, it limited the number of investors in joint stock companies to just five. In rescinding the act, the government made it easier to register, and set up, companies. It also made it much easier for large numbers of an increasingly enthralled public to invest in the new companies. Meanwhile, as noted previously, the financial innovation of new insurance companies allowed for a more conducive environment for risk-taking.

Table of Contents Cover Acknowledgements Note About the Author Preface Introduction Notes Part I: Lessons from the Past: What Cycles Look Like and What Drives Them Chapter 1: Riding the Cycle under Very Different Conditions Notes Chapter 2: Returns over the Long Run Returns over Different Holding Periods The Reward for Risk and the Equity Risk Premium The Power of Dividends Factors That Affect Returns for Investors The Impact of Diversification on the Cycle Notes Chapter 3: The Equities Cycle: Identifying the Phases The Four Phases of the Equity Cycle Mini/High-Frequency Cycles within the Investment Cycle The Interplay between the Cycle and Bond Yields Note Chapter 4: Asset Returns through the Cycle Assets across the Economic Cycle Assets across the Investment Cycle The Impact of Changes in Bond Yields on Equities Structural Shifts in the Value of Equities and Bonds Notes Chapter 5: Investment Styles over the Cycle Sectors and the Cycle Cyclical versus Defensive Companies Value versus Growth Companies Value, Growth and Duration Notes Part II: The Nature and Causes of Bull and Bear Markets: What Triggers Them and What to Look out For Chapter 6: Bear Necessities: The Nature and Shape of Bear Markets Bear Markets Are Not All the Same Cyclical Bear Markets Event-Driven Bear Markets Structural Bear Markets The Relationship between Bear Markets and Corporate Profits A Summary of Bear Market Characteristics Defining the Financial Crisis: A Structural Bear Market with a Difference Finding an Indicator to Flag Bear Market Risk Notes Chapter 7: Bull's Eye: The Nature and Shape of Bull Markets The ‘Super Cycle’ Secular Bull Market Cyclical Bull Markets Variations in the Length of Bull Markets Non-trending Bull Markets Notes Chapter 8: Blowing Bubbles: Signs of Excess Spectacular Price Appreciation … and Collapse Belief in a ‘New Era’ … This Time Is Different Deregulation and Financial Innovation Easy Credit New Valuation Approaches Accounting Problems and Scandals Notes Part III: Lessons for the Future: A Focus on the Post-Financial Crisis Era; What Has Changed and What It Means for Investors Chapter 9: How the Cycle Has Changed Post the Financial Crisis Three Waves of the Financial Crisis The Unusual Gap between Financial Markets and Economies All Boats Were Lifted by the Liquidity Wave The Unusual Drivers of the Return Lower Inflation and Interest Rates A Downtrend in Global Growth Expectations The Fall in Unemployment and Rise in Employment The Rise in Profit Margins Falling Volatility of Macro Variables The Rising Influence of Technology The Extraordinary Gap between Growth and Value Lessons from Japan Notes Chapter 10: Below Zero: The Impact of Ultra-Low Bond Yields Zero Rates and Equity Valuations Zero Rates and Growth Expectations Zero Rates: Backing Out Future Growth Zero Rates and Demographics Zero Rates and the Demand for Risk Assets Notes Chapter 11: The Impact of Technology on the Cycle The Ascent of Technology and Historical Parallels Technology and Growth in the Cycle How Long Can Stocks and Sectors Dominate?

Between November 1636 and February 1637, the price of some tulip bulbs had increased 20 times and, at the height of the bubble, a single bulb could have the same value as a luxury townhouse.5 When the market finally crashed, in February 1637, just as occurred in so many other examples in history, the falls were as spectacular as the rises that preceded them. Also in common with many subsequent bubbles, it is not entirely clear what triggered its ultimate collapse. In this case, there were probably many contributory factors. At the height of the boom in 1636 and early 1637, when demand was at its highest, the bulbs themselves were still in the ground and could not be physically delivered until the following spring. Financial innovation played a part in driving prices ever higher. A futures market in bulbs developed that enabled sellers to sell forward tulips at a given price for a particular quality and weight. The risks compounded when most of these contracts were paid for by credit notes, making the system vulnerable to collapse and, eventually, contagion. Ultimately, the fear that the oncoming spring would force delivery of contracts, many of which might not be deliverable, played a part in its demise.


pages: 355 words: 92,571

Capitalism: Money, Morals and Markets by John Plender

activist fund / activist shareholder / activist investor, Andrei Shleifer, asset-backed security, bank run, Berlin Wall, Big bang: deregulation of the City of London, Black Swan, bonus culture, Bretton Woods, business climate, business cycle, Capital in the Twenty-First Century by Thomas Piketty, central bank independence, collapse of Lehman Brothers, collective bargaining, computer age, Corn Laws, corporate governance, creative destruction, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, discovery of the americas, diversification, Eugene Fama: efficient market hypothesis, eurozone crisis, failed state, Fall of the Berlin Wall, fiat currency, financial innovation, financial intermediation, Fractional reserve banking, full employment, God and Mammon, Gordon Gekko, greed is good, Hyman Minsky, income inequality, inflation targeting, information asymmetry, invention of the wheel, invisible hand, Isaac Newton, James Watt: steam engine, Johann Wolfgang von Goethe, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, joint-stock company, Joseph Schumpeter, labour market flexibility, liberal capitalism, light touch regulation, London Interbank Offered Rate, London Whale, Long Term Capital Management, manufacturing employment, Mark Zuckerberg, market bubble, market fundamentalism, mass immigration, means of production, Menlo Park, money market fund, moral hazard, moveable type in China, Myron Scholes, Nick Leeson, Northern Rock, Occupy movement, offshore financial centre, paradox of thrift, Paul Samuelson, plutocrats, Plutocrats, price stability, principal–agent problem, profit motive, quantitative easing, railway mania, regulatory arbitrage, Richard Thaler, rising living standards, risk-adjusted returns, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, shareholder value, short selling, Silicon Valley, South Sea Bubble, spice trade, Steve Jobs, technology bubble, The Chicago School, The Great Moderation, the map is not the territory, The Wealth of Nations by Adam Smith, Thorstein Veblen, time value of money, too big to fail, tulip mania, Upton Sinclair, Veblen good, We are the 99%, Wolfgang Streeck, zero-sum game

To Stephanie, Tom, Olivia, Celia, Richard and Robin CONTENTS Title Page Dedication Acknowledgements Introduction Chapter One: The Root of All Evil (Or Not, as the Case May Be) Chapter Two: Animal Spirits Chapter Three: Hijacked by Bankers Chapter Four: Industrial Shrinkage, Financial Excess Chapter Five: Sophisters, Economists and Calculators Chapter Six: Trade and the Fatal Embrace Chapter Seven: Speculation – The Missing Shame Gene Chapter Eight: The Dynamics of Debt Chapter Nine: Gold: The 6,000-Year-Long Bubble Chapter Ten: High-Minded about Art Chapter Eleven: Tax and the Division of the Spoils Chapter Twelve: Capitalism, Warts and All Notes Index Copyright ACKNOWLEDGEMENTS This book draws on the wisdom of so many people and so much reading over the years that it would be impossible to thank all my sources individually. What I can do is acknowledge the long-standing support and stimulus from my colleagues at the Financial Times, the enthusiastic encouragement of David Marsh, managing director of the Official Monetary and Financial Institutions Forum, and of Andrew Hilton, director of the Centre for the Study of Financial Innovation. Anyone who writes about capitalism from a historical and cultural perspective also has to acknowledge a debt to Jerry Z. Muller, whose book The Mind and the Market: Capitalism in Western Thought has been an inspiration and a delight. I offer heartfelt gratitude to my old friend Brian Reading of Lombard Street Research, who read the manuscript. He saved me from numerous errors and made characteristically thoughtful suggestions, most of which I have taken up.

They were the folk who believed that trade was a zero-sum game and that the way to enhance the prosperity and strength of a country was to boost exports and restrain imports in order to accumulate reserves of gold. His economic writings, of which A Discourse of Trade was the most important, were admired by Keynes, Schumpeter and Marx. He was also a pioneer of fire insurance after the Great Fire of London in 1666 and helped found England’s first mortgage bank. Barbon combined these remarkable financial innovations with a role as the biggest speculative builder in London, creating the districts around what is now the Strand, and rebuilding the Temple after a fire in 1678. He also developed much of London’s Bloomsbury. His building activities relied heavily on credit, yet he was notoriously reluctant to pay his creditors, even stipulating in his will that his debts should not be met. He ignored restrictions imposed by Acts of Parliament on new building and often demolished existing structures without permission.

It is reasonably clear now that this theory has left a large number of poorer stockholders, especially including employee stockholders, not only unconvinced, but understandably disillusioned and angry. The policy of vastly increasing executive compensation was also, at least with the brilliant vision of hindsight, terribly bad social policy and perhaps even bad morals.42 A similar if less spectacular progression was under way in Europe. The escalation coincided with a power shift within banking whereby traders replaced conventional bankers at the top. They genuinely believed that financial innovations that involved packaging products such as subprime mortgages into bundles of securities that could be sold to investors were both useful and lucrative, as did the credit rating agencies that awarded triple-A status to these securitised products. So, too, did a growing band of mathematicians and scientists who left other research-intensive industries to share in the banking bonanza. At the same time, financial and human resources were diverted away from retail banking, which provides services for households and small businesses, into investment banking.


Capital Ideas Evolving by Peter L. Bernstein

Albert Einstein, algorithmic trading, Andrei Shleifer, asset allocation, business cycle, buy and hold, buy low sell high, capital asset pricing model, commodity trading advisor, computerized trading, creative destruction, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, diversification, diversified portfolio, endowment effect, equity premium, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, high net worth, hiring and firing, index fund, invisible hand, Isaac Newton, John Meriwether, John von Neumann, Joseph Schumpeter, Kenneth Arrow, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, market bubble, mental accounting, money market fund, Myron Scholes, paper trading, passive investing, Paul Samuelson, price anchoring, price stability, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, statistical model, survivorship bias, systematic trading, technology bubble, The Wealth of Nations by Adam Smith, transaction costs, yield curve, Yogi Berra, zero-sum game

.* This disheartening view is the inspiration for much of the work Shiller is doing in the area of financial innovation. “The models everybody is rationally optimizing are so misleading,” he complains: “The puzzle is why it takes so long to design proper institutions to accomplish these purposes. The government has done a lot such as Social Security, disability insurance, and Medicare. But the huge private sector often seems to miss some of the most creative ideas and most significant innovations.” Why does the private sector lag in innovation in risk management? “The problem is not so much with the managers of private sector enterprises,” he observes, “as with the public nature of financial innovations. As financial innovations are not generally * The New Financial Order won the f irst Paul A. Samuelson Award from TIAA-CREF in 1996.

The power of innovative institutions to change markets is clear from just a few examples, which Merton and Bodie place under the heading of “the financial innovation spiral.” Money market funds now compete with banks and thrifts for household savings. Securitization of auto loans and credit card receivables has intensified competition among financial institutions as sources for these purposes. High-yield bonds have liberated many companies from the icy grip of their commercial bankers. In national mortgage markets, many institutions have developed into major alternatives to thrifts as a source for residential mortgages. These institutional innovations have improved the lot of consumers and business firms by reducing the costs of the services they require. Merton is convinced that the most fruitful source for continuing the spiral of financial innovation will develop primarily from the valuation of options, or, more precisely, of contingent claims—the contribution to the theory of finance for which he earned the Nobel Prize.

Samuelson Award from TIAA-CREF in 1996. bern_c06.qxd 82 3/23/07 9:03 AM Page 82 THE THEORETICIANS patentable, financial innovators are reluctant to spend large sums developing new products that others can use. Hence, it is difficult for private sector companies to get important new things started along the lines we suggested in Macro Markets and New Financial Order.” “Why doesn’t everybody who is retired have an annuity indexed to inf lation?” Shiller asks. “The need is so obvious. The public has not demanded annuities, but that is no reason against trying to offer them. After the terrible inf lationary years of the 1970s, why did it take until 1997 before the U.S. government began to offer inf lation-indexed Treasury securities? The U.K. launched this instrument back in 1985.” Shiller shakes his head.


Money and Government: The Past and Future of Economics by Robert Skidelsky

anti-globalists, Asian financial crisis, asset-backed security, bank run, banking crisis, banks create money, barriers to entry, Basel III, basic income, Ben Bernanke: helicopter money, Big bang: deregulation of the City of London, Bretton Woods, British Empire, business cycle, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, constrained optimization, Corn Laws, correlation does not imply causation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, David Graeber, David Ricardo: comparative advantage, debt deflation, Deng Xiaoping, Donald Trump, Eugene Fama: efficient market hypothesis, eurozone crisis, financial deregulation, financial innovation, Financial Instability Hypothesis, forward guidance, Fractional reserve banking, full employment, Gini coefficient, Growth in a Time of Debt, Hyman Minsky, income inequality, incomplete markets, inflation targeting, invisible hand, Isaac Newton, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, Joseph Schumpeter, Kenneth Rogoff, labour market flexibility, labour mobility, law of one price, liberal capitalism, light touch regulation, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, market clearing, market friction, Martin Wolf, means of production, Mexican peso crisis / tequila crisis, mobile money, Mont Pelerin Society, moral hazard, mortgage debt, new economy, Nick Leeson, North Sea oil, Northern Rock, offshore financial centre, oil shock, open economy, paradox of thrift, Pareto efficiency, Paul Samuelson, placebo effect, price stability, profit maximization, quantitative easing, random walk, regulatory arbitrage, rent-seeking, reserve currency, Richard Thaler, rising living standards, risk/return, road to serfdom, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, secular stagnation, shareholder value, short selling, Simon Kuznets, structural adjustment programs, The Chicago School, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, Thomas Malthus, Thorstein Veblen, too big to fail, trade liberalization, value at risk, Washington Consensus, yield curve, zero-sum game

The Indifference of Mainstream Theory to Inequality 288 ii. The Microeconomics of Distribution 290 iii. Distribution and the Macroeconomy 293 iv. The Modern Under-consumptionist Story 298 v. Conclusion 305 11. What Was Wrong with the Banks? 307 i. Pre-crash Orthodoxy 308 ii. Theory 310 iii. Understanding Banking: Some Essential Terms 316 iv. Loosening the Regulatory Noose 318 v. Financial Innovation 322 vi. Conclusion 327 Appendix 11.1: Why Didn’t the Credit Ratings Agencies Do Their Job? 12. Global Imbalances 329 331 i. Introduction 331 ii. A Pre-crash Bird’s-eye View 334 x C on t e n t s iii. Some Basic Theory 335 iv. Current Account Imbalances as a Cause of Meltdown? 336 v. Saving Glut versus Money Glut 338 vi. Banking Imbalances 342 vii. Conclusion 343 Pa r t Fou r A New Macroeconomics 13.

The banking sector was freed up to do its best and worst by national governments and regulators, who held a benevolent view of the financial system. Finance was viewed essentially as an intermediatory, bringing together willing buyers and sellers of goods and services. In the language of the day, the financial market was an ‘efficient’ market, which needed no more regulation than any other market. The peculiar property of finance as a vent for speculation and fraud was ignored. This benign view of finance extended to the financial innovations of the 1990s. Securitization – the process of transforming non-marketable assets into marketable ones – led to a continuous lengthening of the chain of indebtedness. This ‘financialization’ of the economy – the growing share of money being made from purely financial operations – was praised (or at least justified) as ‘making capital allocation more efficient’ and therefore maximizing growth.

Indeed, the methods by which it rescued damaged economies from the financial excesses of the 10 I n t roduc t ion pre-crash years have set the scene for the next financial crash. Our economies are still on life-support systems, and the withdrawal of these will be exceptionally challenging. Chapters 10, 11 and 12 look at the structural causes of financial instability. Chapter 10 analyses the macroeconomic impact of the growth of inequality of income and wealth. The focus of Chapter 11 is on financial innovation, partly in response to the explosive increase in the demand for credit. Chapter 12 examines the contribution of current account imbalances to the instability of the pre-crash economic system. And so to the topic of the final part: what is to be done? The central question of political economy today is as it has always been: what does a government need to do to secure the relatively smooth – and socially and morally tolerable – functioning of a decentralized, money-using, largely privately owned economy?


pages: 280 words: 73,420

Crapshoot Investing: How Tech-Savvy Traders and Clueless Regulators Turned the Stock Market Into a Casino by Jim McTague

algorithmic trading, automated trading system, Bernie Madoff, Bernie Sanders, Bretton Woods, buttonwood tree, buy and hold, computerized trading, corporate raider, creative destruction, credit crunch, Credit Default Swap, financial innovation, fixed income, Flash crash, High speed trading, housing crisis, index arbitrage, locking in a profit, Long Term Capital Management, margin call, market bubble, market fragmentation, market fundamentalism, Myron Scholes, naked short selling, pattern recognition, Ponzi scheme, quantitative trading / quantitative finance, Renaissance Technologies, Ronald Reagan, Sergey Aleynikov, short selling, Small Order Execution System, statistical arbitrage, technology bubble, transaction costs, Vanguard fund, Y2K

In the midst of the journalistic feeding frenzy, it wasn’t long before reporters discovered Arnuk and Saluzzi’s white paper and launched the pair into the limelight. Saluzzi was invited to discuss his findings on Bloomberg television, a cable business channel. The interview was apparently seen by somebody at the SEC, because shortly after the broadcast, Arnuk received an invitation from Henry Hu, chief of the SEC’s Division of Risk, Strategy, and Financial Innovation, to visit Washington, DC with Saluzzi and address the SEC staff. This was exactly the audience that the two traders wanted to reach. Saluzzi and Arnuk brought along a PowerPoint presentation and assumed that they would be addressing a small group of people. Much to their surprise, they were ushered into a heavily populated conference room. The audience included some of the agency’s other division heads and some of its top PhD economists.

What do we really know about the cumulative effect of all these changes on the stability of our capital markets?” When the SEC published its concept release in January 2010, it specifically raised Kaufman’s questions. The concept release also reflected agency concern about the allegations that Arnuk and Saluzzi made. This relatively quick response was unusual for the SEC and tribute to Schapiro’s decision some months earlier to create a new Division of Risk, Strategy, and Financial Innovation. She had populated it with economists and MBAs with real Wall Street experience and academics like Henry Hu of the University of Texas whose studies had focused on market risk. This was the first new division within the SEC since the Great Depression, and it was meant to inject the agency with some vigor. So Kaufman had made a difference. The SEC was going to shine a light on HFT. Yet Kaufman remained dissatisfied.

Schapiro had seen her salary rise from $2.1 million annually to $3 million during her tenure, and she received a severance package valued at $7.8 million upon leaving, giving some people the impression that the task of lining her own pockets had distracted her from the task of regulating her charges. Adeptly dealing with the Flash Crash was an opportunity for her to make up for past sins, both real and perceived. In fact, she had taken one exceptionally imaginative step upon arriving at the SEC to make sure a Madoff-style scandal never again blindsided her: She had created a new division, the first since the agency’s founding in 1934. The Division of Risk, Strategy and Financial Innovation was staffed with risk specialists, economists, and even some physicists to anticipate threats to the markets posed by new and existing investment activities and products. Schapiro recruited University of Texas professor Henry Hu to head the division. A renaissance man with degrees in science and law, Hu in 1993 had written a forward-looking piece for the Yale Law Review predicting that big financial institutions would make significant mistakes employing relatively new products called derivatives.


How I Became a Quant: Insights From 25 of Wall Street's Elite by Richard R. Lindsey, Barry Schachter

Albert Einstein, algorithmic trading, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, asset allocation, asset-backed security, backtesting, bank run, banking crisis, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business cycle, business process, butter production in bangladesh, buy and hold, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, commoditize, computerized markets, corporate governance, correlation coefficient, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Donald Knuth, Edward Thorp, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, full employment, George Akerlof, Gordon Gekko, hiring and firing, implied volatility, index fund, interest rate derivative, interest rate swap, John von Neumann, linear programming, Loma Prieta earthquake, Long Term Capital Management, margin call, market friction, market microstructure, martingale, merger arbitrage, Myron Scholes, Nick Leeson, P = NP, pattern recognition, Paul Samuelson, pensions crisis, performance metric, prediction markets, profit maximization, purchasing power parity, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Richard Feynman, Richard Stallman, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, sorting algorithm, statistical arbitrage, statistical model, stem cell, Steven Levy, stochastic process, systematic trading, technology bubble, The Great Moderation, the scientific method, too big to fail, trade route, transaction costs, transfer pricing, value at risk, volatility smile, Wiener process, yield curve, young professional

I took as my dissertation topic monetary issues in Europe, where several industrial economies still remained. Years passed, and the fascination of watching the dollar and the price of oil fall began to fade. I switched to a different department at the New York Fed, this one tasked with studying financial innovation. It had its origin in a Bank for International Settlements group that also had a quaint name, the Eurodollar Standing Committee. The Committee dated back to concerns about one of the first great financial innovations of the postwar financial system, the Eurodollar market. Today the Eurodollar market would hardly evoke a yawn from most observers, but at the time the central bankers meeting in Basel took an interest, it was considered a great mystery and even a threat. The Eurodollar market had arisen as a side effect of the U.S. current account deficits that had brought down the original Bretton Woods system, it JWPR007-Lindsey 298 May 7, 2007 17:27 h ow i b e cam e a quant appeared to threaten a loss of the Federal Reserve’s ability to limit the U.S. money supply, and to top things off, the Soviet Union and later the oil exporters were among the largest depositors.

Early twentiethcentury financial market participants in Chicago and New York actively JWPR007-Lindsey May 7, 2007 18:27 Introduction 5 traded commodity and equity options during regular time periods, albeit off the exchange floors, and prices were reported in the papers. Like Fermat, what Fischer Black and Myron Scholes (and Robert Merton) added, was a way to determine the “fair” value of an option (subject to various caveats related to the reasonableness of the model’s assumptions). Once adopted, their solution replaced the prior ad hoc pricing approach. Fermat is not the only historical example of a scientist devising a financial innovation that today would label him as a quant. A particularly striking example is the role quants played in improving government finance practices as far back as the sixteenth century. A common means of financing municipal and state debt in the Renaissance was the issuance of life annuities. In return for providing a sum to the government, the provider could designate that a regular annual payment go to a designee for life.

The Eurodollar market had arisen as a side effect of the U.S. current account deficits that had brought down the original Bretton Woods system, it JWPR007-Lindsey 298 May 7, 2007 17:27 h ow i b e cam e a quant appeared to threaten a loss of the Federal Reserve’s ability to limit the U.S. money supply, and to top things off, the Soviet Union and later the oil exporters were among the largest depositors. In my new role, I searched for reasons to worry about financial innovations that, like the Eurodollar market in its time, were poorly understood, and that with some imagination could be seen as potentially harmful. In particular, I studied newfangled currency options such as average-rate, basket and barrier options. And, like the Eurodollar market, these now seem about as threatening to financial stability as a plate of pasta. This was my first encounter with modern finance.


pages: 479 words: 113,510

Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America by Danielle Dimartino Booth

Affordable Care Act / Obamacare, asset-backed security, bank run, barriers to entry, Basel III, Bernie Sanders, break the buck, Bretton Woods, business cycle, central bank independence, collateralized debt obligation, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, financial deregulation, financial innovation, fixed income, Flash crash, forward guidance, full employment, George Akerlof, greed is good, high net worth, housing crisis, income inequality, index fund, inflation targeting, interest rate swap, invisible hand, John Meriwether, Joseph Schumpeter, liquidity trap, London Whale, Long Term Capital Management, margin call, market bubble, Mexican peso crisis / tequila crisis, money market fund, moral hazard, Myron Scholes, natural language processing, negative equity, new economy, Northern Rock, obamacare, price stability, pushing on a string, quantitative easing, regulatory arbitrage, Robert Shiller, Robert Shiller, Ronald Reagan, selection bias, short selling, side project, Silicon Valley, The Great Moderation, The Wealth of Nations by Adam Smith, too big to fail, trickle-down economics, yield curve

“I tried to push back against complacency,” Geithner wrote, “telling a room full of bankers that the wonders of the new financial world would not necessarily prevent catastrophic failures of major institutions, and should not inspire delusions of safety on Wall Street. . . . I suggested that financial innovation was driving risk and leverage into corners of the financial system with weaker supervision, and that our tools for monitoring systemic risk weren’t keeping up.” Hmmm. Geithner’s memory doesn’t match the actual text of his speech, which painted a picture of the system’s financial stability and, yep, complacency. Though Geithner mentioned that financial innovation presented “significant challenges,” he expressed no warnings, sounded no alarms. Bankers had heard this speech a hundred times over rubber chicken. In fact, beyond reiterating that banks must have “a sufficient cushion against adversity,” Geithner’s speech was the opposite of a warning.

(At a conference, I chuckled when an economist stood at a podium deriding the rigidities of the “dismal science.” Somewhat vertically challenged with a bald head, Wells Fargo’s Mark Vitner remarked, “If you seasonally adjust me, I’m George Clooney.”) This created a weird disconnect every time I went to work. Inside the Dallas Fed, there was no housing bubble. ARMs were the greatest financial innovation to ever bless the middle class. Mortgage equity withdrawal was fueling a fantastic wealth effect. Derivatives were sophisticated financial instruments that diffused risk. All of the Fed’s eccentric econometric models showed the future was rosy, that baby boomers would retire with record levels of prosperity. I believed none of those things were true. I believed that Greenspan, above all others, had blood on his hands.

Fourteen stories high, with five stories underground, it was designed to resemble an Italian Renaissance palace. Powerful, impregnable. If the Marriner S. Eccles Federal Reserve Board Building on Constitution Avenue in Washington is the Fed’s brain, the imposing stone behemoth on Liberty Street is the Fed’s beating heart. When Geithner set foot in the door, neither the brain nor the heart of the Fed sensed any danger. Fed economists had “growing confidence that derivatives and other financial innovations designed to hedge and distribute risk—along with better monetary policy to respond to downturns and better technology to smooth out inventory cycles—had made devastating crises a thing of the past,” Geithner said in his memoir, Stress Test. A protégé of Rubin and Summers, Geithner had no experience on Wall Street or in banking. He had a lot to learn about the New York Fed, which occupies a unique place in the Fed’s ecosystem.


pages: 403 words: 87,035

The New Geography of Jobs by Enrico Moretti

assortative mating, Bill Gates: Altair 8800, business climate, call centre, cleantech, cloud computing, corporate raider, creative destruction, desegregation, Edward Glaeser, financial innovation, global village, hiring and firing, income inequality, industrial cluster, Jane Jacobs, Jeff Bezos, Joseph Schumpeter, knowledge economy, labor-force participation, low skilled workers, manufacturing employment, Mark Zuckerberg, mass immigration, medical residency, Menlo Park, new economy, peer-to-peer lending, Peter Thiel, Productivity paradox, Richard Florida, Sand Hill Road, Silicon Valley, Skype, special economic zone, Startup school, Steve Jobs, Steve Wozniak, thinkpad, Tyler Cowen: Great Stagnation, Wall-E, Y Combinator, zero-sum game

In the process, it is creating jobs both at Prosper itself and at the businesses it supports. In 2010, 3,649 patents were granted in the United States for financial or business practice innovations, one of the most important categories. Currently the American public holds a rather negative view of the social value of financial “innovation,” given the role of derivatives in triggering the Great Recession of 2008–2010. But this is probably an overreaction. While there are important exceptions, by and large financial innovation has contributed to supporting America’s economic growth. After all, the fact that planes are flying people from one corner of the country to another at affordable prices has as much to do with innovative hedges against high fuel costs as with advances in aviation technology. Digital entertainment is another fast-growing piece of the innovation sector.

This matters tremendously, not just for Apple’s profit margin and for our sense of national pride, but because it means good jobs. The innovation sector includes advanced manufacturing (such as designing iPhones or iPads), information technology, life sciences, medical devices, robotics, new materials, and nanotechnology. But innovation is not limited to high technology. Any job that generates new ideas and new products qualifies. There are entertainment innovators, environmental innovators, even financial innovators. What they all have in common is that they create things the world has never seen before. We tend to think of innovations as physical goods, but they can also be services—for example, new ways of reaching consumers or new ways of spending our free time. Today this is where the real money is. A part of the $321 that Apple receives ends up in the pockets of Apple’s stockholders, but some of it goes to Apple’s employees in Cupertino.

During the past two decades, its Silicon Alley has become a magnet for creative entrepreneurs and well-educated young workers. It is now a premier location for Internet portals and information services, and along with Los Angeles it accounts for a large number of digital entertainment jobs. In 2011, Google undertook a major expansion of its New York office, paying $2 billion to buy a large building near the meatpacking district. The New York region also remains the undisputed world leader in financial innovation. Historically, the Washington, D.C., area never had many high-tech jobs apart from a sizable cluster of defense contractors. But in the past twenty years the region has been remarkably successful at attracting a wide array of innovative companies to the high-tech Dulles corridor and to the downtown area. It is not on the list of the top ten metropolitan areas for patents because its industry mix is focused on IT and generates relatively fewer patents than other places.


pages: 394 words: 85,734

The Global Minotaur by Yanis Varoufakis, Paul Mason

active measures, banking crisis, Berlin Wall, Big bang: deregulation of the City of London, Bretton Woods, business climate, business cycle, capital controls, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, colonial rule, corporate governance, correlation coefficient, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, declining real wages, deindustrialization, endogenous growth, eurozone crisis, financial innovation, first-past-the-post, full employment, Hyman Minsky, industrial robot, Joseph Schumpeter, Kenneth Rogoff, Kickstarter, labour market flexibility, light touch regulation, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market fundamentalism, Mexican peso crisis / tequila crisis, money market fund, mortgage debt, Myron Scholes, negative equity, new economy, Northern Rock, paper trading, Paul Samuelson, planetary scale, post-oil, price stability, quantitative easing, reserve currency, rising living standards, Ronald Reagan, special economic zone, Steve Jobs, structural adjustment programs, systematic trading, too big to fail, trickle-down economics, urban renewal, War on Poverty, WikiLeaks, Yom Kippur War

After the Crash of 2008, Wall Street’s bosses went into damage-control mode, desperately trying to stem the popular demand for stringent regulation of their institutions. Their argument, predictably, was that too much regulation would stifle ‘financial innovation’, with dire consequences for economic growth (a little like the mafia warning against law enforcement because of its deflationary consequences). In a plush New York conference setting, on a cold December night in 2009, all the big Wall Street institutional players were assembled to hear Paul Volcker address them. Attendance was high because President Obama had entrusted him with the planning of the new regulatory framework for the banks. Volcker lost no time in lashing out with the words: ‘I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth; one shred of evidence.’ One hapless banker retorted that the financial sector in the United States had increased its share of value-added from 2 per cent to 6.5 per cent.

One hapless banker retorted that the financial sector in the United States had increased its share of value-added from 2 per cent to 6.5 per cent. Volcker responded with a killer question: ‘Is that a reflection of your financial innovation, or just a reflection of what you’re paid?’ To finish off the banker, he added: ‘The only financial innovation I recall in my long career was the invention of the ATM.’ The combination of options to buy, hedging and leveraging is such risky business that, had it been a pharmaceutical, never in a million years would it have secured approval from the US Food and Drug Administration. This is now well understood. Much less well understood is the fact that, without the Global Minotaur guaranteeing a steady torrent of capital into the United States (often via London), these practices would never have taken off as a systemic practice – not even in Wall Street.

The British Academy’s answer grudgingly confessed to the combined sins of smug rhetoric and linear extrapolation. Together, these sins fed into the self-congratulatory conviction that a paradigm shift had occurred, enabling the world of finance to create unlimited, benign, riskless debt. The first sin, which took the form of a mathematized rhetoric, lulled authorities and academics into a false belief that financial innovation had engineered risk out of the system; that the new instruments allowed a new form of debt with the properties of quicksilver. Once loans were originated, they were then sliced up into tiny pieces, blended together in packages that contained different degrees of risk,3 and sold all over the globe. By thus spreading financial risk, so the rhetoric went, no single agent faced any significant danger that they would be hurt if some debtors went bust.


pages: 492 words: 118,882

The Blockchain Alternative: Rethinking Macroeconomic Policy and Economic Theory by Kariappa Bheemaiah

accounting loophole / creative accounting, Ada Lovelace, Airbnb, algorithmic trading, asset allocation, autonomous vehicles, balance sheet recession, bank run, banks create money, Basel III, basic income, Ben Bernanke: helicopter money, bitcoin, blockchain, Bretton Woods, business cycle, business process, call centre, capital controls, Capital in the Twenty-First Century by Thomas Piketty, cashless society, cellular automata, central bank independence, Claude Shannon: information theory, cloud computing, cognitive dissonance, collateralized debt obligation, commoditize, complexity theory, constrained optimization, corporate governance, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crowdsourcing, cryptocurrency, David Graeber, deskilling, Diane Coyle, discrete time, disruptive innovation, distributed ledger, diversification, double entry bookkeeping, Ethereum, ethereum blockchain, fiat currency, financial innovation, financial intermediation, Flash crash, floating exchange rates, Fractional reserve banking, full employment, George Akerlof, illegal immigration, income inequality, income per capita, inflation targeting, information asymmetry, interest rate derivative, inventory management, invisible hand, John Maynard Keynes: technological unemployment, John von Neumann, joint-stock company, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, Kevin Kelly, knowledge economy, large denomination, liquidity trap, London Whale, low skilled workers, M-Pesa, Marc Andreessen, market bubble, market fundamentalism, Mexican peso crisis / tequila crisis, MITM: man-in-the-middle, money market fund, money: store of value / unit of account / medium of exchange, mortgage debt, natural language processing, Network effects, new economy, Nikolai Kondratiev, offshore financial centre, packet switching, Pareto efficiency, pattern recognition, peer-to-peer lending, Ponzi scheme, precariat, pre–internet, price mechanism, price stability, private sector deleveraging, profit maximization, QR code, quantitative easing, quantitative trading / quantitative finance, Ray Kurzweil, Real Time Gross Settlement, rent control, rent-seeking, Satoshi Nakamoto, Satyajit Das, savings glut, seigniorage, Silicon Valley, Skype, smart contracts, software as a service, software is eating the world, speech recognition, statistical model, Stephen Hawking, supply-chain management, technology bubble, The Chicago School, The Future of Employment, The Great Moderation, the market place, The Nature of the Firm, the payments system, the scientific method, The Wealth of Nations by Adam Smith, Thomas Kuhn: the structure of scientific revolutions, too big to fail, trade liberalization, transaction costs, Turing machine, Turing test, universal basic income, Von Neumann architecture, Washington Consensus

Garrick Hileman is a senior research associate at the Cambridge Center for Alternative Finance and a researcher at the Center for Macroeconomics. He was recently ranked as one of the 100 most influential economists in the UK and Ireland and he is regularly asked to share his research and perspective with the FT, BBC, CNBC, WSJ, Sky News, and other media. Garrick has been invited to present his research on monetary and financial innovation to government organizations, including central banks and war colleges, as well as private firms such as Visa, Black Rock, and UBS. Garrick has 20 years’ private sector experience with both startups and established companies such as Visa, Lloyd’s of London, Bank of America, The Home Depot, and Allianz. Garrick’s technology experience includes co-founding a San Francisco-based tech incubator, IT strategy consulting for multinationals, and founding MacroDigest <http://www.macrodigest.com/>, which employs a proprietary algorithm to cluster trending economic analysis and perspective.

Without a sufficient understanding of these topics, there is no context for the conversation. The second part of this book delves into the blockchain from the perspective of its transitionary role in finance. Following the financial crisis of 2008, the financial sector has been in a state of flux. On one side, governments and regulators now demand a greater level of transparency with respect to financial innovation, taxation, and cross-border transactions. On the other hand, technological progress is defragmenting the financial sector, causing incumbents to be challenged by tech firms. While the current dialogue looks at the blockchain as an independent technology, this section of the book attempts to clarify its amalgamator function when juxtaposed with other technologies that are currently fragmenting the sector of finance.

However, the transference of roles was not all bad news for financial institutions. As an increasing number of consumers took on debt to purchase products, it meant that the growth of the non-financial institutions had to be leveraged by taking on more debt. As the spiral of debt continued, the risk attached to loans grew in volume, to the point that it was now necessary to address the situation. It is here that financial innovation came to the rescue. As the power of banks decreased due to the issuance of debt by non-financial institutions, the banks installed a new risk management practise via their activities in exchanging securities and specifically through CDOs (Collateralised Debt Obligations), Collateralized Loan Obligations (CLOs) and CDSs (Credit Default Swaps). Previously, banks controlled the amount of risk in the economy by providing or withholding credit.


pages: 543 words: 147,357

Them And Us: Politics, Greed And Inequality - Why We Need A Fair Society by Will Hutton

Andrei Shleifer, asset-backed security, bank run, banking crisis, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Blythe Masters, Boris Johnson, Bretton Woods, business cycle, capital controls, carbon footprint, Carmen Reinhart, Cass Sunstein, centre right, choice architecture, cloud computing, collective bargaining, conceptual framework, Corn Laws, corporate governance, creative destruction, credit crunch, Credit Default Swap, debt deflation, decarbonisation, Deng Xiaoping, discovery of DNA, discovery of the americas, discrete time, diversification, double helix, Edward Glaeser, financial deregulation, financial innovation, financial intermediation, first-past-the-post, floating exchange rates, Francis Fukuyama: the end of history, Frank Levy and Richard Murnane: The New Division of Labor, full employment, George Akerlof, Gini coefficient, global supply chain, Growth in a Time of Debt, Hyman Minsky, I think there is a world market for maybe five computers, income inequality, inflation targeting, interest rate swap, invisible hand, Isaac Newton, James Dyson, James Watt: steam engine, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, knowledge economy, knowledge worker, labour market flexibility, liberal capitalism, light touch regulation, Long Term Capital Management, Louis Pasteur, low cost airline, low-wage service sector, mandelbrot fractal, margin call, market fundamentalism, Martin Wolf, mass immigration, means of production, Mikhail Gorbachev, millennium bug, money market fund, moral hazard, moral panic, mortgage debt, Myron Scholes, Neil Kinnock, new economy, Northern Rock, offshore financial centre, open economy, plutocrats, Plutocrats, price discrimination, private sector deleveraging, purchasing power parity, quantitative easing, race to the bottom, railway mania, random walk, rent-seeking, reserve currency, Richard Thaler, Right to Buy, rising living standards, Robert Shiller, Robert Shiller, Ronald Reagan, Rory Sutherland, Satyajit Das, shareholder value, short selling, Silicon Valley, Skype, South Sea Bubble, Steve Jobs, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, the scientific method, The Wealth of Nations by Adam Smith, too big to fail, unpaid internship, value at risk, Vilfredo Pareto, Washington Consensus, wealth creators, working poor, zero-sum game, éminence grise

Today, it is even more so. In their defence, bankers and financiers usually point to ‘financial innovation’ as an attribute that society should desire and value, but their arguments are hamstrung by their own astonishing inability to distinguish between innovation that is economically and socially useful and that which is not. For example, James Kwak argues it was this blindness that lay behind the crisis in so-called ‘sub-prime’ mortgages – financing offered to ‘sub-prime’ borrowers. The bankers boasted that they were promoting home-ownership, but they were not. They were actually promoting home-buyership, which the buyers, with low or sometimes zero incomes, could not sustain – a socially toxic financial innovation. Other innovations that allegedly better managed risk or liquidity turned out to be illusory, as I discuss in Chapters 6 and 7.

Then there is the three-masted sailing ship, which allowed large vessels to sail close to the wind, permitted the Portuguese and then their European imitators to sail around the world. Without this GPT, there would have been no circumnavigation of the globe; no discovery of the Americas, leading to new centres of power and productive capacity; no European colonisation; no long-distance sea trade; no rich European merchant class; no consequent financial innovations, such as joint stock companies and marine insurance, to deal with the risk and uncertainty of long voyages; and less possibility of the principles of magnetism being understood. Similarly, in the nineteenth century, the railway was much more than just a transport technology. It transformed companies, creating both mass consumption and mass production. It turned local, fragmented markets into powerful, national markets, and thereby enabled the United States to achieve previously unimaginable scale economies – with seismic ramifications for global industrial leadership.

In this respect, the 1992 defeat overshadowed the next decade and a half in much the same way as 1945’s and 1979’s victories had. This meant that New Labour in office did not have the ideological conviction or the political will to check the increasingly reckless expansion of British finance and the City of London. Indeed, by 2007, City Minister Ed Balls and Chancellor Gordon Brown had become articulate advocates of ‘light-touch regulation’ and ‘financial innovation’, regarding finance as a sector in which Britain had an apparent comparative advantage that the state should actively promote. After 1992, Labour politicians were convinced that while they might win a mandate for social investment, notably in health and education, no mandate could be won for social democratic intervention in the economy. In any case, they had stopped believing in the intellectual argument for such an intervention.


pages: 288 words: 64,771

The Captured Economy: How the Powerful Enrich Themselves, Slow Down Growth, and Increase Inequality by Brink Lindsey

"Robert Solow", Airbnb, Asian financial crisis, bank run, barriers to entry, Bernie Sanders, Build a better mousetrap, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, Cass Sunstein, collective bargaining, creative destruction, Credit Default Swap, crony capitalism, Daniel Kahneman / Amos Tversky, David Brooks, diversified portfolio, Donald Trump, Edward Glaeser, endogenous growth, experimental economics, experimental subject, facts on the ground, financial innovation, financial intermediation, financial repression, hiring and firing, Home mortgage interest deduction, housing crisis, income inequality, informal economy, information asymmetry, intangible asset, inventory management, invisible hand, Jones Act, Joseph Schumpeter, Kenneth Rogoff, Kevin Kelly, knowledge worker, labor-force participation, Long Term Capital Management, low skilled workers, Lyft, Mark Zuckerberg, market fundamentalism, mass immigration, mass incarceration, medical malpractice, Menlo Park, moral hazard, mortgage debt, Network effects, patent troll, plutocrats, Plutocrats, principal–agent problem, regulatory arbitrage, rent control, rent-seeking, ride hailing / ride sharing, Robert Metcalfe, Ronald Reagan, Silicon Valley, Silicon Valley ideology, smart cities, software patent, too big to fail, total factor productivity, trade liberalization, transaction costs, tulip mania, Uber and Lyft, uber lyft, Washington Consensus, white picket fence, winner-take-all economy, women in the workforce

The development of new financial products, a process once proudly called “financial innovation,” further expanded the market for mortgage-backed securities and the demand for more underlying mortgages to be issued. In a beguiling bit of alchemy, low-quality mortgages could be transformed into AAA securities by slicing pools of mortgages into “tranches” so that the senior-most slices are the last to absorb any default losses. This alchemy could then be embellished with “synthetic” securities comprising tranches of tranches. Other derivatives, like credit default swaps, appeared to spread risk even more widely, fueling demand for even more expansion of mortgage credit. Egged on by the combination of financial innovation and expectations of ever-rising home prices, mortgage lending exploded and underwriting standards collapsed.

This aspect of financialization, then, has been a consequence of dramatic increase in stock market capitalization since 1980 and the growing dispersion of stock ownership through mutual funds and government-subsidized 401(k) plans. We will not concern ourselves here with this part of the story, except for acknowledging that it is a big part of the story and that it is partly traceable to state action. The other big component of financialization has been an explosion in household credit, an explosion made possible by the financial innovation known as securitization. Between 1980 and 2007, total household credit soared from 48 percent of GDP to 99 percent, with the sharpest increases occurring during the housing bubble. Residential mortgages dominate household credit, which also includes credit cards, student loans, and other consumer borrowing. Over the course of this period, household credit extended by traditional banks held steady at around 40 percent of GDP.

This declining capacity has the further effect of making it harder to expand the political agenda by choking off the information that policymakers need to investigate new problems (including problems, such as rent-seeking arrangements, generated by existing policy).20 In most policy areas, the political environment is profoundly biased toward those with the resources to invest in information—resources that will be particularly abundant when rents can be recycled into politics. The consequence is that real deliberation, which requires high-quality information on both sides of contested questions, is difficult if not impossible, even if politicians and interest groups have no direct exchange of money. Informational imbalances have done much to warp policy in all of our case studies. Finance represents an extreme example. After decades of financial innovation, the old simplicity of the “3-6-3 rule” (pay 3 percent on deposits, lend out at 6 percent, get to the golf course by 3) has given way to mind-boggling complexity overseen by “rocket scientists,” “quant jocks,” and “the smartest guys in the room.” To master these complexities requires advanced degrees and years of experience; it is therefore hopeless to expect twenty-something congressional staffers with BAs to be able to keep up with all the technical arcana and see through the weaknesses in the industry’s arguments.


pages: 545 words: 137,789

How Markets Fail: The Logic of Economic Calamities by John Cassidy

"Robert Solow", Albert Einstein, Andrei Shleifer, anti-communist, asset allocation, asset-backed security, availability heuristic, bank run, banking crisis, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Black-Scholes formula, Blythe Masters, Bretton Woods, British Empire, business cycle, capital asset pricing model, centralized clearinghouse, collateralized debt obligation, Columbine, conceptual framework, Corn Laws, corporate raider, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Daniel Kahneman / Amos Tversky, debt deflation, different worldview, diversification, Elliott wave, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, George Akerlof, global supply chain, Gunnar Myrdal, Haight Ashbury, hiring and firing, Hyman Minsky, income per capita, incomplete markets, index fund, information asymmetry, Intergovernmental Panel on Climate Change (IPCC), invisible hand, John Nash: game theory, John von Neumann, Joseph Schumpeter, Kenneth Arrow, Kickstarter, laissez-faire capitalism, Landlord’s Game, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, market clearing, mental accounting, Mikhail Gorbachev, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, Myron Scholes, Naomi Klein, negative equity, Network effects, Nick Leeson, Northern Rock, paradox of thrift, Pareto efficiency, Paul Samuelson, Ponzi scheme, price discrimination, price stability, principal–agent problem, profit maximization, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, RAND corporation, random walk, Renaissance Technologies, rent control, Richard Thaler, risk tolerance, risk-adjusted returns, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, technology bubble, The Chicago School, The Great Moderation, The Market for Lemons, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, unorthodox policies, value at risk, Vanguard fund, Vilfredo Pareto, wealth creators, zero-sum game

To employ all the money they had borrowed, banks had to search out marginal customers and extend themselves into new, riskier areas. As Minsky put it, “[T]he leverage ratio of banks and the import of speculative and Ponzi financing in the economy are two sides of a coin.” Another shortcoming in the traditional view of banking that Minsky highlighted was its failure to take adequate account of financial innovation. “Like all entrepreneurs in a capitalist economy, bankers are aware that innovation assures profits,” Minsky wrote. “Thus, bankers, whether they be brokers or dealers, are merchants of debt who strive to innovate in the assets they acquire and the liabilities they market.” One quick way for a bank to expand its revenues is by extending credit to people and firms that previously it would have turned down for loans because of doubts about their ability to repay.

One quick way for a bank to expand its revenues is by extending credit to people and firms that previously it would have turned down for loans because of doubts about their ability to repay. In the era when banks ordinarily held on to the loans they issued until they matured, pursuing such a risky lending strategy generally didn’t make sense: the extra income from the new loans wasn’t enough to cover the increased probability of defaults. But, beginning in the 1970s, a series of financial innovations transformed the incentive structure that banks faced. The key development was the rise of “securitization.” In 1970, the Government National Mortgage Association (Ginnie Mae), one of three government-sponsored agencies that guarantee certain types of home loans—the other two are the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac)—issued a new type of bond known as a residential mortgage-backed security (RMBS).

Thus conceived, the so-called shadow banking system would grow to elephantine proportions while remaining largely beyond the purview of regulators, bank stockholders, and journalists. Minsky didn’t realize the full implications of securitization—nobody did—but he was one of the few economists to draw attention to it. After his death in 1996, some of his colleagues in the small but dedicated post-Keynesian school pursued his interest in financial innovation. In his 2002 book, Financial Markets, Money and the Real World, Paul Davidson, of the University of Tennessee, pointed out that almost half the loans that U.S. banks initiated in 2001 had subsequently been transferred to nonbank entities, mostly through securitization. “The downside aspect of this shift in the source of bank profits from interest earnings to originating and servicing fees is that bank loan officers do not worry as much about the creditworthiness of borrowers as long as there is a strong market for these loans,” Davidson wrote.


pages: 346 words: 90,371

Rethinking the Economics of Land and Housing by Josh Ryan-Collins, Toby Lloyd, Laurie Macfarlane

"Robert Solow", agricultural Revolution, asset-backed security, balance sheet recession, bank run, banking crisis, barriers to entry, basic income, Bretton Woods, business cycle, Capital in the Twenty-First Century by Thomas Piketty, collective bargaining, Corn Laws, correlation does not imply causation, creative destruction, credit crunch, debt deflation, deindustrialization, falling living standards, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, garden city movement, George Akerlof, ghettoisation, Gini coefficient, Hernando de Soto, housing crisis, Hyman Minsky, income inequality, information asymmetry, knowledge worker, labour market flexibility, labour mobility, land reform, land tenure, land value tax, Landlord’s Game, low skilled workers, market bubble, market clearing, Martin Wolf, means of production, money market fund, mortgage debt, negative equity, Network effects, new economy, New Urbanism, Northern Rock, offshore financial centre, Pareto efficiency, place-making, price stability, profit maximization, quantitative easing, rent control, rent-seeking, Richard Florida, Right to Buy, rising living standards, risk tolerance, Second Machine Age, secular stagnation, shareholder value, the built environment, The Great Moderation, The Market for Lemons, The Spirit Level, The Wealth of Nations by Adam Smith, Thomas Malthus, transaction costs, universal basic income, urban planning, urban sprawl, working poor, working-age population

Residential mortgage-backed security (RMBS) – A type of asset-backed security that is secured by a collection of domestic mortgages. Section 106 – A section of the Town and Country Planning Act 1990 which allowed local planning authorities to enter into legally binding agreements with developers, with the latter having to provide certain public benefits as part of the development. Securitisation – A financial innovation undertaken by banks involving the pooling together and repackaging a number of illiquid loans – loans that cannot easily be sold or exchanged for cash – and issuing tradable debt securities against these loans that are sold to investors. These securities are repaid as the underlying loans are repaid. Special purpose vehicle (SPV) – An entity set up, usually by a financial institution, for the specific purpose of purchasing the assets and realising their off-balance-sheet treatment for legal and accounting purposes.

(Feldstein, 2008) The lower rate of defaults of securitised products in Europe compared with the US may be a reflection of underlying legal differences in mortgage loans between the two countries, as well as differences in securitisation practice. 5.5 Macroeconomic effects of the liberalisation of mortgage credit The above historical review has shown how, since the 1970s, land has become ‘financialised’, as the deregulation of the financial system and financial innovation allowed for the emergence of repeated property credit booms and busts. In this section we turn to some of the important effects of mortgage credit liberalisation on the wider economy. The liberalisation of mortgage credit has revolutionised the relationship between land values, house prices and the wider economy in the UK. It has led, as we discussed, to a huge increase in the value of land and property relative to the rest of the economy and a huge increase in property assets on banks’ balance sheets relative to non-property assets (such as business loans).

Many advanced economies enjoyed an unprecedented period of steady growth coupled with low inflation from the 1990s and up to the crisis – described as the ‘Great Moderation’ – that may have reassured central banks that policy was working (Bezemer and Grydaki, 2014). Mervyn King described the 1990s as the ‘NICE’ decade – a period of ‘non-inflationary, consistent expansion’ (King, 2003, p. 3). In the 2000s, financial innovations, including RMBS, were seen as spreading risk rather than amplifying it. The build-up of mortgage debt smoothed the business cycle but encouraged excessive leverage in both the banking and household sector which eventually resulted in fragilities that led to financial collapse (Barwell and Burrows, 2011). The smoothing of the cycle enabled by mortgage lending was simply disguising the build-up of much larger, longer and more dangerous ‘credit’ or ‘financial cycles’ that macroeconomics had neglected for much of the post-war period (Borio, 2014).


When the Money Runs Out: The End of Western Affluence by Stephen D. King

Albert Einstein, Asian financial crisis, asset-backed security, banking crisis, Basel III, Berlin Wall, Bernie Madoff, British Empire, business cycle, capital controls, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, congestion charging, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, cross-subsidies, debt deflation, Deng Xiaoping, Diane Coyle, endowment effect, eurozone crisis, Fall of the Berlin Wall, financial innovation, financial repression, fixed income, floating exchange rates, full employment, George Akerlof, German hyperinflation, Hyman Minsky, income inequality, income per capita, inflation targeting, invisible hand, John Maynard Keynes: Economic Possibilities for our Grandchildren, joint-stock company, Kickstarter, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, London Interbank Offered Rate, loss aversion, market clearing, mass immigration, moral hazard, mortgage debt, new economy, New Urbanism, Nick Leeson, Northern Rock, Occupy movement, oil shale / tar sands, oil shock, old age dependency ratio, price mechanism, price stability, quantitative easing, railway mania, rent-seeking, reserve currency, rising living standards, South Sea Bubble, sovereign wealth fund, technology bubble, The Market for Lemons, The Spirit Level, The Wealth of Nations by Adam Smith, Thomas Malthus, Tobin tax, too big to fail, trade route, trickle-down economics, Washington Consensus, women in the workforce, working-age population

With world trade and international financial relationships nurtured by newly created international institutions, the protectionism and isolationism of the interwar years became but a distant memory: economic activity in the industrialized world thus began to flourish thanks to the unleashing of huge trade multipliers, with exports from Japan to the US, for example, rising at an annual rate of approaching 20 per cent throughout the 1950s and 1960s. Financial innovations that had first appeared in the 1920s – most obviously, the arrival of consumer credit – began to spread far and wide, allowing consumers to spend today and pay 11 4099.indd 11 29/03/13 2:23 PM When the Money Runs Out tomorrow. US household debt rose from less than 40 per cent of household income at the beginning of the 1950s to almost 140 per cent of household income before the onset of the financial crisis.

This difficulty must fall somewhere and must necessarily be severely felt by a large portion of mankind.2 As it turned out, Malthus wrote his Essay at just the wrong time. The nineteenth century witnessed the arrival of the Industrial Revolution, an extraordinary leap forward in economic and financial affairs. New steam-­related technologies emerged to deliver enormous productivity gains. Financial innovations – the growth of the joint-­stock company, the development of banks and other financial institutions – allowed savings to be channelled more effectively into the new investment opportunities. Back-­breaking work slowly disappeared, the children of labourers – on the land and in the factories – became the aspirational middle classes and per capita incomes went through the roof: between 1820 and 1900, the incomes of British citizens rose 167 per cent.

Underneath all this, however, was a key assumption, namely that the ultimate ‘real’ assets underpinning all of this paper wealth – in the main, US housing – were actually worth something. Specifically, the belief was that US housing would never fall in value: after all, it had never done so since the Second World War, so there was, apparently, little reason to think that a sudden decline was imminent. Yet, as a consequence of financial innovation, combined with political momentum in favour of a wider property-­owning democracy, the nature of the US housing market was changing: borrowers were becoming increasingly ‘subprime’ and, thus, were slowly but surely becoming a bigger credit risk. Yet, with the system slicing and dicing credit risk into so many tiny parts, it was difficult for any one observer to spot the risk to the system as a whole.


pages: 593 words: 189,857

Stress Test: Reflections on Financial Crises by Timothy F. Geithner

Affordable Care Act / Obamacare, asset-backed security, Atul Gawande, bank run, banking crisis, Basel III, Bernie Madoff, Bernie Sanders, break the buck, Buckminster Fuller, Carmen Reinhart, central bank independence, collateralized debt obligation, correlation does not imply causation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, David Brooks, Doomsday Book, eurozone crisis, financial innovation, Flash crash, Goldman Sachs: Vampire Squid, housing crisis, Hyman Minsky, illegal immigration, implied volatility, Kickstarter, London Interbank Offered Rate, Long Term Capital Management, margin call, market fundamentalism, Martin Wolf, McMansion, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mortgage debt, Nate Silver, negative equity, Northern Rock, obamacare, paradox of thrift, pets.com, price stability, profit maximization, pushing on a string, quantitative easing, race to the bottom, RAND corporation, regulatory arbitrage, reserve currency, Saturday Night Live, savings glut, selection bias, short selling, sovereign wealth fund, The Great Moderation, The Signal and the Noise by Nate Silver, Tobin tax, too big to fail, working poor

In fact, economists were starting to debate whether America’s long stretch of stability constituted a new normal, a Great Moderation, a quasi-permanent era of resilience to shocks. There was growing confidence that derivatives and other financial innovations designed to hedge and distribute risk—along with better monetary policy to respond to downturns and better technology to smooth out inventory cycles—had made devastating crises a thing of the past. I did not share that confidence. I had no particular knowledge or insight into whether the new financial innovations were stabilizing or destabilizing, but I was reflexively skeptical of excess conviction in any form, especially excess optimism. My dominant professional experiences had involved financial failures. I had seen during the emerging-market crises of the previous decade how long periods of stability and growth could breed instability and disaster.

I spent more time with smart executives such as Deryck Maughan, a Salomon Brothers banker I knew in Japan who later became CEO, and smart investors such as Stan Druckenmiller, a hedge fund billionaire I sometimes consulted about markets, than I spent with the sordid elements of the financial industry. And working for Secretary Rubin surely affected my view of Wall Street competence, because he was as competent as anyone I knew. I did come of age professionally at a time when financial innovation and the freer flow of capital across borders were widely seen as good things. As a young international negotiator, I pushed for open markets for the U.S. financial industry, even though I sometimes had misgivings that we were pushing too hard. I greatly admired Rubin, Summers, and Greenspan, and I shared their general approval of markets and financial innovation. But the common broad-brush caricature of that trio as unswerving free-market ideologues is unfair. For example, during the Clinton years, they all pushed for stricter regulation of the mortgage giants Fannie Mae and Freddie Mac, the “government-sponsored enterprises” (GSEs) that were exploiting their implicit federal backstop to load up on low-priced leverage.

I had seen during the emerging-market crises of the previous decade how long periods of stability and growth could breed instability and disaster. Confidence had always been an evanescent thing, and in this new age of mobile capital, trauma in one part of the world or one corner of the financial system could spread quickly. I didn’t see how a few years of calm or some clever financial innovations would cure the basic human tendency toward mania and self-delusion. History suggests that financial crises are usually preceded by proclamations that crises are a thing of the past. In my very first public speech at the New York Fed in March 2004, I tried to push back against complacency, telling a room full of bankers that the wonders of the new financial world would not necessarily prevent catastrophic failures of major institutions, and should not inspire delusions of safety on Wall Street.


pages: 422 words: 113,830

Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism by Kevin Phillips

algorithmic trading, asset-backed security, bank run, banking crisis, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, business cycle, buy and hold, collateralized debt obligation, computer age, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency peg, diversification, Doha Development Round, energy security, financial deregulation, financial innovation, fixed income, Francis Fukuyama: the end of history, George Gilder, housing crisis, Hyman Minsky, imperial preference, income inequality, index arbitrage, index fund, interest rate derivative, interest rate swap, Joseph Schumpeter, Kenneth Rogoff, large denomination, Long Term Capital Management, market bubble, Martin Wolf, Menlo Park, mobile money, money market fund, Monroe Doctrine, moral hazard, mortgage debt, Myron Scholes, new economy, oil shale / tar sands, oil shock, old-boy network, peak oil, plutocrats, Plutocrats, Ponzi scheme, profit maximization, Renaissance Technologies, reserve currency, risk tolerance, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, Satyajit Das, shareholder value, short selling, sovereign wealth fund, The Chicago School, Thomas Malthus, too big to fail, trade route

Mohamed El-Erian, president of the Harvard Management Company, observed in 2007 that “Over the past two years, markets have developed powerful liquidity factories . . . as more investors have embraced debt in an attempt to increase the impact of their investments.” He cited hedge funds and private equity firms. Bond manager Bill Gross reminded clients that much as circa 1950 economics texts had described how money deposited at a local bank could be multiplied five- or sixfold by the operations of the banking system, latter-day financial innovators had done an “end run” around the banks: “Derivatives and structures with three- and four-letter abbreviations—CDOs, CLOs, ABCP, CPDOs, SIVs (the world awaits investment banking’s next creation: IOU?)—can now take a ‘depositor’s’ dollar and multiply it ten or twenty times” (see pages 108-111). It makes sense, although none of the materials I have read precisely explain the new mechanics.

Most of it still stands, and now we can look further ahead. Doing so is just as important in 2009 as it was in 1933. ONE Introduction The Panic of August We are living through the first crisis of our brave new world of securitised financial markets. It is too early to tell how economically important this upheaval will prove. But nobody can doubt its significance for the financial system. Its origins lie with credit expansion and financial innovation in the U.S. itself. It cannot be blamed on “crony capitalism” in peripheral economies, but rather on irresponsibility in the core of the world economy. —Martin Wolf, Financial Times, September 2007 The “crack cocaine” of our generation appears to be debt. We just can’t seem to get enough of it. And, every time it looks like the U.S. consumer may be approaching his maximum tolerance level, somebody figures out how to lever on even more debt using some new and more complex financing.

Not unless, as the old adage says, God once again took particular care of fools, drunks, and the United States of America. It is the thesis of this book that far-reaching economic and political events and consequences began to unfold in midsummer’s melee—developments that at least in part followed the direction that many specialists had foreseen—regarding U.S. housing prices, credit-bubble risk, the instability of so many financial innovations never crisis-tested, the ever-more-apparent inadequacy of global oil production, the related vulnerability of the dollar, and, behind it all, the false assurance of American “imperial” hubris. The administration of George W. Bush, rarely known for strategic grasp, miscued again in the early days of the crisis. Statements by the president, the secretary of the treasury, and the chairman of the Federal Reserve Board that the low-quality-mortgage meltdown would be short-lived and safely contained were disproved almost overnight.


pages: 387 words: 119,244

Making It Happen: Fred Goodwin, RBS and the Men Who Blew Up the British Economy by Iain Martin

asset-backed security, bank run, Basel III, beat the dealer, Big bang: deregulation of the City of London, call centre, central bank independence, computer age, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, deindustrialization, deskilling, Edward Thorp, Etonian, Eugene Fama: efficient market hypothesis, eurozone crisis, falling living standards, financial deregulation, financial innovation, G4S, high net worth, interest rate swap, invisible hand, joint-stock company, Kickstarter, light touch regulation, London Whale, Long Term Capital Management, moral hazard, negative equity, Neil Kinnock, Nick Leeson, North Sea oil, Northern Rock, old-boy network, pets.com, Red Clydeside, shareholder value, The Wealth of Nations by Adam Smith, too big to fail, upwardly mobile, value at risk

But while there are certainly people in this story and in the wider world of banking for whom avarice seems to have been the main motivation, greed on its own is an insufficient explanation for why the blow-up of the Royal Bank of Scotland was quite so spectacular. Says a senior figure in the City who came to know Goodwin: ‘Fred was building a monument and he was bloody proud of it.’ In making his monument he was building on foundations laid hundreds of years before by men who were financial innovators and patriots. Those who cared about the Royal Bank could point to an exceptional heritage and claim plausibly that it was no ordinary company, not some here today gone tomorrow firm willing to be treated as a chattel by asset-stripping foreigners. Its very history seemed to endow it with a special status. Indeed, to understand properly why RBS and the rest of us ended up where we did on that cold, grey dawn on 8 October 2008 we have to examine the story of Goodwin’s rise, and go back to the man who hired him, his immediate predecessor, whose extraordinary reinvention of the Royal Bank was motivated by patriotic pride and a desire to build the best bank in the modern world out of a Scottish institution which first opened for business in 1727.

After killing his opponent in a duel he escaped from prison in London, established the Banque de France, introduced paper money and created an enormous bubble that gulled French investors. His purchase, on behalf of the French government, of the Mississippi Company in Louisiana was designed to boost trade. It was inspired in part by the Company of Scotland and the mania for joint stock companies and trading in shares. Law fled France once his bubble burst. In Scotland too, periodically, restraint would also vanish in a miasma of financial innovation and greed. The Ayr Bank had liabilities of more than £1m and crashed spectacularly in 1772, stalling the Scottish economy for a while and ruining many farmers and merchants. Established just three years previously, with the aristocracy of Ayrshire and surrounding counties heavily invested, the Ayr Bank had expanded too fast, made too many loans and became overextended. To fill the gap it started borrowing ever-larger amounts from elsewhere.

From his bathtub (he did his best thinking in the bath, he told interviewers), he would emerge to issue Delphic pronouncements about the condition of the global economy. He received an honorary knighthood from the Queen for his ‘outstanding contribution to global economic stability’. ‘If risk is properly dispersed, shocks to the overall economic system will be better absorbed and less likely to create cascading failures that could threaten financial stability,’ he said in 2002.15 The financial innovation of recent years was, he declared, on the whole an immensely positive development because it diluted risks so that they were much more widely dispersed. This was exactly what some banks, growing in size, wanted to hear. Goodness, the complex new products they were experimenting with to expand their activities might actually make the world a safer place. It was a beneficent analysis that also suited politicians who had to fight elections.


pages: 251 words: 76,128

Borrow: The American Way of Debt by Louis Hyman

asset-backed security, barriers to entry, big-box store, business cycle, cashless society, collateralized debt obligation, credit crunch, deindustrialization, deskilling, diversified portfolio, financial innovation, Ford paid five dollars a day, Home mortgage interest deduction, housing crisis, income inequality, market bubble, McMansion, mortgage debt, mortgage tax deduction, Network effects, new economy, Paul Samuelson, plutocrats, Plutocrats, price stability, Ronald Reagan, statistical model, technology bubble, transaction costs, women in the workforce

Banks of every size had credit card programs, but it was the largest banks that had the most clients and thus the largest initial networks. Bank of America, in particular, had a long history of consumer finance across California and easily transitioned into this new form of lending. In September 1967, for instance, 58 percent of all credit card debt was in the California Federal Reserve district. New York, that long-standing bastion of financial innovation, had only 13 percent of the balances.10 Bank of America (BofA) launched BankAmericard in 1959. It was a disaster. It grew too quickly, and its explosion meant that good as well as bad credit risks received cards. There was widespread fraud. Bank of America, confident in the program’s promise, kept up despite losses and by 1961 was able to run it profitably, proving the viability of bank credit cards.11 Regional banks looked to the BofA as a model for their programs.

The percentage of households with credit cards rose from 35 percent in 1980 to 65 percent in 1991.9 These new borrowers were poorer and riskier than any before, but credit card companies had, so they believed, figured out a way to handle all the risk. They also believed they had found a nearly endless source of capital. Though the credit departments of department stores of the 1950s and ’60s had collapsed under their scarcity of capital, credit card and mortgage companies of the 1970s and ’80s faced no such obstacle because of a financial innovation that underpinned this debt expansion. Securitization had come to the credit card and, through its ability to repackage risk, facilitated this new group of high-risk borrowers. After John and Priscilla Myers moved into their split-level in 1984, they might have watched a shopping channel on their newly installed cable television. Relatively new, the shopping channels of the 1980s offered retail in the living room.

Its largest subsidiary, City National Bank & Trust, wasn’t even among the top 150 banks when it became the second bank—after Bank of America—to offer BankAmericard in 1966. Over the 1960s and ’70s, City National became one of the leading credit card processors, offering its services to other banks, credit unions, and even finance companies. By 1977, it handled 33 million transactions annually—90 percent of which were on behalf of other banks.10 Its actual banking assets remained small, but it became a hotbed of financial innovation, always at the edge of new technologies such as point-of-sale machines, ATMS, and electronic banking. For years Banc One had offered credit cards to traditional upper-middle-class borrowers. The profits of their credit cards in the early 1980s emboldened lenders like Banc One to push into new markets such as television shopping. Banc One agreed to the deal, expecting the channel’s customers to have a high but manageable default rate of 5 to 6 percent.11 Banc One even expected the default rates, at first, to be much higher, before the portfolio was “seasoned” and the good risks were sorted out from the bad.


pages: 414 words: 101,285

The Butterfly Defect: How Globalization Creates Systemic Risks, and What to Do About It by Ian Goldin, Mike Mariathasan

"Robert Solow", air freight, Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, barriers to entry, Basel III, Berlin Wall, Bretton Woods, BRICs, business cycle, butterfly effect, clean water, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, connected car, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, deglobalization, Deng Xiaoping, discovery of penicillin, diversification, diversified portfolio, Douglas Engelbart, Douglas Engelbart, Edward Lorenz: Chaos theory, energy security, eurozone crisis, failed state, Fellow of the Royal Society, financial deregulation, financial innovation, financial intermediation, fixed income, Gini coefficient, global pandemic, global supply chain, global value chain, global village, income inequality, information asymmetry, Jean Tirole, John Snow's cholera map, Kenneth Rogoff, light touch regulation, Long Term Capital Management, market bubble, mass immigration, megacity, moral hazard, Occupy movement, offshore financial centre, open economy, profit maximization, purchasing power parity, race to the bottom, RAND corporation, regulatory arbitrage, reshoring, Silicon Valley, six sigma, Stuxnet, supply-chain management, The Great Moderation, too big to fail, Toyota Production System, trade liberalization, transaction costs, uranium enrichment

We have chosen to use the financial sector as our first case study for two main reasons. First, the global financial crisis that followed the failure of Lehman Brothers in 2008 constitutes the first truly global manifestation of systemic risk that we see as characterizing the twenty-first century. Although many blame the bursting of the real estate bubble for starting the crisis, few have examined how economic integration and financial innovation in a deregulated environment created a financial network that was inherently vulnerable to systemic risk. Our second reason for choosing the financial sphere for our first analytical chapter is the stunning pace of innovation and technological advancement in this sector, which makes the financial system an incubator of globalization. This means that we can see how globalization has created new risks in just the past decade—even in a sector that seemingly featured one of the most sophisticated national and international regulatory regimes.

For example, it has been argued that markets for securities might become fragile if investors were to demand safe assets but neglect certain tail risks.26 Such a situation closely resembles that in the period between 2003 and 2007, when large numbers of new mortgage-backed securities were issued that investors perceived as safe. It has also been shown that heterogeneous expectations and adaptive behavior can lead to a situation in which more hedging instruments can destabilize markets.27 A similar motive emerges with respect to financial innovation, which typically increases the part of portfolio variance that is due to speculation when traders do not share the same assumptions about the evolution of markets.28 All of these findings rely on models that deviate from the traditional mantra of maintaining full rationality where all agents have perfect knowledge about the economy and each other. What this literature clearly shows is that even a slight deviation from perfect rationality can lead to financial instability when banks issue excessive numbers of securities.

Jenny Strasburg and Jacob Bunge, 2012, “Loss Swamps Trading Firm: Knight Capital Searches for Partner as Tab for Computer Glitch Hits $440 Million,” Wall Street Journal, 2 August, accessed 21 January 2013, http://online.wsj.com/article/SB10000872396390443866404577564772083961412.html. 15. Matthew Jarzemsky, 2012, “‘Fat-Finger’ Error Caused Oil-Stock Price Swings,” Wall Street Journal, 19 September, accessed 21 January 2013, http://blogs.wsj.com/marketbeat/2012/09/19/fat-finger-error-caused-oil-stock-price-swings/?KEYWORDS=Oilwell+Varco. 16. Lawrence J. White, 1997, “Technological Change, Financial Innovation, and Financial Regulation in the U.S.: The Challenges for Public Policy,” presentation at the Conference on Performance of Financial Institutions, Wharton Financial Institutions Center, University of Pennsylvania, Philadelphia, May 8–10, 24. 17. Ibid. 18. Charles Roxburgh, Susan Lund, and John Piotrowski, 2011, Updated Research: Mapping Global Capital Markets (New York: McKinsey), August, 2, accessed 21 January 2013, http://www.mckinsey.com/insights/mgi/research/financial_markets/mapping_global_capital_markets_2011. 19.


Investment: A History by Norton Reamer, Jesse Downing

activist fund / activist shareholder / activist investor, Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Berlin Wall, Bernie Madoff, break the buck, Brownian motion, business cycle, buttonwood tree, buy and hold, California gold rush, capital asset pricing model, Carmen Reinhart, carried interest, colonial rule, credit crunch, Credit Default Swap, Daniel Kahneman / Amos Tversky, debt deflation, discounted cash flows, diversified portfolio, dogs of the Dow, equity premium, estate planning, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, family office, Fellow of the Royal Society, financial innovation, fixed income, Gordon Gekko, Henri Poincaré, high net worth, index fund, information asymmetry, interest rate swap, invention of the telegraph, James Hargreaves, James Watt: steam engine, joint-stock company, Kenneth Rogoff, labor-force participation, land tenure, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, margin call, means of production, Menlo Park, merger arbitrage, money market fund, moral hazard, mortgage debt, Myron Scholes, negative equity, Network effects, new economy, Nick Leeson, Own Your Own Home, Paul Samuelson, pension reform, Ponzi scheme, price mechanism, principal–agent problem, profit maximization, quantitative easing, RAND corporation, random walk, Renaissance Technologies, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sand Hill Road, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spinning jenny, statistical arbitrage, survivorship bias, technology bubble, The Wealth of Nations by Adam Smith, time value of money, too big to fail, transaction costs, underbanked, Vanguard fund, working poor, yield curve

Surely, it did not help—the Crash drove negative wealth effects in some consumers as they saw an erosion of value of their assets, and that surely did not inspire confidence. Nonetheless, the Crash was not the cause of the Depression. Today, however, the situation is rather different. Virtually all parts of the real economy are dependent to some degree upon the financial markets, and most important, the conditions of creditworthiness. Progress in Managing Cyclical Crises 223 There is a little irony to the effects of financial innovation. Financial innovation, of which securitization is a part, serves to socialize risk. It spreads risk from the balance sheets of a few to the balance sheets of many. In this regard, financial innovation on the whole has been a positive force; it has been the force behind vigorous insurance markets and higher loan volumes. However, in socializing risk, financial innovation has also done something else: it has created a common source of risk for many more economic agents than would otherwise be involved.

The question on the minds of many when it first arose was simple: who has exposure to this? Of course, because of financial innovation, the answer was that many more people had exposure to the risk who were otherwise far removed from the original lending apparatus: banks, foreign governments, municipalities, pensions, individuals, and other institutions. They all had to endure the financial shock at once because of this common source of risk. Financial innovation, for all the good it normally does, had now created a situation not unlike the outbreak of a deadly virus: at first, nobody was quite sure who may have contracted the virus, so agents tried to avoid contact with one another by ceasing to further interlink their balance sheets through the credit market. The lesson behind financial innovation is clear: there are many benefits of socializing risk, but if we are not exceedingly careful to understand the potential nature and magnitude of that risk, we may impair an array of institutions at once.

Hong, Financial history of China. Ibid. Liu, “First look at usury capital.” Hong, Financial history of China. Quigen Liu, “䆎Ё೑সҷଚϮǃ催߽䌋䌘ᴀ㒘㒛Ёⱘÿড়䌘ÿϢÿড়ӭ’” [Joint-stock partnerships in business and usury capital organization in ancient China], Hebei Academic Journal (Hebei University), no. 5 (1994): 86–91. Valerie Hansen and Ana Mata-Fink, “Records from a Seventh-Century Pawnshop in China,” in The Origins of Value: The Financial Innovations That Created Modern Capital Markets, eds. William N. Goetzmann and K. Geert Rouwenhorst (Oxford: Oxford University Press, 2005), 54–58; Homer and Sylla, History of Interest Rates, 614. Hansen and Mata-Fink, “Records from a Pawnshop,” 58–59. Michael T. Skully, “The Development of the Pawnshop Industry in East Asia,” in Financial Landscapes Reconstructed: The Fine Art of Mapping Development, eds.


pages: 226 words: 59,080

Economics Rules: The Rights and Wrongs of the Dismal Science by Dani Rodrik

airline deregulation, Albert Einstein, bank run, barriers to entry, Bretton Woods, business cycle, butterfly effect, capital controls, Carmen Reinhart, central bank independence, collective bargaining, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, distributed generation, Donald Davies, Edward Glaeser, endogenous growth, Eugene Fama: efficient market hypothesis, Everything should be made as simple as possible, Fellow of the Royal Society, financial deregulation, financial innovation, floating exchange rates, fudge factor, full employment, George Akerlof, Gini coefficient, Growth in a Time of Debt, income inequality, inflation targeting, informal economy, information asymmetry, invisible hand, Jean Tirole, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, labor-force participation, liquidity trap, loss aversion, low skilled workers, market design, market fundamentalism, minimum wage unemployment, oil shock, open economy, Pareto efficiency, Paul Samuelson, price stability, prisoner's dilemma, profit maximization, quantitative easing, randomized controlled trial, rent control, rent-seeking, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, school vouchers, South Sea Bubble, spectrum auction, The Market for Lemons, the scientific method, The Wealth of Nations by Adam Smith, Thomas Kuhn: the structure of scientific revolutions, Thomas Malthus, trade liberalization, trade route, ultimatum game, University of East Anglia, unorthodox policies, Vilfredo Pareto, Washington Consensus, white flight

With a few, but notable, exceptions, such as the future Nobel Prize winner Robert Shiller and the future governor of India’s Central Bank and Chicago economist Raghu Rajan, economists overlooked the extent of problems in housing and finance. Shiller had long argued that asset prices were excessively volatile and had focused on a bubble in housing prices.5 Rajan had fretted about the downside of what was then praised as “financial innovation” and warned as early as 2005 that bankers were taking excessive risks, earning a rebuke from Larry Summers, then president of Harvard, as a “Luddite.”6 That economists were mostly blind-sided by the crisis is undeniable. Many interpreted this as evidence of a fundamental breakdown in economics. The discipline needed to be rethought and reconfigured. But what makes this episode particularly curious is that there were, in fact, plenty of models to help explain what had been going on under the economy’s hood.

Excessive reliance on EMH, to the neglect of models of bubbles and other financial-market pathologies, betrayed a broader set of predilections. There was great faith in what financial markets could achieve. Markets became, in effect, the engine of social progress. They would not only mediate efficiently between savers and investors; they would also distribute risk to those most able to bear it and provide access to credit for previously excluded households, such as those with limited means or no credit history. Through financial innovation, portfolio holders could eke out the maximum return while taking on the least amount of risk. Moreover, markets came to be viewed not only as inherently efficient and stable, but also as self-disciplining. If big banks and speculators engaged in shenanigans, markets would discover and punish them. Investors who made bad decisions and took inappropriate risks would be driven out; those who behaved responsibly would profit from their prudence.

Such thinking by economists had legitimized and enabled a great wave of financial deregulation that set the stage for the crisis. And it didn’t hurt that these views were shared by some of the top economists in government, such as Larry Summers and Alan Greenspan. In sum, economists (and those who listened to them) became overconfident in their preferred models of the moment: markets are efficient, financial innovation improves the risk-return trade-off, self-regulation works best, and government intervention is ineffective and harmful. They forgot about the other models. There was too much Fama, too little Shiller. The economics of the profession may have been fine, but evidently there was trouble with its psychology and sociology. Errors of Commission: The Washington Consensus In 1989, John Williamson convened a conference in Washington, DC, for major economic policy makers from Latin America.


When Free Markets Fail: Saving the Market When It Can't Save Itself (Wiley Corporate F&A) by Scott McCleskey

Asian financial crisis, asset-backed security, bank run, barriers to entry, Bernie Madoff, break the buck, call centre, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, financial innovation, fixed income, information asymmetry, invisible hand, Isaac Newton, iterative process, Long Term Capital Management, margin call, money market fund, moral hazard, mortgage debt, place-making, Ponzi scheme, prediction markets, risk tolerance, shareholder value, statistical model, The Wealth of Nations by Adam Smith, time value of money, too big to fail, web of trust

See Office of Information and Regulatory Affairs (OIRA) over-the-counter market, 39, 71, 168 P Parmalat, 84 Petrou, Karen, 43 Plan B, 10, 20, 22, 30, 81, 144 point-in-time ratings, 96 political capture, 104 privacy laws, 134–35, 137, 141 private equity funds, 105, 180 E1BINDEX 06/16/2010 194 11:28:9 n Page 194 Index R Regan administration, xv regulation and innovation about, 41–44 conclusions, 45 credit default swaps (CDSs), 42–44 financial innovation and risk management, 42 financial innovation pushes boundary of complexity further, 43 financial regulators and regulatory lag on innovations, 43 internal risk controls, 44 legislation to reform markets after near-collapse of financial system, 41 market complexity, 44 mortgage-backed securities, 42 policy implications, 44 regulation could stifle all innovation, 42 residential mortgage-backed securities, 44 transparency as regulatory tool, 44 regulation of free markets about, xv–xvi Bernie Madoff scandal, xxi Commodities Future Trading Commission and transparency to credit derivatives market, xvi conclusion, xx–xxi credit rating agencies and subprime-loan pools, xvii–xix, 88, 93 credit rating agencies diluted meaning of AAA, xxi Efficient Market Theory, xix market collapse is 2008, xx markets, inefficiencies and imbalances of distorted, xvii market self-regulation, xix–xx perfect markets regulate themselves, xx philosophy to math, the shift from, xvii–xix regulation, ideological legitimacy of, xv regulation is not separate from market, xv regulation vs. justice, xx regulation vs. retribution, xx self interest and free trade, xvii selfish interest drives irresponsible, inordinate risk-taking and fraud, xxi Smith, Adam, xvi–xvii subprime mortgages, xxi transparency and market self-regulation, xix regulations are there other ways to achieve the same aim?

Rather than diluting risk, securitization concentrated the risk into mortgage backed securities that then infected the entire financial system as they were sold to financial institutions and investors everywhere. Some have argued that securitization is a product we would have been better off without. This brings us in the next chapter to the question of whether regulation should act as the gatekeeper to financial innovation. C05 06/16/2010 11:17:40 Page 41 5 CHAPTER FIVE Should Regulation Stifle Innovation? A C O M M O N C O M PL A IN T A B O U T proposed regulations is that they would have the consequence, unintended or otherwise, of ‘‘stifling’’ innovation in the financial services industry—the creation and growth of new financial products. The charge is routinely rolled out in opposition to regulations of any sort, and had been for years before the financial crisis.

The charge is routinely rolled out in opposition to regulations of any sort, and had been for years before the financial crisis. It was no surprise, then, that the charge would arise with respect to major pieces of legislation aimed at reforming the markets in the wake of the near-collapse of the financial system. In the U.S. market, the idea of stifling innovation is akin to censorship in the arts—by limiting creativity you limit genius and progress. The notion that financial innovation is at the heart of economic growth is so deep-seated among free marketers that it has become nearly unchallengeable. And it is true, up to a point. But while the logic of expanding the frontier of financial engineering is compelling on the surface, the financial crisis has challenged the underlying assumption that all innovation is good. Without a doubt, innovation has increased choice, efficiency, and the management of risk in the markets for as long as there have been economies.


pages: 365 words: 88,125

23 Things They Don't Tell You About Capitalism by Ha-Joon Chang

"Robert Solow", affirmative action, Asian financial crisis, bank run, banking crisis, basic income, Berlin Wall, Bernie Madoff, borderless world, Carmen Reinhart, central bank independence, collateralized debt obligation, colonial rule, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, deindustrialization, deskilling, ending welfare as we know it, Fall of the Berlin Wall, falling living standards, financial deregulation, financial innovation, full employment, German hyperinflation, Gini coefficient, hiring and firing, Hyman Minsky, income inequality, income per capita, invisible hand, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, Kenneth Rogoff, knowledge economy, labour market flexibility, light touch regulation, Long Term Capital Management, low skilled workers, manufacturing employment, market fundamentalism, means of production, Mexican peso crisis / tequila crisis, microcredit, Myron Scholes, North Sea oil, offshore financial centre, old-boy network, post-industrial society, price stability, profit maximization, profit motive, purchasing power parity, rent control, shareholder value, short selling, Skype, structural adjustment programs, the market place, The Wealth of Nations by Adam Smith, Thomas Malthus, Tobin tax, Toyota Production System, trade liberalization, trickle-down economics, women in the workforce, working poor, zero-sum game

.’; you spend much more time than before driving to the new supermarket and walking through the now longer aisles when you get there, because those apples are cheaper than in the old supermarket only because the new supermarket is in the middle of nowhere and thus can have more floor space. There are some service activities, such as banking, which have greater scope for productivity increase than other services. However, as revealed by the 2008 financial crisis, much of the productivity growth in those activities was due not to a real rise in their productivity (e.g., reduction in trading costs due to better computers) but to financial innovations that obscured (rather than genuinely reduced) the riskiness of financial assets, thereby allowing the financial sector to grow at an unsustainably rapid rate (see Thing 22). To sum up, the fall in the share of manufacturing in total output in the rich countries is not largely due to the fall in (relative) demand for manufactured goods, as many people think. Nor is it due mainly to the rise of manufactured exports from China and other developing countries, although that has had big impacts on some sectors.

However, Simon’s theory shows that many regulations work not because the government necessarily knows better than the regulated (although it may sometimes do – see Thing 12) but because they limit the complexity of the activities, which enables the regulated to make better decisions. The 2008 world financial crisis illustrates this point very nicely. In the run-up to the crisis, our ability to make good decisions was simply overwhelmed because things were allowed to evolve in too complex a manner through financial innovation. So many complex financial instruments were created that even financial experts themselves did not fully understand them, unless they specialized in them – and sometimes not even then (see Thing 22). The top decision-makers of the financial firms certainly did not grasp much of what their businesses were doing. Nor could the regulatory authorities fully figure out what was going on. As discussed above, now we are seeing a flood of confessions – some voluntary, others forced – from the key decision-makers.

True, some of the excesses of the recent period have given finance a bad name, not least in the above-mentioned countries. However, we should not rush into restraining financial markets simply because of this once-in-a-century financial crisis that no one could have predicted, however big it may be, as the efficiency of its financial market is the key to a nation’s prosperity. What they don’t tell you The problem with financial markets today is that they are too efficient. With recent financial ‘innovations’ that have produced so many new financial instruments, the financial sector has become more efficient in generating profits for itself in the short run. However, as seen in the 2008 global crisis, these new financial assets have made the overall economy, as well as the financial system itself, much more unstable. Moreover, given the liquidity of their assets, the holders of financial assets are too quick to respond to change, which makes it difficult for real-sector companies to secure the ‘patient capital’ that they need for long-term development.


pages: 223 words: 10,010

The Cost of Inequality: Why Economic Equality Is Essential for Recovery by Stewart Lansley

"Robert Solow", banking crisis, Basel III, Big bang: deregulation of the City of London, Bonfire of the Vanities, borderless world, Branko Milanovic, Bretton Woods, British Empire, business cycle, business process, call centre, capital controls, collective bargaining, corporate governance, corporate raider, correlation does not imply causation, creative destruction, credit crunch, Credit Default Swap, crony capitalism, David Ricardo: comparative advantage, deindustrialization, Edward Glaeser, Everybody Ought to Be Rich, falling living standards, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, Goldman Sachs: Vampire Squid, high net worth, hiring and firing, Hyman Minsky, income inequality, James Dyson, Jeff Bezos, job automation, John Meriwether, Joseph Schumpeter, Kenneth Rogoff, knowledge economy, laissez-faire capitalism, light touch regulation, Long Term Capital Management, low skilled workers, manufacturing employment, market bubble, Martin Wolf, mittelstand, mobile money, Mont Pelerin Society, Myron Scholes, new economy, Nick Leeson, North Sea oil, Northern Rock, offshore financial centre, oil shock, plutocrats, Plutocrats, Plutonomy: Buying Luxury, Explaining Global Imbalances, Right to Buy, rising living standards, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, shareholder value, The Great Moderation, The Spirit Level, The Wealth of Nations by Adam Smith, Thomas Malthus, too big to fail, Tyler Cowen: Great Stagnation, Washington Consensus, Winter of Discontent, working-age population

Despite a series of economic, business and financial crises in the immediate postmillennium years—from the bursting of the dot-com bubble to the collapse of the energy-trading giant, Enron—the belief in markets proved remarkably resilient. Across the globe, regulators, politicians and financiers had come round to the view that, after a shaky decade and a half, the market model had finally triumphed. According to Kenneth Rogoff, chief economist at the IMF from 2001 to 2003, ‘the policy community has developed a smug belief that enhanced macroeconomic stability at the national level combined with continuing financial innovation at the international level have obviated any need to tinker with the (international financial) system’.206 The prophets of market ideology made grand claims for their beliefs. The medicine of the markets had at last overturned the failings of post-war welfare capitalism. The rise of finance to a more central place in the economy had lowered financial risk. The de-regulation of financial and labour markets had brought greater economic stability and dynamism.

They became the base for the record levels of liquidity that led to a larger and larger banking sector, while injecting much higher, and ultimately unsustainable, levels of risk into the global financial system. As David Moss described it, ‘The rise of these massive [American banking] institutions represented a profound change in our financial system and a powerful new source of systemic risk.’251 Far from improving the efficiency with which resources were allocated, as banking executives liked to claim, ballooning levels of liquidity, fed by more and more complex forms of financial innovation, merely fuelled a series of unsustainable financial and asset bubbles. While it was the role of government to put a cap on risk, a fourth mechanism then came into play. In more equal societies, the financial sector is more circumscribed and much less able to capture regulators and politicians. As wealth became more concentrated, so did the distribution of power. From the early 1990s, the finance industry and its lobbyists were able to exercise an increasingly disproportionate degree of influence at the highest levels to ensure weak financial regulation by the state, lower taxes on the wealthy and inaction on tax havens.

But gradually other interest groups with legitimate claims for a share of the influence, from trades unions and town halls to manufacturers and small businesses, became at best marginalised, at worst, ignored. The only voices that came to count, it seemed, were those coming from corporate boardrooms and City offices. The Treasury itself became little more than an outpost of the City. A torrent of City lobbying secured Treasury support for the idea that financial innovation was good for the economy, that the City was a key generator of social value and should be the central engine of economic growth. As Manchester University academics have described it, ‘The new Treasury doctrine is the impossibility of upsetting the City.’260 The forces that drove economic instability were not external shocks that could not have been foreseen, but ones implicit to the great shifts in policy direction instituted from the late 1970s.


pages: 338 words: 106,936

The Physics of Wall Street: A Brief History of Predicting the Unpredictable by James Owen Weatherall

Albert Einstein, algorithmic trading, Antoine Gombaud: Chevalier de Méré, Asian financial crisis, bank run, beat the dealer, Benoit Mandelbrot, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business cycle, butterfly effect, buy and hold, capital asset pricing model, Carmen Reinhart, Claude Shannon: information theory, collateralized debt obligation, collective bargaining, dark matter, Edward Lorenz: Chaos theory, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, George Akerlof, Gerolamo Cardano, Henri Poincaré, invisible hand, Isaac Newton, iterative process, John Nash: game theory, Kenneth Rogoff, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, martingale, Myron Scholes, new economy, Paul Lévy, Paul Samuelson, prediction markets, probability theory / Blaise Pascal / Pierre de Fermat, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk-adjusted returns, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Coase, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, statistical arbitrage, statistical model, stochastic process, The Chicago School, The Myth of the Rational Market, tulip mania, Vilfredo Pareto, volatility smile

Still, it’s not as though market crashes or speculative bubbles are a new phenomenon — after all, the largest market collapse in modern times occurred in 1929, long before derivatives became important. What’s more, for the past forty years, essentially the period over which financial innovation has been most important, the financial services sector has buoyed Western economies. In the United States, for instance, the financial services industry has grown six times faster than the economy as a whole. This rapid growth has occurred at the same time that other industries, such as manufacturing, have either declined or grown much more slowly. Financial innovation, like other technological innovation, has thus played a major role in buoying the U.S. and other Western economies over the past three decades. Moreover, there is broad agreement among economists that a large, well-developed financial sector generally spurs growth in other areas of the economy — at least to a point.

The final part of the book will show how models have continued to evolve outside of mainstream finance, as physicists have imported newer and more sophisticated ideas to finance and economics, identifying the problems with our current models and figuring out how to improve them. Black was instrumental in producing a new status quo on Wall Street, but his ideas were just the beginning of the era of financial innovation. 6 The Prediction Company WHEN THE SANTA FE TRAIL was first pioneered in 1822, it stretched from the westernmost edge of the United States — Independence, Missouri — through Comanche territory and into the then-Mexican state of Nuevo Mexico. From there it passed over the high plains of what is now eastern Colorado and then took the Glorieta Pass through the Sangre de Cristo Mountains, the southernmost subrange of the Rockies.

But the process that I have described in this book is the best way we have ever come up with for addressing our biggest challenges. We shouldn’t abandon it here. There’s a third criticism of financial modeling that one sometimes hears. This one is a little deeper. It has been made most influentially by Warren Buffett, who has famously warned of “geeks bearing formulas.” This view has it that financial innovation is a dangerous thing because it makes financial markets inherently riskier. The excesses of the 2000s that led to the recent crash were enabled by physicists and mathematicians who didn’t understand the real-world consequences of what they were doing, and by profit-hungry banks that let these quants run wild. There is much that is right in this criticism. The idea that derivatives, including options, are a manufactured “financial product” has proved extremely powerful — and profitable.


Debtor Nation: The History of America in Red Ink (Politics and Society in Modern America) by Louis Hyman

asset-backed security, bank run, barriers to entry, Bretton Woods, business cycle, card file, central bank independence, computer age, corporate governance, credit crunch, declining real wages, deindustrialization, diversified portfolio, financial independence, financial innovation, fixed income, Gini coefficient, Home mortgage interest deduction, housing crisis, income inequality, invisible hand, late fees, London Interbank Offered Rate, market fundamentalism, means of production, mortgage debt, mortgage tax deduction, p-value, pattern recognition, profit maximization, profit motive, risk/return, Ronald Reagan, Silicon Valley, statistical model, technology bubble, the built environment, transaction costs, union organizing, white flight, women in the workforce, working poor, zero-sum game

For Great Society policymakers and promoters, the problems of inequality were framed as a problem of credit access rather than job access. More credit, and not higher wages, would be enough to solve the problems of America’s cities. Toward that end, federal policy fashioned the financial innovation that made possible America’s debt explosion—the asset-backed security—that expanded well beyond its original purpose. Solving the urban crisis would require solving the housing crisis. But to fix the housing crisis, radical financial innovation would have to occur to maintain the capital flows into mortgages. As the urban riots became the urban crisis, however, mortgage markets had a crisis of their own. American mortgage markets had abruptly frozen—the so-called Credit Crunch of 1966—as investors rapidly withdrew their deposits from banks and put their money in the securities markets.

As automobile production exploded in the 1920s, so too did the need for automobile financing for both consumers and dealers alike.61 The capital requirements of more expensive, mass-produced goods led retailers and entrepreneurs to explore new options in consumer finance and, in the process of meeting their own immediate needs, created a novel financial institution that was neither an informal lender nor a commercial bank—the finance company. Modern, pervasive installment credit found its institutional bedrock in the financial innovation of the early automobile industry. The financial infrastructure of installment credit grew out of the very requirements of heavy capital manufacturing for mass production, but once created, finance companies found other markets outside of the automobile industry. They turned to less capital-intensive retail sectors, which enabled the expansion of installment credit throughout the American economy.

While the expansion of debt occurred because consumers were less and less able, on average, to pay back what they borrowed, the massive investment necessary to roll over that outstanding debt required lenders to use capital markets in innovative ways. Moving beyond the resale networks of the mid-twentieth century, new ways to sell debt anonymously on national and even international capital markets inaugurated a new relationship between consumer credit and investor capital. In an insecure world, unsecured debt came of age. Mortgage-backed Securities and the Great Society The financial innovation that ultimately allowed capital markets to directly fund any form of debt began with the federal government, not business. In the late 1960s, the federal government sought a way to 224 CHAPTER SEVEN channel capital into America’s rioting cities. Capital would make possible the Great Society ambitions of saving America’s cities and the newly rising pension funds needed to invest. Ironically, pension funds borne of strong union movements helped provide the justification for policies based on remedying poverty through better access to capital, rather than better access to wages.


pages: 446 words: 117,660

Arguing With Zombies: Economics, Politics, and the Fight for a Better Future by Paul Krugman

affirmative action, Affordable Care Act / Obamacare, Andrei Shleifer, Asian financial crisis, bank run, banking crisis, basic income, Berlin Wall, Bernie Madoff, bitcoin, blockchain, Bonfire of the Vanities, business cycle, capital asset pricing model, carbon footprint, Carmen Reinhart, central bank independence, centre right, Climategate, cognitive dissonance, cryptocurrency, David Ricardo: comparative advantage, different worldview, Donald Trump, Edward Glaeser, employer provided health coverage, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, fiat currency, financial deregulation, financial innovation, financial repression, frictionless, frictionless market, fudge factor, full employment, Growth in a Time of Debt, hiring and firing, illegal immigration, income inequality, index fund, indoor plumbing, invisible hand, job automation, John Snow's cholera map, Joseph Schumpeter, Kenneth Rogoff, knowledge worker, labor-force participation, large denomination, liquidity trap, London Whale, market bubble, market clearing, market fundamentalism, means of production, New Urbanism, obamacare, oil shock, open borders, Paul Samuelson, plutocrats, Plutocrats, Ponzi scheme, price stability, quantitative easing, road to serfdom, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, secular stagnation, The Chicago School, The Great Moderation, the map is not the territory, The Wealth of Nations by Adam Smith, trade liberalization, transaction costs, universal basic income, very high income, working-age population

Citigroup wasn’t supposed to have tens of billions of dollars in subprime exposure; it did. Florida’s Local Government Investment Pool, which acts as a bank for the state’s school districts, was supposed to be risk-free; it wasn’t (and now schools don’t have the money to pay teachers). How did things get so opaque? The answer is “financial innovation”—two words that should, from now on, strike fear into investors’ hearts. O.K., to be fair, some kinds of financial innovation are good. I don’t want to go back to the days when checking accounts didn’t pay interest and you couldn’t withdraw cash on weekends. But the innovations of recent years—the alphabet soup of C.D.O.s and S.I.V.s, R.M.B.S., and A.B.C.P.—were sold on false pretenses. They were promoted as ways to spread risk, making investment safer.

But it wasn’t a message many wanted to hear. But the parallels between ourselves and Japan grew stronger over time. By 2005 or so I and many (but not enough) others had grown concerned about what looked like an immense housing bubble. It seemed obvious that bad things would happen when that bubble burst. As it turned out, it was far worse than almost anyone realized. Years of financial deregulation and financial “innovation” (which often amounted to finding ways to evade regulation) had created a banking system that was, in a modern, high-tech way, just as vulnerable to panics as the banking system on the eve of the Great Depression. And the panic came. The columns in this section describe the growing fear I and others felt that something was going terribly wrong, and the wall of misconception we had to climb when the things we feared might happen, did.

At a deep level, I believe that the problem was ideological: policymakers, committed to the view that the market is always right, simply ignored the warning signs. We know, in particular, that Alan Greenspan brushed aside warnings from Edward Gramlich, who was a member of the Federal Reserve Board, about a potential subprime crisis. And free-market orthodoxy dies hard. Just a few weeks ago Henry Paulson, the Treasury secretary, admitted to Fortune magazine that financial innovation got ahead of regulation—but added, “I don’t think we’d want it the other way around.” Is that your final answer, Mr. Secretary? Now, Mr. Paulson’s new proposal to help borrowers renegotiate their mortgage payments and avoid foreclosure sounds in principle like a good idea (although we have yet to hear any details). Realistically, however, it won’t make more than a small dent in the subprime problem.


pages: 346 words: 89,180

Capitalism Without Capital: The Rise of the Intangible Economy by Jonathan Haskel, Stian Westlake

"Robert Solow", 23andMe, activist fund / activist shareholder / activist investor, Airbnb, Albert Einstein, Andrei Shleifer, bank run, banking crisis, Bernie Sanders, business climate, business process, buy and hold, Capital in the Twenty-First Century by Thomas Piketty, cloud computing, cognitive bias, computer age, corporate governance, corporate raider, correlation does not imply causation, creative destruction, dark matter, Diane Coyle, Donald Trump, Douglas Engelbart, Douglas Engelbart, Edward Glaeser, Elon Musk, endogenous growth, Erik Brynjolfsson, everywhere but in the productivity statistics, Fellow of the Royal Society, financial innovation, full employment, fundamental attribution error, future of work, Gini coefficient, Hernando de Soto, hiring and firing, income inequality, index card, indoor plumbing, intangible asset, Internet of things, Jane Jacobs, Jaron Lanier, job automation, Kenneth Arrow, Kickstarter, knowledge economy, knowledge worker, laissez-faire capitalism, liquidity trap, low skilled workers, Marc Andreessen, Mother of all demos, Network effects, new economy, open economy, patent troll, paypal mafia, Peter Thiel, pets.com, place-making, post-industrial society, Productivity paradox, quantitative hedge fund, rent-seeking, revision control, Richard Florida, ride hailing / ride sharing, Robert Gordon, Ronald Coase, Sand Hill Road, Second Machine Age, secular stagnation, self-driving car, shareholder value, sharing economy, Silicon Valley, six sigma, Skype, software patent, sovereign wealth fund, spinning jenny, Steve Jobs, survivorship bias, The Rise and Fall of American Growth, The Wealth of Nations by Adam Smith, Tim Cook: Apple, total factor productivity, Tyler Cowen: Great Stagnation, urban planning, Vanguard fund, walkable city, X Prize, zero-sum game

To be effective, a national investment bank or loan guarantee program would need to be larger and larger each year. This is not inherently impossible, but it is certainly not what most supporters of government lending programs propose, expect, or support. The second way to address the problem is by devising new types of lending. Financial innovation has been something of a dirty word since the financial crisis—former Federal Reserve Chairman Paul Volcker went so far as to say the only beneficial financial innovation of the decades prior to the financial crisis was the automated teller machine—but, in fact, lenders have over the years come up with novel ways to use at least some types of intangible assets as security. One recent working paper (Mann 2014) suggests that 16 percent of patents registered at the US Patent and Trademark Office have been pledged as collateral at some point.

A couple of studies have looked at the impact of US banking deregulation on investment in innovation: one showed that the deregulation of interstate banking saw an increase in lending to innovating companies (based on the number and quality of their patents), implying that greater competition pushes banks to be more willing to lend to businesses making (at least one type of) intangible investment (Amore, Schneider, and Zaldokas 2012). There are also a growing number of specific financial innovations focused on lending against intangibles. When David Bowie died in 2016, there were plenty of tributes to his musical innovations, but rather fewer to the contribution he made to intangible finance by raising a $55 million bond against his future royalties. The governments of Singapore and Malaysia (working together with UK organizations such as the Intellectual Property Office), for example, have begun programs to subsidize or guarantee bank loans against intellectual property, in the hope that these subsidies will increase the availability of intangible-backed loans.

We might speculate that the reason VCs can seem like a clique is not because the venture capitalists are unusually bad or cliquish people, but because the underlying model of the VC business thrives on dense social networks, which will always tend to gravitate to cliquishness in the absence of countervailing effort, and perhaps even then. What Venture Capital Can’t Do So there is a strong case for saying that venture capital is well suited to investing in intangible-rich businesses and should be rightly held up as a positive type of financial innovation. But VC is not a panacea for business investment, and on its own VC will struggle to solve the problem of how to finance the capital development of an intangible economy. There are three problems that face VC firms and VC-backed companies, some of which arise from the nature of intangible investments themselves. The first is the problem of spillovers. The managers of VC-backed firms have strong incentives to create valuable companies—really successful founders can, after all, become very rich.


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Barometer of Fear: An Insider's Account of Rogue Trading and the Greatest Banking Scandal in History by Alexis Stenfors

Asian financial crisis, asset-backed security, bank run, banking crisis, Big bang: deregulation of the City of London, bonus culture, capital controls, collapse of Lehman Brothers, credit crunch, Credit Default Swap, Eugene Fama: efficient market hypothesis, eurozone crisis, financial deregulation, financial innovation, fixed income, game design, Gordon Gekko, inflation targeting, information asymmetry, interest rate derivative, interest rate swap, London Interbank Offered Rate, loss aversion, mental accounting, millennium bug, Nick Leeson, Northern Rock, oil shock, price stability, profit maximization, regulatory arbitrage, reserve currency, Rubik’s Cube, Snapchat, the market place, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, Y2K

In September 2009, Adair Turner, the chairman of the FSA at the time, delivered a speech in London that went on to be cited frequently in the British media.16 He was critical towards the City and the role banks had played in the run-up to the financial crisis. ‘Not all financial innovation is valuable, not all trading plays a useful role, and a bigger financial system is not necessarily a better one,’ he said. ‘There are good reasons for believing that the financial industry, more than any other sector of the economy, has an ability to generate unnecessary demand for its own services – that more trading and more financial innovation can under some circumstances create harmful volatility against which customers have to hedge, creating more demand for trading liquidity and innovative products.’ Banks had been at the forefront in creating all these new derivatives, and no matter how useful they might seem, he questioned whether they brought any benefits to society as a whole.

This is also why, in 2009, the former Chairman of the Federal Reserve, Alan Greenspan, famously described the LIBOR–OIS spread as ‘the barometer of fears of bank insolvency’.5 It was precisely that: a kind of fear index relating to banks. This fear had soared since 9 August 2007. From a personal perspective, the global financial crisis also acted as a trigger point in revealing the wider implications of LIBOR. The STIRT desks at the banks had not been particularly glamorous before 2007. We traded a range of instruments that were important, but not interesting and complex enough to represent the forefront of financial innovation. The turnover in OISs, FRAs, IRSs (interest rate swaps), CRSs (cross-currency basis swaps) and FX swaps, among others, was enormous. However, options, long-end interest rate swaps and structured products enjoyed considerably more prestige. The crisis turned everything upside down. Suddenly, the spotlight fell on us. Options traders needed to know the direction of LIBOR in order to price customer deals and value their books correctly.

Opponents raised concerns surrounding the possible inflationary effects caused by excessive lending by banks, the weakening role of the central bank in controlling the monetary system,9 the difficulties for smaller banks of competing with the new ‘universal’ banks, and the Eurocurrency market’s destabilising impact on exchange rates. Some argued that the market had created a set of semi-independent international interest rates over which no single country or institution had control.10 Questions were also asked about the vulnerability of domestic banks as a result of the opaqueness of the new financial innovations and whether and how they should be regulated. In fact, the arguments used back then were surprisingly similar to some of those used during and after the financial crisis of 2007–08. Banks were seen as having lent recklessly. Banks had created financial instruments that hardly anybody understood. The deregulation process had gone too far. Many banks had become too big to fail. Central banks had to resort to extraordinary measures to save the global financial system from collapse.


pages: 249 words: 66,383

House of Debt: How They (And You) Caused the Great Recession, and How We Can Prevent It From Happening Again by Atif Mian, Amir Sufi

"Robert Solow", Andrei Shleifer, asset-backed security, balance sheet recession, bank run, banking crisis, Ben Bernanke: helicopter money, break the buck, business cycle, Carmen Reinhart, collapse of Lehman Brothers, creative destruction, debt deflation, Edward Glaeser, en.wikipedia.org, financial innovation, full employment, high net worth, Home mortgage interest deduction, housing crisis, Joseph Schumpeter, Kenneth Rogoff, Kickstarter, liquidity trap, Long Term Capital Management, market bubble, Martin Wolf, money market fund, moral hazard, mortgage debt, negative equity, paradox of thrift, quantitative easing, Robert Shiller, Robert Shiller, school choice, shareholder value, the payments system, the scientific method, tulip mania, young professional, zero-sum game

If the investors are convinced that their loan will be repaid even if the business manager steals some money from the cash drawer, then the investors are willing to ignore the stealing. In contrast, if the investors are equity investors, meaning that they share the profits of the business, they will have a strong incentive to detect theft. Debt convinces investors that they don’t have to worry about fraud because their senior claim on the asset protects them. In a world of neglected risks, financial innovation should be viewed with some degree of skepticism. If investors systematically ignore certain outcomes, financial innovation may just be secret code for bankers trying to fool investors into buying securities that look safe but are actually extremely vulnerable. * * * In a cruel twist of irony, Kindleberger passed away in 2003 at the age of ninety-two, just as the mortgage-credit boom was starting. He did an interview with the Wall Street Journal the year before he died.

In our research, we directly linked these two patterns by showing that the rate of securitization was much stronger in low credit-quality zip codes compared to high credit-quality zip codes. Securitization transformed global capital inflows into a wild expansion of mortgage credit to marginal borrowers. But it was only possible if the lenders were sure their funds were protected. Manufacturing Safe Debt A cynical view of financial innovation sees it merely as bankers fooling investors into buying very risky securities that are passed off as safe. There is substantial research demonstrating that this is exactly what private-label securitization was during the housing boom. Josh Coval, Jakub Jurek, and Erik Stafford show that when investors buying mortgage-backed securities made small mistakes in assessing their vulnerability, securitization enabled banks to amplify the effect of these mistakes.

Daron Acemoglu, Kenneth Rogoff, and Michael Woodford (Chicago: University of Chicago Press, 2010), 1–65. 9. This can be confirmed by noting that 100 × $125,000 = $12.5 million. 10. See, for example, Edward Glaeser, Joshua Gottlieb, and Joseph Gyourko, “Can Cheap Credit Explain the Housing Boom?” (working paper no. 16230, NBER, July 2010). 11. Nicola Gennaioli, Andrei Shleifer, and Robert Vishny, “Neglected Risks, Financial Innovation, and Financial Fragility,” Journal of Financial Economics 104 (2012): 452–68. 12. Solow, foreword to Manias, Panics and Crashes. 13. Jon Hilsenrath, “A 91-Year-Old Who Foresaw Selloff is ‘Dubious’ of Stock-Market Rally,” Wall Street Journal, July 25, 2002. Chapter Nine 1. Euronews, “Spain’s Unforgiving Eviction Law,” December 11, 2012; Suzanne Daley, “In Spain, Homes Are Taken but Debt Stays,” New York Times, October 27, 2010. 2.


pages: 554 words: 158,687

Profiting Without Producing: How Finance Exploits Us All by Costas Lapavitsas

"Robert Solow", Andrei Shleifer, asset-backed security, bank run, banking crisis, Basel III, borderless world, Branko Milanovic, Bretton Woods, business cycle, capital controls, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, computer age, conceptual framework, corporate governance, credit crunch, Credit Default Swap, David Graeber, David Ricardo: comparative advantage, disintermediation, diversified portfolio, Erik Brynjolfsson, eurozone crisis, everywhere but in the productivity statistics, financial deregulation, financial independence, financial innovation, financial intermediation, financial repression, Flash crash, full employment, global value chain, global village, High speed trading, Hyman Minsky, income inequality, inflation targeting, informal economy, information asymmetry, intangible asset, job satisfaction, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, liberal capitalism, London Interbank Offered Rate, low skilled workers, M-Pesa, market bubble, means of production, money market fund, moral hazard, mortgage debt, Network effects, new economy, oil shock, open economy, pensions crisis, price stability, Productivity paradox, profit maximization, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, race to the bottom, regulatory arbitrage, reserve currency, Robert Shiller, Robert Shiller, savings glut, Scramble for Africa, secular stagnation, shareholder value, Simon Kuznets, special drawing rights, Thales of Miletus, The Chicago School, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, Tobin tax, too big to fail, total factor productivity, trade liberalization, transaction costs, union organizing, value at risk, Washington Consensus, zero-sum game

Moreover, private US banks took advantage of low interest rates to engage in financial innovation – above all, in securitization – thus feeding financial expansion. The real estate bubble in the US effectively came to an end in 2006 but booming conditions in the financial markets lasted until the summer of 2007. The bubble kept getting bigger after 2004, despite US interest rates beginning to rise, as the US received capital inflows from developing countries expanding dollar reserves. During the same period heavy buying and selling also took place in the housing market in the UK and elsewhere.26 TABLE 1 US mortgage loans, 2001–2006, $bn Table 1 shows the path of the US housing market as bank lending and financial innovation came fully on stream inducing bubble conditions. Mortgage origination expanded rapidly as interest rates declined after 2001, but the pace of expansion in the prime mortgage market weakened after 2003, leading to a decline in total originations.

Post-Keynesianism, needless to say, is a broad current with many different strains, a point of some importance in assessing post-Keynesian views on financialization.48 It is interesting to note that the post-Keynesian approach to financialization has not originated with Hyman Minsky, whose work is the cornerstone of post-Keynesian financial analysis. The bulk of Minsky’s output is concerned with developing his path-breaking treatment of financial instability that postulated destabilizing balance sheet behaviour by large capitalist enterprises over the cycle as optimism became increasingly unbridled and led to excessive debt accumulation.49 Minsky’s empirical knowledge of the US financial system also made him aware of the risks of financial innovation, including securitization. However, there is little discussion in his work of the long-term balance between finance and the rest of the economy. To be precise, there are brief references to ‘money manager capitalism’ in some very late work.50 Nonetheless, the characteristic features and broader implications of ‘money manager capitalism’ were not examined in depth by Minsky. Post-Keynesian analysis of financialization is generally based on the concept of the rentier, and in particular of the moneylender as rentier.

There have also been several studies of institutional investors in specific contexts, for instance, on Swiss pension funds, see José Corpataux, Olivier Crevoisier, and Thierry Theurillat, ‘The Expansion of the Finance Industry and Its Impact on the Economy’, Economic Geography 85:3, 2009. Note that Robin Blackburn was one of the first Anglo-Saxon Marxists systematically to deploy the term financialization and to examine it in relation to the rise of pension funds. For Blackburn, functioning capitalists have come to terms with institutional investors accepting shareholder value. Power has been devolved to the ‘shady’ areas of the financial system, partly through financial innovation. See Robin Blackburn, Banking on Death, or Investing in Life: The History and Future of Pensions, London: Verso, 2002; and Robin Blackburn, ‘Finance and the Fourth Dimension’, New Left Review 39, 2006, pp. 39–70. 63 Paul Langley, The Everyday Life of Global Finance, Oxford: Oxford University Press, 2008; Paul Langley, ‘Financialization and the Consumer Credit Boom’, Competition and Change 12:2, pp. 133–47, 2008. 64 Randy Martin, Financialization of Daily Life, Philadelphia: Temple University Press, 2002; Michael Pryke and Paul du Gay, ‘Take an Issue: Cultural Economy and Finance’, Economy and Society 36:3, 2007. 65 Manuel B.


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How the Other Half Banks: Exclusion, Exploitation, and the Threat to Democracy by Mehrsa Baradaran

access to a mobile phone, affirmative action, asset-backed security, bank run, banking crisis, banks create money, barriers to entry, British Empire, call centre, Capital in the Twenty-First Century by Thomas Piketty, cashless society, credit crunch, David Graeber, disintermediation, disruptive innovation, diversification, failed state, fiat currency, financial innovation, financial intermediation, Goldman Sachs: Vampire Squid, housing crisis, income inequality, Internet Archive, invisible hand, Kickstarter, M-Pesa, McMansion, microcredit, mobile money, moral hazard, mortgage debt, new economy, Own Your Own Home, payday loans, peer-to-peer lending, price discrimination, profit maximization, profit motive, quantitative easing, race to the bottom, rent-seeking, Ronald Reagan, Ronald Reagan: Tear down this wall, savings glut, the built environment, the payments system, too big to fail, trade route, transaction costs, unbanked and underbanked, underbanked, union organizing, white flight, working poor

As such, Congress responded forcefully. The BHCA prohibited any commercial nonbank company from controlling a bank. The act, although anticompetitive and even inefficient, was a follow-through of Brandeis and Roosevelt’s desire to keep banks from getting too powerful. The act reinforced the long-held policy of the government stepping in to halt the natural movement of banks toward conglomeration. These hard-line rules stifled financial innovation and banking efficiency, but that was a tradeoff policymakers were willing to make to protect community banks and the public from too much bank power. Because the economy was booming, neither the government nor the banking industry agitated for a change of policy. That is, until the banking world was transformed in the 1970s. CIVIL RIGHTS AND THE SOCIAL CONTRACT FOR EQUALITY The social contract initiated during the Great Depression, whereby the federal government enlisted banks to further policy goals, was amended during the civil rights era to achieve the state’s goals of racial equality.

THE BANKING TRANSFORMATION AND DEREGULATION Beginning in the late 1970s and 1980s, the banking sector started facing an identity crisis. After years of operating a safe and boring model dictated by the regulations imposed during the New Deal, the model began to fall apart. Unit banking and the restrictions and prohibitions of the fifty years following the Great Depression had allowed banks to profit modestly by keeping their balance sheets focused on deposits and loans. But suddenly, technological advances, financial innovation, capital markets, and commercial paper markets started to offer safe and enticing alternatives to banks. Banks started hemorrhaging customers, a process called disintermediation, which means cutting out the middleman. Deposits went directly to high-yield markets and sidestepped highly regulated banks.99 Concerns about banks’ waning profitability led to growing pressure on the government to deregulate banks and allow them to compete more freely with other institutions.

Paul Tucker, “Regimes for Handling Bank Failures—Redrawing the Banking Social Contract,” remarks, British Bankers’ Association Annual International Banking Conference “Restoring Confidence—Moving Forward,” London, June 30, 2009, accessed January 18, 2015, www.bis.org/review/r090708d.pdf. 21. Gary Gorton, “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007,” conference, Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference: Financial Innovation and Crisis, May 9, 2009, accessed March 13, 2015, www.frbatlanta.org/news/conferences/09-financial_markets_agenda.cfm. 22. See “Adding Up the Government’s Total Bailout Tab,” New York Times, July 24, 2011, accessed March 13, 2015, www.nytimes.com/interactive/2009/02/04/business/20090205-bailout-totals-graphic.html?_r=0. As of April 30, 2011, the government had made bail-out commitments of 12.2 trillion dollars.


pages: 409 words: 125,611

The Great Divide: Unequal Societies and What We Can Do About Them by Joseph E. Stiglitz

"Robert Solow", accounting loophole / creative accounting, affirmative action, Affordable Care Act / Obamacare, agricultural Revolution, Asian financial crisis, banking crisis, Berlin Wall, Bernie Madoff, Branko Milanovic, Bretton Woods, business cycle, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, carried interest, clean water, collapse of Lehman Brothers, collective bargaining, computer age, corporate governance, credit crunch, Credit Default Swap, deindustrialization, Detroit bankruptcy, discovery of DNA, Doha Development Round, everywhere but in the productivity statistics, Fall of the Berlin Wall, financial deregulation, financial innovation, full employment, George Akerlof, ghettoisation, Gini coefficient, glass ceiling, global supply chain, Home mortgage interest deduction, housing crisis, income inequality, income per capita, information asymmetry, job automation, Kenneth Rogoff, Kickstarter, labor-force participation, light touch regulation, Long Term Capital Management, manufacturing employment, market fundamentalism, mass incarceration, moral hazard, mortgage debt, mortgage tax deduction, new economy, obamacare, offshore financial centre, oil shale / tar sands, Paul Samuelson, plutocrats, Plutocrats, purchasing power parity, quantitative easing, race to the bottom, rent-seeking, rising living standards, Ronald Reagan, school vouchers, secular stagnation, Silicon Valley, Simon Kuznets, The Chicago School, the payments system, Tim Cook: Apple, too big to fail, trade liberalization, transaction costs, transfer pricing, trickle-down economics, Turing machine, unpaid internship, upwardly mobile, urban renewal, urban sprawl, very high income, War on Poverty, Washington Consensus, We are the 99%, white flight, winner-take-all economy, working poor, working-age population

In some cases, companies were so embarrassed about calling such rewards “performance bonuses” that they felt compelled to change the name to “retention bonuses” (even if the only thing being retained was bad performance). Those who have contributed great positive innovations to our society, from the pioneers of genetic understanding to the pioneers of the Information Age, have received a pittance compared with those responsible for the financial innovations that brought our global economy to the brink of ruin. SOME PEOPLE LOOK at income inequality and shrug their shoulders. So what if this person gains and that person loses? What matters, they argue, is not how the pie is divided but the size of the pie. That argument is fundamentally wrong. An economy in which most citizens are doing worse year after year—an economy like America’s—is not likely to do well over the long haul.

It doesn’t have to be this way. We could have a much simpler tax system without all the distortions—a society where those who clip coupons for a living pay the same taxes as someone with the same income who works in a factory; where someone who earns his income from saving companies pays the same tax as a doctor who makes the income by saving lives; where someone who earns his income from financial innovations pays the same taxes as a someone who does research to create real innovations that transform our economy and society. We could have a tax system that encourages good things like hard work and thrift and discourages bad things, like rent seeking, gambling, financial speculation, and pollution. Such a tax system could raise far more money than the current one—we wouldn’t have to go through all the wrangling we’ve been going through with sequestration, fiscal cliffs, and threats to end Medicare and Social Security as we know it.

Does he realize that since the era of deregulation and liberalization began in the late 1970s, GDP growth has slowed markedly, and that what growth has occurred has primarily benefited those at the top? Does he know that prior to these “reforms,” the U.S. had not had a financial crisis—now a regular occurrence around the world—for a half-century, and that deregulation led to a bloated financial sector that attracted many talented young people who otherwise might have devoted their careers to more productive activities? Their financial innovations made them extremely rich but brought America and the global economy to the brink of ruin. Australia’s public services are the envy of the world. Its health care system delivers better outcomes than that of the U.S., at a fraction of the cost. It has an income-contingent education-loan program that permits borrowers to spread their repayments over more years if necessary, and in which, if their income turns out to be particularly low (perhaps because they chose important but low-paying jobs, say, in education or religion), the government forgives some of the debt.


pages: 819 words: 181,185

Derivatives Markets by David Goldenberg

Black-Scholes formula, Brownian motion, capital asset pricing model, commodity trading advisor, compound rate of return, conceptual framework, correlation coefficient, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, en.wikipedia.org, financial innovation, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, law of one price, locking in a profit, London Interbank Offered Rate, Louis Bachelier, margin call, market microstructure, martingale, Myron Scholes, Norbert Wiener, Paul Samuelson, price mechanism, random walk, reserve currency, risk/return, riskless arbitrage, Sharpe ratio, short selling, stochastic process, stochastic volatility, time value of money, transaction costs, volatility smile, Wiener process, yield curve, zero-coupon bond, zero-sum game

You won’t exercise the call because it is out-of-the-money in this case. So no matter what state of the world prevails, you will end up having to buy the underlying commodity for $E. But that is exactly what a long forward contract is; the obligation to buy the underlying commodity for $E, no matter what happens at time T. 11.8 FINANCIAL INNOVATION USING EUROPEAN PUT-CALL PARITY 11.8.1 Generalized Forward Contracts Using these ideas linking forward contracts to European puts and calls, we can do a little financial innovation. When you take a long position in a ‘normal’ forward contract, the forward price must equal Ft,T=erτSt in order to avoid arbitrage. There is no up-front payment required because, at this forward price, the current value of the forward contract to all longs and shorts is zero. This creates a limitation on the types of forward contracts that can be written.

increment of ABM process 555; shifted arithmetic Brownian motion (ABM) model of prices 541–2; reduced process 570; stochastic differential equations (SDEs) 553, 559, 562–3, 564, 566, 567–8, 570, 571, 583; stochastic integral equations (SIEs) 559, 560, 561, 564, 565–6, 567; stochastic processes 540–1, 543, 562, 587, 588; transition density function for shifted arithmetic Brownian motion 545–6; Wiener measure (and process) 540–1 option sellers 328 option trading strategies 345–67, 415–34; basic (naked) strategies 347–63; ‘calling away’ of stock 422; concept checks: covered call strategies, choice of 426; solution to 434; covered call write, upside potential of 422; solution to 433; cushioning calls 422; In-the-Money covered call writes 421; solution to 433; market for call options, dealing with profit potential and 354; solution to 367; payout present value on longing zero-coupon riskless bond 362; solution to 367; positions taken, definition of risk relative to 427; profit diagram for long call option, working on 418; rationalization of profits, short call positions 357; stock price fluctuations, dealing with 353; solution to 366–7; upside volatility in short positions, dealing with 359; covered call hedging strategy 419–27; economic interpretation of 426–7; covered call writes, types of 420–6; covered calls and protective put strategies 419; diversification, maximum effect of 419–20; Dollar Returns, percentage rates of 366; economic characteristics 358; European Put-Call Parity 416, 417, 418, 419, 426, 429; exercises for learning development of 364–6, 431–3; finite-maturity financial instruments, options as 354; generation of synthetic option strategies from European Put-Call Parity 416–18; In-the-Money covered call writes 421–4; key concepts 364, 431; long a European call option on the underlying 351–5; economic characteristics 353; long a European put option on the underlying 348, 357–9; economic characteristics 358; long a zero-coupon riskless bond and hold to maturity 348, 360–2; economic characteristic 361; long call positions, difference between long underlying positions and 354; long the underlying 347–9; economic characteristics 349; Merck stock price fluctuations 346–7; natural and synthetic strategies 416; natural stock, economic equivalence with synthetic stock 418; Out-of-the-Money covered call writes 424–6; potential price paths 346–7; profit diagrams 346–7; protective put hedging strategy 427–30; economic interpretation of 429–30; insurance, puts as 427–9; puts as insurance 427–9; short a European call option on the underlying 348, 355–7; economic characteristics 357; short a European put option on the underlying 348, 359–60; economic characteristics 360; short a zero-coupon riskless bond and hold to maturity 348, 362–3; economic characteristic 363; short the underlying 348, 349–51; economic characteristics 351; synthetic equivalents on basic (naked) strategies 416–18; synthetic strategies, natural strategies and 416 option valuation: binomial option pricing model (BOPM) 445–8; risk-neutral valuation 624–33; direct valuation by risk-averse investor 626–31; manipulations 624–6; for risk-neutral investors 631–3 options and options scenarios 323–6 Options Clearing Corporation (OCC) 328 options markets 323–44; American options 328; anticipation of selling 339; anticipatory buying 339–40; basic American call (put) option pricing model 332–4; buying back stock 339; CBOE (Chicago Board Options Exchange) 324–5, 334; asked price entries 335, 336; bid entries 335, 336; equity option specifications 343; exchange-traded option contracts 325; last sale entries 335, 336; Merck call options and price quotes 334–7; mini equity option specifications 344; net entries 335, 336; open interest entries 335, 336; volume entries 335, 336; concept checks: individual equity options, product specifications for 326; solution to 342; mini equity options, product specifications for 326; solution to 342; MRK OV-E price quote 337; option positions 331; option sales 332; solution to 342; option’s rights 331; payoff diagram construction 338; put option positions 332; context in study of 326–7; decision-making, option concept in 324; delayed exercise premium 331, 337; European options 328; exercise price 328, 336; exercises for learning development of 341–2; exercising options 328; expiration date 336; expiration month code 336; financial engineering techniques 337–8; immediate exercise value 330; implicit short positions 340; importance of options 323–4; In-the-Money calls 337; insurance features, options and 327; intrinsic value 326, 330, 333, 337; key concepts 341; learning options, framework for 326–7; leverage, options and 327; liquidity option 333; long and short positions, identification of 339–40; long positions 339–40; long vs. short positions 339–40; maturity dates 328; moneyness 329; naked (unhedged) positions 327; non-simultaneous price quote problem 334–6; option buyers 328; option market premiums 328; option sellers 328; options and options scenarios 323–6; Options Clearing Corporation (OCC) 328; options embedded in ordinary securities 324; options in corporate finance 324; payoff and profit diagrams 326, 338; plain vanilla put and call options, definitions and terminology for 327–32; put and call options 323–5, 327, 328, 329, 338; puts and calls, infrastructure for understanding about 337–8; reading option price quotes 334–7; real asset options 324; short positions 339–40; short sales, covering of 339; speculation on option prices 327; standard equity option 336; standard stock option 334; strategic, option-like scenarios 324; strike price 328; strike price code 336; time premium 326, 330–1, 333, 337; underlying assets or scenarios 327, 334; identification of long and short positions in 339–40; see also binomial option pricing model (BOPM); equivalent martingale measures (EMMs); model-based option pricing (MBOP) in real time; rational option pricing (ROP) order execution 125–6; futures contract definition and 126 order submission 125–6 orders, types of 127–34 Out-of-the-Money covered call writes 424–6 over the counter (OTC): markets 12–13, 14, 17 over-the-counter (OTC): bilateral agreements 278 overall profits (and losses) 144, 150, 151, 153, 156, 157 overnight averages 11 par swap rate 294, 301 parameterization 454, 477–8, 502 partial equilibrium (PE) 453; models of, risk-neutral valuation and 614 participants in futures market 122–5 path structures: in binomial process 440–2, 442–4; multi-period BOPM model (N=3) 497; thinking of BOPM in terms of paths 493–9 paying fixed 293; in interest rate derivatives (IRDs) 278–9; and receiving floating in commodity forward contracts 276 payoff and profit: diagrams of 326, 338; difference between 66 payoff position with forward contracts 37 payoff to long forward position in IBM 40 payoff to short forward position in IBM 43 payoffs per share: to naked long forward contract 68–9; to naked long spot position 67, 68–9 perfect negative correlation 166 perfect positive correlation 609–11 performance bonds (margins) 144–5, 148 physical probability: measure of, martingale hypothesis for 530; risk-neutralization of 604 pit trading, order flow process and 136–9 plain vanilla interest-rate swaps 274; dealer intermediated swaps 284–93; non-dealer intermediated swaps 281–4 plain vanilla put and call options, definitions and terminology for 327–32 portfolio price dynamics, replication of 457 portfolio theory, hedging as 165–8 portfolio variance, calculation of 179–81 position accountability 214, 215, 228, 229 preference-free risk-neutral valuation 598, 600 present and future spot prices 20–3 present value (PV): valuation of forward contracts (assets with dividend yield) 94; valuation of forward contracts (assets without dividend yield) 69, 75 price contingent claims with unhedgeable risks 599–601 price paths: ending at specific terminal price, numbers of 442–4; numbers of 440–2 price quotes: in forward markets 9–11; in futures markets 17–19; in spot markets 6–7 pricing a swap 294 pricing by arbitrage and FTAP2 597–8 pricing currency forwards 105 pricing European options under shifted arithmetic Brownian motion (ABM) with no drift 542–51; Bachelier option pricing formula, derivation of 547–51; fundamental theorems of asset pricing (FTAP) 542–3; transition density functions 543–7 pricing foreign exchange forward contracts using no-arbitrage 106–7 pricing mechanism, risk-neutral valuation and 596 pricing options: at expiration (BOPM) 445–6; at time t=0 (BOPM) 446–8; tools for (MBOP) 448–53; relationships between tools 450–3 pricing states 509 pricing zero-coupon, unit discount bonds in continuous time 69–73 primitive Arrow-Debreu (AD) securities, option pricing and 508–14; concept check, pricing ADu(ω) and ADd(ω) 514; exercise 1, pricing B(0,1) 510; exercise 2, pricing ADu(ω) and ADd(ω) 511–14 probability density function 544 profit diagrams 346–7 protection, market orders with 127–9 protective put hedging strategy 427–30; economic interpretation of 429–30; insurance, puts as 427–9 put and call options 323–5, 327, 328, 329, 338; infrastructure for understanding about 337–8 puts as insurance 427–9 quality spreads 299 random variables 536 random walk model of prices 530–1 randomness, state of nature and 23 rate of return of risky asset over small time interval, components of 555–6 rational option pricing (ROP) 369–414; adjusted intrinsic value (AIV) for a European call, definition of 375–6; adjusted time premium (ATP) 397; basic European option pricing model, interpretation of 397–8; certainty equivalent (CE) cash flow 397; concept checks: adjusted intrinsic value (AIV) for calls, calculation of 413; solution to 413; adjusted intrinsic value (AIV) for puts, calculation of 381; solution to 413; directional trades and relative trades, difference between 372; dominance principle and value of European call option 376; solution to 413; exercise price of options, working with 391; forward contracts, overpaying on 403; generalized forward contracts, current value on 404; rational option pricing (ROP) or model-based option pricing (MBOP) 407; short stock position, risk management of 399; solution to 413–14; working from strategies to current costs and back 393; solution to 413; continuation region 385; convexity of option price 406; current costs and related strategies, technique of going back and forth between 393; directional trades 371–2; dominance principle 372, 373; implications of 374–88; equilibrium forward price 402; European Put-Call Parity, financial innovation with 401–5; European Put-Call Parity, implications of 394–400; American option pricing model, analogue for European options 396–8; European call option 394–6; European option pricing model, interpretation of 397–8; European put option 398–9; synthesis of forward contracts from puts and calls 399–400; exercises for learning development of 409–12; financial innovation using European Put-Call Parity 401–5; American Put-Call Parity (no dividends) 403–5; generalized forward contracts 401–3; full replication of European call option (embedded insurance contract) 391–2; generalized forward price 402; key concepts 408–9; LBAC (lower bound for American call option on underlying, no dividends) 374–5; LBACD (lower bound for American call option on underlying, continuous dividends) 383–5; call on underlier with continuous, proportional dividends over life of option 384–5; call on underlier with no dividends over life of option 384; LBAP (lower bound for American put option on underlying, no dividends) 378–80; intrinsic value lower bound for American put, example of 379–80; LBAPD (lower bound for American put option on underlying, continuous dividends) 387–8; LBEC (lower bound for European call option on underlying, no dividends) 375–8; implications of 377–8; LBECD (lower bound for European call option on underlying, continuous dividends) 382–3; LBEP (lower bound for European put option on underlying, no dividends) 380–1; adjusted intrinsic value (AIV) for European put, definition of 380–1; LBEPD (lower bound for European put option on underlying, continuous dividends) 386–7; model-based option pricing (MBOP) 371, 398; model-independent vs. model-based option pricing 370–1; model risk 372; No-Arbitrage in Equilibrium (NAIE) 372, 405–6; partial replication of European call option (embedded forward contract) 388–91; postscript on 405–7; relative pricing trades vs. directional trades 371–2; risk-free arbitrage 373; static replication, principle of 393–4; static replication and European Put-Call Parity (no dividends) 388–94; current costs and related strategies, technique of going back and forth between 393; fully replicating European call option (embedded insurance contract) 391–2; partially replicating European call option (embedded forward contract) 388–91; working backwards from payoffs to costs to derive European Put-Call Parity 393–4; sub-replication 404; super-replication 404; working backwards from payoffs to costs to derive European Put-Call Parity 393–4 raw price change, present value of 243 reading option price quotes 334–7 real asset options 324 realization of daily value 149 realized daily cash flows, creation of 243 receiving floating 293 receiving variable in interest rate derivatives (IRDs) 279–80 recontracting future positions 149, 151 Registered Commodity Representatives (RCRs) 122–3 relative pricing 65–6 relative pricing trades vs. directional trades 371–2 relative risks of hedge portfolio’s return, analysis of 618–24; risk-averse investor in hedge portfolio, role of risk premia for 620–4; risk neutrality in hedge portfolio, initial look at 618–20 replicability: option pricing in continuous time 588; risk-neutral valuation 597–8, 600, 601, 603, 605, 606, 614, 615, 631, 633 replicating portfolio, construction of 478–84; concept check, interpretation of hedge ratio 482; down state, replication in 481; hedge ratio, interpretation of 482–3; replication over period 2 (under scenario 1) 479–82; replication under scenario 2 (over period 2) 484; scenarios 478–9; solving equations for ?

Directional Trades 11.3 The Dominance Principle 11.4 Implications of the Dominance Principle, ROP for Puts and Calls 11.4.1 Lower Bound for an American Call Option on an Underlying with no Dividends (LBAC) 11.4.2 Lower Bound for a European Call Option on an Underlying with no Dividends (LBEC) 11.4.3 Lower Bound for an American Put Option on an Underlying with no Dividends (LBAP) 11.4.4 Lower Bound for a European Put Option on an Underlying with no Dividends (LBEP) 11.4.5 Lower Bound for a European Call Option on an Underlying with Continuous Dividends (LBECD) 11.4.6 Lower Bound for an American Call Option on an Underlying with Continuous Dividends (LBACD) 11.4.7 Lower Bound for a European Put Option on an Underlying with Continuous Dividends (LBEPD) 11.4.8 Lower Bound for an American Put Option on an Underlying with Continuous Dividends (LBAPD) 11.5 Static Replication and European Put-Call Parity (No Dividends) 11.5.1 Partially Replicating a European Call Option (the Embedded Forward Contract) 11.5.2 Fully Replicating a European Call Option (the Embedded Insurance Contract) 11.5.3 From Strategies to Current Costs and Back 11.5.4 Working Backwards from Payoffs to Costs to Derive European Put-Call Parity 11.6 Basic Implications of European Put-Call Parity 11.6.1 What is a European Call Option? 11.6.2 The Analogue of the Basic American Option Pricing Model for European Options 11.6.3 What is a European Put Option? 11.7 Further Implications of European Put-Call Parity 11.7.1 Synthesizing Forward Contract from Puts and Calls 11.8 Financial Innovation using European Put-Call Parity 11.8.1 Generalized Forward Contracts 11.8.2 American Put-Call Parity (No Dividends) 11.9 Postscript on ROP CHAPTER 12 OPTION TRADING STRATEGIES, PART 2 12.1 Generating Synthetic Option Strategies from European Put-Call Parity 12.2 The Covered Call Hedging Strategy 12.2.1 Three Types Of Covered Call Writes 12.2.2 Economic Interpretation of the Covered Call Strategy 12.3 The Protective Put Hedging Strategy 12.3.1 Puts as Insurance 12.3.2 Economic Interpretation of the Protective Put Strategy CHAPTER 13 MODEL-BASED OPTION PRICING IN DISCRETE TIME, PART 1: THE BINOMIAL OPTION PRICING MODEL (BOPM, N=1) 13.1 The Objective of Model-Based Option Pricing (MBOP) 13.2 The Binomial Option Pricing Model, Basics 13.2.1 Modeling Time in a Discrete Time Framework 13.2.2 Modeling the Underlying Stock Price Uncertainty 13.3 The Binomial Option Pricing Model, Advanced 13.3.1 Path Structure of the Binomial Process, Total Number of Price Paths 13.3.2 Path Structure of the Binomial Process, Total Number of Price Paths Ending at a Specific Terminal Price 13.3.3 Summary of Stock Price Evolution for the N-Period Binomial Process 13.4 Option Valuation for the BOPM (N=1) 13.4.1 Step 1, Pricing the Option at Expiration 13.4.2 Step 2, Pricing the Option Currently (time t=0) 13.5 Modern Tools for Pricing Options 13.5.1 Tool 1, The Principle of No-Arbitrage 13.5.2 Tool 2, Complete Markets or Replicability, and a Rule of Thumb 13.5.3 Tool 3, Dynamic and Static Replication 13.5.4 Relationships between the Three Tools 13.6 Synthesizing a European Call Option 13.6.1 Step 1, Parameterization 13.6.2 Step 2, Defining the Hedge Ratio and the Dollar Bond Position 13.6.3 Step 3, Constructing the Replicating Portfolio 13.6.4 Step 4, Implications of Replication 13.7 Alternative Option Pricing Techniques 13.8 Appendix: Derivation of the BOPM (N=1) as a Risk-Neutral Valuation Relationship CHAPTER 14 OPTION PRICING IN DISCRETE TIME, PART 2: DYNAMIC HEDGING AND THE MULTI-PERIOD BINOMIAL OPTION PRICING MODEL, N>1 14.1 Modeling Time and Uncertainty in the BOPM, N>1 14.1.1 Stock Price Behavior, N=2 14.1.2 Option Price Behavior, N=2 14.2 Hedging a European Call Option, N=2 14.2.1 Step 1, Parameterization 14.2.2 Step 2, Defining the Hedge Ratio and the Dollar Bond Position 14.2.3 Step 3, Constructing the Replicating Portfolio 14.2.4 The Complete Hedging Program for the BOPM, N=2 14.3 Implementation of the BOPM for N=2 14.4 The BOPM, N>1 as a RNVR Formula 14.5 Multi-period BOPM, N>1: A Path Integral Approach 14.5.1 Thinking of the BOPM in Terms of Paths 14.5.2 Proof of the BOPM Model for general N CHAPTER 15 EQUIVALENT MARTINGALE MEASURES: A MODERN APPROACH TO OPTION PRICING 15.1 Primitive Arrow–Debreu Securities and Option Pricing 15.1.1 Exercise 1, Pricing B(0,1) 15.1.2 Exercise 2, Pricing ADu(ω) and ADd(ω) 15.2 Contingent Claim Pricing 15.2.1 Pricing a European Call Option 15.2.2 Pricing any Contingent Claim 15.3 Equivalent Martingale Measures (EMMs) 15.3.1 Introduction and Examples 15.3.2 Definition of a Discrete-Time Martingale 15.4 Martingales and Stock Prices 15.4.1 The Equivalent Martingale Representation of Stock Prices 15.5 The Equivalent Martingale Representation of Option Prices 15.5.1 Discounted Option Prices 15.5.2 Summary of the EMM Approach 15.6 The Efficient Market Hypothesis (EMH), A Guide To Modeling Prices 15.7 Appendix: Essential Martingale Properties CHAPTER 16 OPTION PRICING IN CONTINUOUS TIME 16.1 Arithmetic Brownian Motion (ABM) 16.2 Shifted Arithmetic Brownian Motion 16.3 Pricing European Options under Shifted Arithmetic Brownian Motion with No Drift (Bachelier) 16.3.1 Theory (FTAP1 and FTAP2) 16.3.2 Transition Density Functions 16.3.3 Deriving the Bachelier Option Pricing Formula 16.4 Defining and Pricing a Standard Numeraire 16.5 Geometric Brownian Motion (GBM) 16.5.1 GBM (Discrete Version) 16.5.2 Geometric Brownian Motion (GBM), Continuous Version 16.6 Itô’s Lemma 16.7 Black–Scholes Option Pricing 16.7.1 Reducing GBM to an ABM with Drift 16.7.2 Preliminaries on Generating Unknown Risk-Neutral Transition Density Functions from Known Ones 16.7.3 Black–Scholes Options Pricing from Bachelier 16.7.4 Volatility Estimation in the Black–Scholes Model 16.8 Non-Constant Volatility Models 16.8.1 Empirical Features of Volatility 16.8.2 Economic Reasons for why Volatility is not Constant, the Leverage Effect 16.8.3 Modeling Changing Volatility, the Deterministic Volatility Model 16.8.4 Modeling Changing Volatility, Stochastic Volatility Models 16.9 Why Black–Scholes is Still Important CHAPTER 17 RISK-NEUTRAL VALUATION, EMMS, THE BOPM, AND BLACK–SCHOLES 17.1 Introduction 17.1.1 Preliminaries on FTAP1 and FTAP2 and Navigating the Terminology 17.1.2 Pricing by Arbitrage and the FTAP2 17.1.3 Risk-Neutral Valuation without Consensus and with Consensus 17.1.4 Risk-Neutral Valuation without Consensus, Pricing Contingent Claims with Unhedgeable Risks 17.1.5 Black–Scholes’ Contribution 17.2 Formal Risk-Neutral Valuation without Replication 17.2.1 Constructing EMMs 17.2.2 Interpreting Formal Risk-Neutral Probabilities 17.3 MPRs and EMMs, Another Version of FTAP2 17.4 Complete Risk-Expected Return Analysis of the Riskless Hedge in the (BOPM, N=1) 17.4.1 Volatility of the Hedge Portfolio 17.4.2 Direct Calculation of σS 17.4.3 Direct Calculation of σC 17.4.4 Expected Return of the Hedge Portfolio 17.5 Analysis of the Relative Risks of the Hedge Portfolio’s Return 17.5.1 An Initial Look at Risk Neutrality in the Hedge Portfolio 17.5.2 Role of the Risk Premia for a Risk-Averse Investor in the Hedge Portfolio 17.6 Option Valuation 17.6.1 Some Manipulations 17.6.2 Option Valuation Done Directly by a Risk-Averse Investor 17.6.3 Option Valuation for the Risk-Neutral Investor Index FIGURES 1.1 Canada/US Foreign Exchange Rate 1.2 Intermediation by the Clearing House 1.3 Offsetting Trades 1.4 Gold Fixing Price in London Bullion Market (USD$) 2.1 Graphical Method to Get Hedged Position Profits 2.2 Payoff Per Share to a Long Forward Contract 2.3 Payoff Per Share to a Short Forward Contract 2.4 Profits per bu. for the Unhedged Position 3.1 Profits Per Share to a Naked Long Spot Position 3.2 Payoffs Per Share to a Naked Long Spot Position 3.3 Payoffs (=Profits) Per Share to a Naked Long Forward Position 3.4 Payoffs Per Share to a Naked Long Spot Position and to a Naked Long Forward Position 5.1 Order Flow Process (Pit Trading) 5.2 The Futures Clearing House 5.3 Offsetting Trades 5.4 Overall Profits for Example 2 6.1 Long vs.


pages: 246 words: 74,341

Financial Fiasco: How America's Infatuation With Homeownership and Easy Money Created the Economic Crisis by Johan Norberg

accounting loophole / creative accounting, bank run, banking crisis, Bernie Madoff, Black Swan, business cycle, capital controls, central bank independence, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, David Brooks, diversification, financial deregulation, financial innovation, helicopter parent, Home mortgage interest deduction, housing crisis, Howard Zinn, Hyman Minsky, Isaac Newton, Joseph Schumpeter, Long Term Capital Management, market bubble, Martin Wolf, Mexican peso crisis / tequila crisis, millennium bug, money market fund, moral hazard, mortgage tax deduction, Naomi Klein, new economy, Northern Rock, Own Your Own Home, price stability, Ronald Reagan, savings glut, short selling, Silicon Valley, South Sea Bubble, The Wealth of Nations by Adam Smith, too big to fail

How the U.S. central bank (the Fed) and the surpluses of fast-growing emerging economies made money cheaper than ever in the past decade, and why that money ended up in people's homes. Chapter 2: Housing policy. The story of how U.S. politicians-both Democrats and Republicans-worked systematically to increase the share of families who owned their homes, even when that undermined traditional requirements of creditworthiness. Chapter 3: Financial innovations. How to transform big risks into smaller risks by repackaging them, labeling them, and selling them. How regulations and bonuses caused everybody to flock into the market for mortgage-backed securities, and why even cows could have made a fortune from such securities. Chapter 4: The crisis. The story of how the fall of an investment bank gave the global economy cardiac arrest, a CEO was knocked to the floor by a subordinate, and a country went belly-up.

James Grant once wrote a book entitled The Trouble with Prosperity, and U.S. economist Hyman Minsky claimed that "stability leads to instability." Their point is that nothing is more dangerous than good times because they encourage investors to borrow more and take bigger risks. If things look good, they are going to get worse. "Investors said, `I don't want to be in equities anymore, and I'm not getting any return in my bond positions,"' explains a financier who is the author of many financial innovations: "Two things happened. They took more and more leverage, and they reached for riskier asset classes. Give me yield, give me leverage, give me return."" It's the Deficit, Stupid U.S. households were not alone in opening wide their pocketbooks and bankbooks: The U.S. government did the same. By 2002, the Bush administration had turned a $127 billion surplus into a $158 billion deficit.

., 36, 38 Fannie Mae (Federal National Mortgage Association), 25-28, 147 aggressive risk-taking, 40-43 collapse of, 36-43, 77-79 Cuomo and, 32 early repayment penalties, 34 exposure to housing market, 42-43 flexible standards and procedures, 31-32, 40, 43 fraud and abuse scandal, 37-39, 40 "junk loans," 42 monitoring of loans, 34 nationalized, 79 political contributions and other favors from, 30, 38-39 securitized mortgages, 47 special privileges for Countrywide, 30 stockholder dividends, 77 subprime project rollout, 32-34 Farley, James, 107 Federal Housing Administration (FHA), 34-36, 127-28 Federal Housing Enterprise Oversight, Office of, 36, 38 Federal Reserve Bank Greenspan on, I interest rates and, 2, 3-5, 12-13, 14, 21 lending to investment banks, 79-80 as a model, 3-4 short- and long-term interest rate behaviors, 17-18 Federal Reserve Bank of Boston, flexible underwriting standards and, 31-32, 43 Federal Reserve Board, monetary policy control, 103-4 federal spending, 19-20 Ferguson, Niall, 130 FHA. See Federal Housing Administration (FHA) financial innovations for risk pooling, 7 adjustable-rate mortgages, 7, 71 liberalization of financial markets and, 131 nonrecourse mortgages, 9 See also mortgage-backed securities; risk-taking, excessive financial markets, 129-31 confidence and cooperation, 131-38 false sense of security and, 138-45 regulation and supervision responsibilities, 145 fines for discrimination in lending, 31 First Boston, 47 First Union, oversubscribed securitized mortgages, 27 Fitch, 60, 61 fixed-rate mortgages, 7 Fixing Global Finance, 16 "flipping" real estate, 8-9 foreclosures, 24-25 Fortis, 119, 146 fraud and abuse, 144-45 Fannie Mae and Freddie Mac, 37-39, 40 Subprime XYZ package, 65-68 Freddie Mac (Federal Home Loan Mortgage Corporation), 25-28, 147 aggressive risk-taking, 40-43 collapse of, 36-43, 77-79 Cuomo and, 32 exposure to housing market, 42-43 flexible standards and procedures, 31-32, 40, 43 fraud and abuse scandal, 37-39, 40 "junk loans," 42 monitoring of loans, 34 nationalized, 79 political contributions and other favors from, 30, 38-39 securitized mortgages, 27, 47 stockholder dividends, 77 subprime project rollout, 33-34 free-market system, Bush (G.


pages: 270 words: 73,485

Hubris: Why Economists Failed to Predict the Crisis and How to Avoid the Next One by Meghnad Desai

"Robert Solow", 3D printing, bank run, banking crisis, Berlin Wall, Big bang: deregulation of the City of London, Bretton Woods, BRICs, British Empire, business cycle, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, correlation coefficient, correlation does not imply causation, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, deindustrialization, demographic dividend, Eugene Fama: efficient market hypothesis, eurozone crisis, experimental economics, Fall of the Berlin Wall, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, German hyperinflation, Gunnar Myrdal, Home mortgage interest deduction, imperial preference, income inequality, inflation targeting, invisible hand, Isaac Newton, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, laissez-faire capitalism, liquidity trap, Long Term Capital Management, market bubble, market clearing, means of production, Mexican peso crisis / tequila crisis, mortgage debt, Myron Scholes, negative equity, Northern Rock, oil shale / tar sands, oil shock, open economy, Paul Samuelson, price stability, purchasing power parity, pushing on a string, quantitative easing, reserve currency, rising living standards, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, secular stagnation, seigniorage, Silicon Valley, Simon Kuznets, The Chicago School, The Great Moderation, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, The Wealth of Nations by Adam Smith, Tobin tax, too big to fail, women in the workforce

But as to what happened, why it did and why no one saw what was coming, the reply she got could not have satisfied her. Since then some economists such as Nouriel Roubini have claimed that they predicted the crisis. But if this is the case, no one took them seriously. Raghuram Rajan, formerly Chief Economist at the International Monetary Fund (IMF) and the current Governor of the Reserve Bank of India, is credited with having argued, in 2005, that the new set of financial innovations were increasing the volatility in financial markets and heightening risk.3 He was dismissed as a “luddite.” Once the crisis struck, people recalled that the Bank of International Settlements (BIS) and the IMF had made gentle warning noises. The noises had to be gentle because of the fear that acknowledging the problem could make it a self-fulfilling prophecy. An Economic Crisis or a Crisis of Economics?

In a world of low interest rates, the search for high yields intensified. A variety of agents grew up promising large wealth-holders higher than the widely available yields. Businesses such as hedge funds, private equity firms and “special vehicles,” which could treat money in imaginative ways to assure better than average returns, proliferated. They could borrow from banks on the strength of their collateral, and indeed behaved like shadow banks. Financial innovations also began to explode. The original idea of Black and Scholes on pricing options was extended to more sophisticated instruments using the calculation of risk based on statistical mathematics (stochastic calculus), allowing for the creation of new assets even when the buyers (and often even the sellers) could not quite grasp the principles underlying such assets. University finance departments attracted math and science graduates and the legend grew of “rocket scientists” working in brokerage firms inventing new assets.

Even foreign investors such as German banks got into the act as these were supposed to be triple A securities which were guaranteed by the US government (not technically so, but de facto). Interest rates in the US had averages at around 6 percent between 1971 and 2001. By 2005 they had come down to nearly 1 percent, falling steadily from above 5 percent in 2000. Raghuram Rajan, who was Chief Economist of the IMF and a professor at Chicago, did warn in 2005 that there were fault lines in the global financial architecture which financial innovations might expose. But he was dismissed as a “Luddite.” This was an amazing situation, with low inflation, low interest rates and plenty of credit. But then another aspect of globalization impinged on the world economy. GDP growth accelerated in China and this put pressure on raw material prices, especially oil prices. The Fed saw signs of impending inflation and US interest rates went up to 5 percent by 2007.


pages: 495 words: 136,714

Money for Nothing by Thomas Levenson

Albert Einstein, asset-backed security, bank run, British Empire, carried interest, clockwork universe, credit crunch, Edmond Halley, Edward Lloyd's coffeehouse, experimental subject, failed state, Fellow of the Royal Society, fiat currency, financial innovation, Fractional reserve banking, income inequality, Isaac Newton, joint-stock company, market bubble, open economy, price mechanism, quantitative easing, Republic of Letters, risk/return, side project, South Sea Bubble, The Wealth of Nations by Adam Smith

Turning the value of a song over time into cash is, after all, exactly the same transformation as the one that converted a lottery ticket or an annuity into a share that could be sold up and down Exchange Alley. Still, Pangloss is no more persuasive as an economic analyst than as an observer of social life. It is absolutely true that increasingly complex and mathematically intricate financial innovation has, for example, made it cheaper to buy a house or drive off in a new car. But as de Tocqueville feared almost two centuries ago, the modern, utterly interconnected and increasingly powerful financial system is not always the best of all possible worlds. Here again, the South Sea year has some lessons to teach about the risks of financial innovation. The Bubble may be past, that is, but its implications are not, as the world would be reminded, brutally, in the reverberations of a truly wretched Monday morning in September 2008. EPILOGUE “an endemic disease” September 18, 2008, dawned clear over Manhattan.

A host of men, gamblers like Neale, theorists of money like John Locke, Defoe’s “projectors,” and more, had used the moment to launch one experiment after another to extract the nation from its troubles. Two decades later, Harley faced a similar risk of a collapse of Britain’s ability to borrow. Trying to navigate that crisis within a financial milieu dominated by his political opponents, he was met by a round of offers similar to those proposed twenty years before, a renewed push for financial innovation that would, if its proponents could be believed, both save the nation and make those riding to the rescue very rich indeed. * * * — ONE SUCH SCHEME stood out. It had several moving parts, but it turned on a single, simple idea: a forced marriage of two of the financial revolution’s signature inventions, official debt and the joint-stock company. The plan was to transfer government obligations to a new, private company.

For just one example: by the 1990s, it became possible to trade on the future value of the song “Rebel Rebel.” That particular bit of financial engineering became known as the Bowie Bond, in which for the first time musically inclined (or celebrity-dazzled) punters could buy and sell shares of a pop star’s future earnings. Selling shares in a bundle of royalties to come from his songs brought a tidy $25 million to the man behind Ziggy Stardust. That was exactly the result financial innovation is supposed to deliver: Bowie got cash in hand to use as he saw fit, while buyers of his bonds got a stream of income extending into the future, and, perhaps, an extra, unquantifiable happy jolt every time Major Tom spoke on their radio, floating in his most peculiar way. Isaac Newton and Robert Walpole might have been amazed by the reality of David Bowie, but they would have had no problem with the thinking behind selling a stream of future earnings.


pages: 358 words: 106,729

Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram Rajan

accounting loophole / creative accounting, Andrei Shleifer, Asian financial crisis, asset-backed security, assortative mating, bank run, barriers to entry, Bernie Madoff, Bretton Woods, business climate, business cycle, Clayton Christensen, clean water, collapse of Lehman Brothers, collateralized debt obligation, colonial rule, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, diversification, Edward Glaeser, financial innovation, fixed income, floating exchange rates, full employment, global supply chain, Goldman Sachs: Vampire Squid, illegal immigration, implied volatility, income inequality, index fund, interest rate swap, Joseph Schumpeter, Kenneth Rogoff, knowledge worker, labor-force participation, Long Term Capital Management, longitudinal study, market bubble, Martin Wolf, medical malpractice, microcredit, money market fund, moral hazard, new economy, Northern Rock, offshore financial centre, open economy, price stability, profit motive, Real Time Gross Settlement, Richard Florida, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, school vouchers, short selling, sovereign wealth fund, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, upwardly mobile, Vanguard fund, women in the workforce, World Values Survey

We should not worry so much about rugged individualism as about undifferentiated groupthink, for that is the primary source of systemic problems. A competitive system is also likely to produce the financial innovation necessary to broaden access and spread risk. Financial innovation nowadays seems to be synonymous with credit-default swaps and collateralized debt obligations, derivative securities that few outside Wall Street now think should have been invented. But innovation also gave us the money-market account, the credit card, interest-rate swaps, indexed funds, and exchange-traded funds, all of which have proved very useful. So, as with many things, financial innovations span the range from the good to the positively dangerous. Some have proposed a total ban on offering a financial product unless it has been vetted, much as the Food and Drug Administration vets new drugs.

Some progressive economists dispute whether the recent crisis was at all related to government intervention in low-income housing credit.49 This certainly was not the only factor at play, and to argue that it was is misleading. But it is equally misleading to say it played no part. The private financial sector did not suddenly take up low-income housing loans in the early 2000s out of the goodness of its heart, or because financial innovation permitted it to do so—after all, securitization has been around for a long time. To ignore the role played by politicians, the government, and the quasi-government agencies is to ignore the elephant in the room. I have argued that an important political response to inequality was populist credit expansion, which allowed people the consumption possibilities that their stagnant incomes otherwise could not support.

Rich professional organizations have little incentive to give up their rents, so public pressure may be required for them to reexamine their certification requirements. Another factor restricting mobility, certainly in the current downturn, is home ownership. Anecdotal evidence suggests that hard-to-sell homes, and homes that are worth less than the debt that is owed, are weighing down workers and preventing them from looking elsewhere for employment. A number of financial innovations that would allow households to purchase insurance against home-price declines have been proposed, and in light of the recent crisis, demand for these instruments may increase.33 This is also a reason why the government’s focus on encouraging home ownership needs to be revisited. Although the modern economy needs some workers to specialize, workers like Badri, encountered in chapter 4, may tend to grow overly specialized in one industry.


pages: 976 words: 235,576

The Meritocracy Trap: How America's Foundational Myth Feeds Inequality, Dismantles the Middle Class, and Devours the Elite by Daniel Markovits

"Robert Solow", 8-hour work day, activist fund / activist shareholder / activist investor, affirmative action, Anton Chekhov, asset-backed security, assortative mating, basic income, Bernie Sanders, big-box store, business cycle, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, carried interest, collateralized debt obligation, collective bargaining, computer age, corporate governance, corporate raider, crony capitalism, David Brooks, deskilling, Detroit bankruptcy, disruptive innovation, Donald Trump, Edward Glaeser, Emanuel Derman, equity premium, European colonialism, everywhere but in the productivity statistics, fear of failure, financial innovation, financial intermediation, fixed income, Ford paid five dollars a day, Frederick Winslow Taylor, full employment, future of work, gender pay gap, George Akerlof, Gini coefficient, glass ceiling, helicopter parent, high net worth, hiring and firing, income inequality, industrial robot, interchangeable parts, invention of agriculture, Jaron Lanier, Jeff Bezos, job automation, job satisfaction, John Maynard Keynes: Economic Possibilities for our Grandchildren, knowledge economy, knowledge worker, Kodak vs Instagram, labor-force participation, longitudinal study, low skilled workers, manufacturing employment, Mark Zuckerberg, Martin Wolf, mass incarceration, medical residency, minimum wage unemployment, Myron Scholes, Nate Silver, New Economic Geography, new economy, offshore financial centre, Paul Samuelson, payday loans, plutocrats, Plutocrats, Plutonomy: Buying Luxury, Explaining Global Imbalances, precariat, purchasing power parity, rent-seeking, Richard Florida, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, school choice, shareholder value, Silicon Valley, Simon Kuznets, six sigma, Skype, stakhanovite, stem cell, Steve Jobs, supply-chain management, telemarketer, The Bell Curve by Richard Herrnstein and Charles Murray, Thomas Davenport, Thorstein Veblen, too big to fail, total factor productivity, transaction costs, traveling salesman, universal basic income, unpaid internship, Vanguard fund, War on Poverty, Winter of Discontent, women in the workforce, working poor, young professional, zero-sum game

the services they made possible: See generally Dan Awrey, “Toward a Supply-Side Theory of Financial Innovation,” Journal of Comparative Economics 41, no. 2 (2013): 401, and Donald MacKenzie, “Is Economics Performative? Option Theory and the Construction of Derivatives Markets,” paper presented in Tacoma, WA, June 25, 2005, who argues that financial models, and in particular Black-Scholes option pricing, shape financial markets. between just 1970 and 1982: For a list, see William L. Silber, “The Process of Financial Innovation,” American Economic Review 73, no. 2 (1983): 89 (listing thirty-eight innovative financial products developed from 1970 to 1982, ranging from “Debit Cards” and ATMs to “Interest Rate Futures”). For more on financial innovation in the period, see Merton Miller, “Financial Innovation: The Last Twenty Years and the Next,” Journal of Financial and Quantitative Analysis 21, no. 4 (December 1986): 459 (describing the financial “revolution” of the previous twenty years as having occurred largely due to reactions to regulation and taxes), and Peter Tufano, “Financial Innovation,” in The Handbook of Economics of Finance, ed.

For more on financial innovation in the period, see Merton Miller, “Financial Innovation: The Last Twenty Years and the Next,” Journal of Financial and Quantitative Analysis 21, no. 4 (December 1986): 459 (describing the financial “revolution” of the previous twenty years as having occurred largely due to reactions to regulation and taxes), and Peter Tufano, “Financial Innovation,” in The Handbook of Economics of Finance, ed. George Constantinides, Milton Harris, and René Stulz (Amsterdam: North Holland, 2003), 307 (exploring the history of financial innovation and the explanations given for the extensive amount of innovation seen in both the past and the present). The number of financial patents awarded annually has also increased starkly since midcentury, although changes in patent law confound efforts to read innovation directly off patent numbers. Financial patents remained relatively unused until the State Street decision in 1998.

Middle-class borrowing, in other words, bent upward just as middle-class incomes flattened out, and borrowing grew on a scale big enough to fill the income gap that middle-class households lost to stagnant wages.* The scale of the borrowing, moreover, approached the shift in wages from the middle to the top. As the Nobel Prize–winning economist Joseph Stiglitz has observed, “The negative impact of stagnant real incomes and rising income inequality . . . was largely offset by financial innovation . . . and lax monetary policy that increased the ability of households to finance consumption by borrowing. . . . The support for the bubble thus depended on expansionary monetary policy together with financial sector innovation leading to ever-increasing asset prices that allowed households virtually unlimited access to credit.” If the standard of living in midcentury America was funded by income, and the standard of living of the European middle class is increasingly supported by government redistribution, the American middle class increasingly relies on borrowed funds.


pages: 302 words: 84,428

Mastering the Market Cycle: Getting the Odds on Your Side by Howard Marks

activist fund / activist shareholder / activist investor, Albert Einstein, business cycle, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, financial innovation, fixed income, if you build it, they will come, income inequality, Isaac Newton, job automation, Long Term Capital Management, margin call, money market fund, moral hazard, new economy, profit motive, quantitative easing, race to the bottom, Richard Feynman, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, secular stagnation, short selling, South Sea Bubble, stocks for the long run, superstar cities, The Chicago School, The Great Moderation, transaction costs, VA Linux, Y2K, yield curve

Rather, the ready availability of leverage made it easy to invest heavily in assets whose prices had risen a great deal, and in innovative, untested, synthetic, levered investment products, many of which would go on to fail. Perhaps most importantly among the contributing factors, the period was marked by risky behavior on the part of financial institutions. When the world is characterized by benign macro events, hyper-financial activity and financial innovation, there is a tendency for providers of capital to compete for market share in a process I call “the race to the bottom” (I’ll make reference later on to a memo of that name). The mood in the years 2005–07 was summed up by Citigroup CEO Charles Prince in June 2007, virtually on the eve of the Global Financial Crisis, in a statement that became emblematic of the era: “When the music stops, in terms of liquidity, things will be complicated.

Levered mortgage backed securities (and financial derivatives, most of which contain high levels of built-in leverage) generally switched from being return-enhancing tools to weapons of financial mass destruction, as levered funds and securities breached loan covenants, and issuers ultimately proved unable to service their debt. Of course, the new financial products demonstrated—as usual—that financial innovations promising high returns with low risk rarely keep that promise. As for the relaxed regulations, the financial conglomerates permitted by revocation of the Glass-Steagall Act had extensive problems; the repeal of the uptick rule allowed the stocks of financial institutions to be driven down relentlessly; and several banks proved unable to survive under the high levels of leverage that had been allowed.

And that means investors with the ability to understand cycles will find opportunities for profit. Thus far I’ve covered a lot of the past and a bit of the present. Now, as I conclude, I want to turn to the future. Over the course of my career, I’ve witnessed numerous occasions on which pundits said the occurrence of one type of cycle or another had come to an end. Whether because of economic vitality, financial innovation, astute corporate management, or the supposed omniscience of central bankers and heads of Treasury, they observed that the fluctuations of either the economic cycle or the cycle in profits would be seen no more. I spent some time on this subject in “Will It Be Different This Time?” (November 1996). First I described a newspaper article that had appeared a few days earlier: It recounted the case currently being made for this remaining a continuous, recession-free economic expansion.


pages: 275 words: 84,980

Before Babylon, Beyond Bitcoin: From Money That We Understand to Money That Understands Us (Perspectives) by David Birch

agricultural Revolution, Airbnb, bank run, banks create money, bitcoin, blockchain, Bretton Woods, British Empire, Broken windows theory, Burning Man, business cycle, capital controls, cashless society, Clayton Christensen, clockwork universe, creative destruction, credit crunch, cross-subsidies, crowdsourcing, cryptocurrency, David Graeber, dematerialisation, Diane Coyle, disruptive innovation, distributed ledger, double entry bookkeeping, Ethereum, ethereum blockchain, facts on the ground, fault tolerance, fiat currency, financial exclusion, financial innovation, financial intermediation, floating exchange rates, Fractional reserve banking, index card, informal economy, Internet of things, invention of the printing press, invention of the telegraph, invention of the telephone, invisible hand, Irish bank strikes, Isaac Newton, Jane Jacobs, Kenneth Rogoff, knowledge economy, Kuwabatake Sanjuro: assassination market, large denomination, M-Pesa, market clearing, market fundamentalism, Marshall McLuhan, Martin Wolf, mobile money, money: store of value / unit of account / medium of exchange, new economy, Northern Rock, Pingit, prediction markets, price stability, QR code, quantitative easing, railway mania, Ralph Waldo Emerson, Real Time Gross Settlement, reserve currency, Satoshi Nakamoto, seigniorage, Silicon Valley, smart contracts, social graph, special drawing rights, technoutopianism, the payments system, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, tulip mania, wage slave, Washington Consensus, wikimedia commons

It is impossible to say what the unintended consequences of current innovations in financial technology will be, but we can observe that there will be some. While not the subject of this book, I do find it interesting to note the role that the City of London played in shifting the new technology of the tally from debt to medium of exchange. London has always survived and thrived through the introduction of money technologies: ranging from banknotes and bills of exchange, through derivatives and EFT. The City has always been associated with financial innovation and, crucially, the creation of markets. Look at insurance, where it is pre-eminent. London didn’t invent insurance: the preamble to the Insurance Act of 1601 talks about it as a long-established business (Raphael 1994). Indeed, it starts with the words: ‘Whereas it hath bene tyme out of mynde an usage amongste Merchantes…’. What London did invent was the insurance market: Lloyd’s. Today, the City of London is still good at being a market.

Chapter 3 Money and markets There is required for carrying on the trade of the nation, a determinate sum of specifick money, which varies, sometimes more, sometimes less as the circumstances we are in requires. — Sir Dudley North in Discourses upon Trade (1691) New technology brings along new opportunities. In the Western, capitalist tradition, new technology works with long cycles of change in a well-understood way. The recession that follows the collapse of a bubble once again creates conditions for the emergence of a new economics and of new policies. In the context of financial innovations, these policy tools will have to conform closely to the characteristics of the current technological revolution and its paradigm (Perez 2005), which is why I think it important to separate the present paradigm from the present time, if you see what I mean. Thus, technological evolution often leads to crises as the technology races ahead of institutions and legal systems, but the crises may be an indispensable part of the co-evolution of financial services, because they in turn lead to regulation that puts markets onto a firm footing and allows them to grow even more.

It was this regulatory decision along with the technological change that reshaped the industry. After the low-profit late 1970s and the loss-making early 1980s, credit cards were profitable and the business exploded. In the United Kingdom, regulators opted for a light touch and allowed Barclaycard to grow. In both countries credit cards became a mass-market phenomenon, leading to increased competition, which in turn drove financial innovations and additional products and services ranging from frequent flyer miles and cash rebates to credit towards future purchases and a wide variety of ‘cobranding’ in all sorts of industries. A note about card fraud Dee Hock’s earlier comment on card fraud is very interesting because the co-evolution of cards and fraud helps us to learn a great deal about putting new money technology in place.


pages: 316 words: 87,486

Listen, Liberal: Or, What Ever Happened to the Party of the People? by Thomas Frank

Affordable Care Act / Obamacare, Airbnb, Amazon Mechanical Turk, American ideology, barriers to entry, Berlin Wall, Bernie Sanders, blue-collar work, Burning Man, centre right, circulation of elites, Clayton Christensen, collective bargaining, Credit Default Swap, David Brooks, deindustrialization, disruptive innovation, Donald Trump, Edward Snowden, Fall of the Berlin Wall, financial innovation, Frank Gehry, full employment, George Gilder, gig economy, Gini coefficient, income inequality, Jaron Lanier, Jeff Bezos, knowledge economy, knowledge worker, Lean Startup, mandatory minimum, Marc Andreessen, Mark Zuckerberg, market bubble, mass immigration, mass incarceration, McMansion, microcredit, mobile money, moral panic, mortgage debt, Nelson Mandela, new economy, obamacare, payday loans, Peter Thiel, plutocrats, Plutocrats, Ponzi scheme, post-industrial society, postindustrial economy, pre–internet, profit maximization, profit motive, race to the bottom, Republic of Letters, Richard Florida, ride hailing / ride sharing, Ronald Reagan, sharing economy, Silicon Valley, Steve Jobs, Steven Levy, TaskRabbit, Thorstein Veblen, too big to fail, Travis Kalanick, Uber for X, union organizing, urban decay, women in the workforce, Works Progress Administration, young professional

The only lesson we really needed to learn from the working-class experience was how they pulled off their political triumph in the 1930s, which Florida thought the creative class now needed to replicate: “Just as Franklin Delano Roosevelt forged a new majority on the swelling ranks of blue-collar workers, so must the party that hopes to win this presidential election earn the enthusiastic support of today’s ascending economic and political force—the creative class.”16 Florida spoke those words in June of 2008. The collapse of the ultra-creative Lehman Brothers investment bank came a scant three months later, and I would like to be able to say that these dreams of prosperity-through-tastefulness followed—right down the drain with the hedge funds and subprime lenders of the world. After all, one of the greatest deeds of the creative class was … financial innovation—meaning, among other things, the poisoned mortgage-backed securities that brought the global economy so close to death. But the ideas I have described in this chapter did not suffer the same fate. As with free trade and welfare reform, there seems to be no refutation that can dissuade their supporters. Indeed, with the election of the young and innovative challenger, Barack Obama, they got a second wind.

Sure enough, as far as I have been able to determine, few of the people who write or talk about innovation even acknowledge the possibility that innovations might be harmful instead of noble and productive. And yet recent history is littered with exactly such stuff: Innovations that allow companies to spy on us. Innovations that allow terrorist groups to recruit online. Innovations that allowed Enron to do all the fine things it used to do. Come to think of it, the whole economic debacle of the last ten years owes its existence to the financial innovations of the Nineties and the Aughts—the credit default swaps, or the algorithms companies used to hand out mortgage loans—innovations that were celebrated in their day in the same mindlessly positive way we celebrate tech today. Somehow that stuff never comes up, however. We know what innovation is about, and it’s righteousness and triumph. Success is all you’ll find when you riffle through the inno-thoughts produced by the various foundations, institutes, websites, mentors, accelerators, incubators, and entrepreneurship competitions.

The circumvention strategy is everywhere in inno-land once you start looking for it. Airbnb allows consumers and providers to get around various safety and zoning rules with which conventional hotels must comply.15 Amazon allows customers in many places to avoid paying sales taxes. The circumvention strategy isn’t restricted to software innovations, either. One of the great attractions of credit default swaps—a big financial innovation of the last decade—is that they were completely unregulated. Monopoly is the telos of innovation, the holy grail fervently sought after by every young coder sweating away in the incubator. The reason is plain enough: monopoly is the most direct road to profit, and the online world offers countless opportunities to achieve it. Jaron Lanier has described all the ways dominant digital networks can use market power to coerce customers, users, and advertisers; in his account the powerful players are all patterned after Wal-Mart, which so effectively dominates its suppliers and ruins its small-town competitors.16 With Amazon, the Wal-Mart comparison is obvious.


pages: 304 words: 80,965

What They Do With Your Money: How the Financial System Fails Us, and How to Fix It by Stephen Davis, Jon Lukomnik, David Pitt-Watson

activist fund / activist shareholder / activist investor, Admiral Zheng, banking crisis, Basel III, Bernie Madoff, Black Swan, buy and hold, centralized clearinghouse, clean water, computerized trading, corporate governance, correlation does not imply causation, credit crunch, Credit Default Swap, crowdsourcing, David Brooks, Dissolution of the Soviet Union, diversification, diversified portfolio, en.wikipedia.org, financial innovation, financial intermediation, fixed income, Flash crash, income inequality, index fund, information asymmetry, invisible hand, Kenneth Arrow, Kickstarter, light touch regulation, London Whale, Long Term Capital Management, moral hazard, Myron Scholes, Northern Rock, passive investing, performance metric, Ponzi scheme, post-work, principal–agent problem, rent-seeking, Ronald Coase, shareholder value, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, Steve Jobs, the market place, The Wealth of Nations by Adam Smith, transaction costs, Upton Sinclair, value at risk, WikiLeaks

But mathematical economics and statistics suggested that this was a good thing. That was the view of the IMF, the global institution charged with warning of instability, whose “banner message was one of continued optimism within a prevailing benign global environment.” In evaluating why it had made such a gigantic mistake, the IMF subsequently reflected, “To a large extent this was due to the belief that, thanks to the presumed ability of financial innovations to remove risks off banks’ balance sheets, large financial institutions were in a strong position, and thereby, financial markets in advanced countries were fundamentally sound.”19 In other words, banks’ borrowing and lending had increased dramatically, but their understanding of risk was thought to reduce the threat of a breakdown. While those financial instruments worked in theory, they didn’t take into account the phenomena one finds in the real world.

“Public Funds Take Control of Assets, Dodging Wall Street,” New York Times, August 19, 2013. 62. Ibid. 63. US Department of Labor, “Fact Sheet: Final Rule to Improve Transparency of Fees and Expenses to Workers in 401(k)–Type Retirement Plans” (US Department of Labor, February 2012). 64. Ibid. 3 The Return of Ownership 1. Robert Monks and Allen Sykes, “Capitalism without Owners Will Fail: A Policymaker’s Guide to Reform” (Center for the Study of Financial Innovation, 2002). 2. Merriam-Webster.com defines capitalism as “an economic system characterized by private or corporate ownership of capital goods, by investments that are determined by private decision, and by prices, production, and the distribution of goods that are determined mainly by competition in a free market.” Other dictionaries similarly cite private ownership as central to the definition of capitalism. www.merriam-webster.com/dictionary/capitalism, accessed September 27, 2013.

Anat Admati, and Martin Hellwig, The Bankers’ New Clothes: What Is Wrong with Banking and What to Do about It (Princeton University Press, 2013). 33. John Sutherland, discussion at ICGN Annual Conference, Amsterdam, 2014. 8 Capitalism 1. One area where banks can claim to have made substantial productivity improvements is in transferring money. Indeed, Paul Volcker, former chairman of the US Federal Reserve, declared that in the past generation, “the ATM is the only financial innovation he [Volcker] can think of which has improved society.” Alan Murray, “Paul Volcker: Think More Boldly,” Wall Street Journal, December 14, 2009. 2. For example, a US federal court found that an electrical engineering company and the record keeper of its 401(k) plan had violated fiduciary duty. The result: $37 million less in savings than there should have been. John F. Wasik, “Finding, and Battling, Hidden Costs of 401(k) Plans,” New York Times, November 7, 2014. 3.


pages: 354 words: 118,970

Transaction Man: The Rise of the Deal and the Decline of the American Dream by Nicholas Lemann

Affordable Care Act / Obamacare, Airbnb, airline deregulation, Albert Einstein, augmented reality, basic income, Bernie Sanders, Black-Scholes formula, buy and hold, capital controls, computerized trading, corporate governance, cryptocurrency, Daniel Kahneman / Amos Tversky, dematerialisation, diversified portfolio, Donald Trump, Elon Musk, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, fixed income, future of work, George Akerlof, gig economy, Henry Ford's grandson gave labor union leader Walter Reuther a tour of the company’s new, automated factory…, index fund, information asymmetry, invisible hand, Irwin Jacobs, Joi Ito, Joseph Schumpeter, Kenneth Arrow, Kickstarter, life extension, Long Term Capital Management, Mark Zuckerberg, mass immigration, means of production, Metcalfe’s law, money market fund, Mont Pelerin Society, moral hazard, Myron Scholes, new economy, Norman Mailer, obamacare, Paul Samuelson, Peter Thiel, price mechanism, principal–agent problem, profit maximization, quantitative trading / quantitative finance, Ralph Nader, Richard Thaler, road to serfdom, Robert Bork, Robert Metcalfe, rolodex, Ronald Coase, Ronald Reagan, Sand Hill Road, shareholder value, short selling, Silicon Valley, Silicon Valley ideology, Silicon Valley startup, Social Responsibility of Business Is to Increase Its Profits, Steve Jobs, TaskRabbit, The Nature of the Firm, the payments system, Thomas Kuhn: the structure of scientific revolutions, Thorstein Veblen, too big to fail, transaction costs, universal basic income, War on Poverty, white flight, working poor

But what she took from the conversation was that to Summers’s mind, in every other instance he’d been right and she’d been wrong. Robert Merton, the Nobel Prize–winning financial economist who’d invented the key techniques that made the derivatives markets possible, was outraged by what he considered grandstanding after the crisis by Paul Volcker (who said there hadn’t been a useful financial innovation since the automatic teller machine) and Warren Buffett (who called derivatives “financial weapons of mass destruction”); Merton went around the world giving presentations about how “an explosion of extraordinary financial innovation” had rescued the world from the “major financial and economic crisis” of the 1970s. When the Financial Crisis Inquiry Commission finished its forensic work, it sent to the Obama Justice Department a list of nineteen financial executives, including Rubin, who the commission thought might be investigated for breaking the law.

A government report: Doug Elmendorf, memorandum to Janet Yellen, December 21, 1998, 2. Morgan Stanley got the most: Bradley Keoun, “Morgan Stanley at Brink of Collapse Got $107 Billion from Fed,” Bloomberg News, August 22, 2011. “perfect storm”: Author’s interview with Robert Reich. Just after Obama took office: Author’s interview with Brooksley Born. “an explosion of extraordinary financial innovation”: Robert C. Merton, “On the Role of Financial Innovation and Derivative Markets in Financial Globalization and Capital Markets,” slide presentation prepared for International Capital Markets Conference, Bangkok, Thailand, November 30, 2015. “I wouldn’t trust you!”: Lloyd Blankfein, testimony before the Senate Government Affairs Subcommittee on Government Relations, April 27, 2010. A video record of the exchange can be found on CSPAN’s website.

Elmendorf wrote: One specific effect of asymmetric information [meaning that in over-the-counter derivatives markets, no party to a transaction knew the underlying economic condition of the other parties] is to increase the risk of a general financial panic (“systemic risk”). Because market participants cannot judge the financial health of institutions they deal with, bad news about one institution has a contagion effect on other institutions, reducing their access to capital as well. The doctrine of “too big to fail” is based on this point … Financial innovation has worsened this problem. Institutions have many new avenues for taking risk that are difficult for even sophisticated market participants to fully understand, and the interrelationships are even more complex … In the case of banks, the existence of deposit insurance coupled with access to the payments system [operated by the Federal Reserve] creates moral hazard with a clear incentive for excessive risk-taking.


Firefighting by Ben S. Bernanke, Timothy F. Geithner, Henry M. Paulson, Jr.

Asian financial crisis, asset-backed security, bank run, Basel III, break the buck, Build a better mousetrap, business cycle, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Doomsday Book, financial deregulation, financial innovation, housing crisis, Hyman Minsky, income inequality, invisible hand, Kenneth Rogoff, labor-force participation, light touch regulation, London Interbank Offered Rate, Long Term Capital Management, margin call, money market fund, moral hazard, mortgage debt, negative equity, Northern Rock, pets.com, price stability, quantitative easing, regulatory arbitrage, Robert Shiller, Robert Shiller, savings glut, short selling, sovereign wealth fund, special drawing rights, The Great Moderation, too big to fail

The danger was heightened because so much risk had migrated to financial institutions that operated outside the constraints and protections of the traditional banking system, and because so much of the leverage was in the form of unstable short-term financing that could vanish at the first hint of trouble. These vulnerabilities were allowed to fester by America’s balkanized financial regulatory bureaucracy, a hodgepodge of agencies and authorities and regulations that for decades had failed to keep pace with changing market realities and rapid financial innovations. And one of those innovations, securitization, the mechanism Wall Street used to slice and dice mortgages into complex financial products that became ubiquitous in modern finance, helped transform panic about the risks embedded in underlying mortgages into panic about the stability of the entire system. These problems did not seem pressing during the boom, when the financial system appeared unusually stable, conventional wisdom held that home prices would continue to rise indefinitely, and many in Wall Street, Washington, and academia believed that serious financial crises were a thing of the past.

The boom was masking some serious long-term economic challenges for America—rising income inequality, persistently stagnant wages, slow productivity growth, a troubling decline in labor participation for working-age men—but overall the U.S. economy seemed in pretty good shape. There was also widespread confidence that if the economy did stumble, the financial system would be resilient. It had, after all, weathered a series of modest recessions and other tests reasonably well in the previous decades, and banks seemed to have plenty of capital to absorb losses in case of a downturn. At the time, serious economists were arguing that financial innovations like derivatives, because of their purported ability to better diversify risks, had made crises a thing of the past. But financial crises will never be a thing of the past. Long periods of stability can create overconfidence that breeds instability, as the economist Hyman Minsky famously observed. It is during those boom times, when liquidity seems limitless and asset values seem destined to keep rising, that risk taking tends to get excessive, posing dangers that can extend well beyond the risk takers.

As a career public servant at Treasury and later the International Monetary Fund, Tim had seen the challenges in dealing with financial crises in Mexico, Asia, and around the world. And as the CEO of Goldman Sachs, Hank had lived through episodes like the collapse of the hedge fund Long-Term Capital Management and the Russian default. We had all learned how quickly overheated markets could collapse, and while none of us was as worried as we should have been, none of us thought that financial innovations and the sophistication of modern finance had immunized us against crisis. The financial system is vital to the economy. But finance, at least as it’s organized in modern economies, is inherently fragile. Before we discuss the specific factors that made the system unusually vulnerable to panic a decade ago, it’s worth touching on why the system is, was, and always will be vulnerable to panic.


pages: 482 words: 149,351

The Finance Curse: How Global Finance Is Making Us All Poorer by Nicholas Shaxson

activist fund / activist shareholder / activist investor, Airbnb, airline deregulation, anti-communist, bank run, banking crisis, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, Blythe Masters, Boris Johnson, Bretton Woods, British Empire, business climate, business cycle, capital controls, carried interest, Cass Sunstein, Celtic Tiger, central bank independence, centre right, Clayton Christensen, cloud computing, corporate governance, corporate raider, creative destruction, Credit Default Swap, cross-subsidies, David Ricardo: comparative advantage, demographic dividend, Deng Xiaoping, desegregation, Donald Trump, Etonian, failed state, falling living standards, family office, financial deregulation, financial innovation, forensic accounting, Francis Fukuyama: the end of history, full employment, gig economy, Gini coefficient, global supply chain, high net worth, income inequality, index fund, invisible hand, Jeff Bezos, Kickstarter, land value tax, late capitalism, light touch regulation, London Whale, Long Term Capital Management, low skilled workers, manufacturing employment, Mark Zuckerberg, Martin Wolf, Mont Pelerin Society, moral hazard, neoliberal agenda, Network effects, new economy, Northern Rock, offshore financial centre, old-boy network, out of africa, Paul Samuelson, plutocrats, Plutocrats, Ponzi scheme, price mechanism, purchasing power parity, pushing on a string, race to the bottom, regulatory arbitrage, rent-seeking, road to serfdom, Robert Bork, Ronald Coase, Ronald Reagan, shareholder value, sharing economy, Silicon Valley, Skype, smart grid, Social Responsibility of Business Is to Increase Its Profits, South Sea Bubble, sovereign wealth fund, special economic zone, Steve Ballmer, Steve Jobs, The Chicago School, Thorstein Veblen, too big to fail, transfer pricing, wealth creators, white picket fence, women in the workforce, zero-sum game

(If you can’t afford to buy your own home, this is one big reason why house prices are so high: Basel released enormous volumes of credit into housing markets.) Banks’ safety cushions were profitably smaller now, but they still wanted to pare the rules down further. And this is where those two great financialising innovations, derivatives and securitisation, came into the picture, and where things really began to go crazy. At each stage of this process the financial innovators found regulatory and other obstacles in their way, and at each stage they found ways around them with the help of the British spider’s web. Securitisation is an old craft, which emerged in its modern form in the US in the 1970s. This is where a bank takes income-generating assets like mortgages or government bonds and bundles them all together and sells them to a special purpose vehicle, which is typically a company set up for a particular function – in this case, to own these assets.

(If you bet on a horse in a race, that doesn’t stop you placing a second bet on the same horse in the same race; you don’t need to find another horse or another race.) And that is what began to happen. Bankers began to joke that ‘Bistro’ stood for ‘BIS total rip-off’ – referring to the Bank for International Settlements, which oversaw the Basel Accord. And the CDS concept at the heart of it all would turn out to be one of the most profitable – and dangerous – financial innovations of all time. But before their full power could be unleashed, there were still a few hurdles to overcome. For one thing, regulators hadn’t formally accepted the concept yet. Once again, the banks were able to find help in the usual place, light-touch London. To understand what happened next, it is helpful to take a brief diversion to a blog written a few years ago by Jolyon Maugham, a UK tax lawyer.

He had also said, channelling the wisdom of British tax havens, that he didn’t believe there should be laws against fraud because it wasn’t necessary: people would simply stop doing business with bad actors, he opined, and they’d be driven from the market.27 Greenspan joined deregulatory forces with President Bill Clinton’s treasury secretary, the former Goldman Sachs banker Robert Rubin, and Rubin’s deputy Lawrence Summers, and this Third-Wayish trio cheer-led the frenzy of financial innovation now exploding across US trading rooms. In November 1999 this new breed of American anti-regulators brought down their biggest trophy kill, the repeal of the Glass-Steagall Act, a singularly effective piece of antitrust legislation which had for six and a half decades prevented banks from gambling with their depositors’ money. ‘This historic legislation,’ gushed Summers at the repeal ceremony in 1999, ‘will better enable American companies to compete in the new economy.’


pages: 585 words: 151,239

Capitalism in America: A History by Adrian Wooldridge, Alan Greenspan

"Robert Solow", 2013 Report for America's Infrastructure - American Society of Civil Engineers - 19 March 2013, Affordable Care Act / Obamacare, agricultural Revolution, air freight, Airbnb, airline deregulation, American Society of Civil Engineers: Report Card, Asian financial crisis, bank run, barriers to entry, Berlin Wall, Bonfire of the Vanities, Bretton Woods, British Empire, business climate, business cycle, business process, California gold rush, Charles Lindbergh, cloud computing, collateralized debt obligation, collective bargaining, Corn Laws, corporate governance, corporate raider, creative destruction, credit crunch, debt deflation, Deng Xiaoping, disruptive innovation, Donald Trump, edge city, Elon Musk, equal pay for equal work, Everybody Ought to Be Rich, Fall of the Berlin Wall, fiat currency, financial deregulation, financial innovation, fixed income, full employment, George Gilder, germ theory of disease, global supply chain, hiring and firing, income per capita, indoor plumbing, informal economy, interchangeable parts, invention of the telegraph, invention of the telephone, Isaac Newton, Jeff Bezos, jimmy wales, John Maynard Keynes: technological unemployment, Joseph Schumpeter, Kenneth Rogoff, Kitchen Debate, knowledge economy, knowledge worker, labor-force participation, Louis Pasteur, low skilled workers, manufacturing employment, market bubble, Mason jar, mass immigration, means of production, Menlo Park, Mexican peso crisis / tequila crisis, minimum wage unemployment, mortgage debt, Myron Scholes, Network effects, new economy, New Urbanism, Northern Rock, oil rush, oil shale / tar sands, oil shock, Peter Thiel, plutocrats, Plutocrats, popular capitalism, post-industrial society, postindustrial economy, price stability, Productivity paradox, purchasing power parity, Ralph Nader, Ralph Waldo Emerson, RAND corporation, refrigerator car, reserve currency, rising living standards, road to serfdom, Robert Gordon, Ronald Reagan, Sand Hill Road, savings glut, secular stagnation, Silicon Valley, Silicon Valley startup, Simon Kuznets, Social Responsibility of Business Is to Increase Its Profits, South Sea Bubble, sovereign wealth fund, stem cell, Steve Jobs, Steve Wozniak, strikebreaker, supply-chain management, The Great Moderation, The Rise and Fall of American Growth, The Wealth of Nations by Adam Smith, Thomas Malthus, Thorstein Veblen, too big to fail, total factor productivity, trade route, transcontinental railway, tulip mania, Tyler Cowen: Great Stagnation, union organizing, Unsafe at Any Speed, Upton Sinclair, urban sprawl, Vannevar Bush, War on Poverty, washing machines reduced drudgery, Washington Consensus, white flight, wikimedia commons, William Shockley: the traitorous eight, women in the workforce, Works Progress Administration, Yom Kippur War, young professional

They thus convert financiers from agents of improved productivity into rent seekers. This creates a delicate problem: how do you guard against the destructive side of financial innovation without blunting the constructive side? One unhelpful solution has been to produce detailed rules about what financial institutions can do. This was the approach that was adopted by the Dodd-Frank legislation, on the basis of a notion of how the financial system works that significantly deviated from the reality of markets. This approach is replete with dangers: it promotes a culture of box ticking, slows down innovation, empowers lobbying groups, and, most fatally of all, leaves lots of room for financial innovators to outthink bureaucrats. A much better solution is also a simpler one: increase the amount of capital reserves that banks are required to keep in order to operate.

Peter Drucker, who had made his name dissecting big companies, most notably General Motors in Concept of the Corporation, published a spirited book on entrepreneurship, Innovation and Entrepreneurship (1985). The new generation of entrepreneurs could draw on three resources that existed more abundantly in America than elsewhere, and that, when combined with an entrepreneur-friendly president in Washington, produced a business revolution. Financial innovators provided new sources of cash such as junk bonds from Michael Milken and venture capital from Silicon Valley’s well-established venture-capital industry. Great universities provided science parks, technology offices, business incubators, and venture funds. A liberal immigration policy provided a ready supply of willing hands and brains. Amar Bhidé of Tufts University suggests that “venturesome consumption” also promoted American entrepreneurialism.

Share owners could monitor their companies and measure their performance against other corporate assets. Day traders, sitting at home surrounded by their television screens and computer monitors, had more financial information at their disposal than lords of finance, ensconced in their paneled offices, had had in the nineteenth century. The overregulation of Main Street banks also had the paradoxical effect of encouraging further financial innovation. The banks were so imprisoned by New Deal regulations that, by the 1980s, not a single one of the world’s top ten banks was based in the United States. Half of them had been based there in the 1950s. While banks stagnated, other intermediaries innovated to take up the slack: over the thirty years after 1970, the share of financial assets held by “new” intermediaries such as money-market mutual funds, mortgage pools, and securitized loans mushroomed, while the proportion held by “traditional” intermediaries such as commercial banks, mutual savings banks, and life insurance companies declined.


pages: 348 words: 99,383

The Financial Crisis and the Free Market Cure: Why Pure Capitalism Is the World Economy's Only Hope by John A. Allison

Affordable Care Act / Obamacare, American ideology, bank run, banking crisis, Bernie Madoff, business cycle, clean water, collateralized debt obligation, correlation does not imply causation, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, disintermediation, fiat currency, financial innovation, Fractional reserve banking, full employment, high net worth, housing crisis, invisible hand, life extension, low skilled workers, market bubble, market clearing, minimum wage unemployment, money market fund, moral hazard, negative equity, obamacare, Paul Samuelson, price mechanism, price stability, profit maximization, quantitative easing, race to the bottom, reserve currency, risk/return, Robert Shiller, Robert Shiller, The Bell Curve by Richard Herrnstein and Charles Murray, too big to fail, transaction costs, yield curve, zero-sum game

They were also misled by the artificial economic environment created by the Federal Reserve. In addition, as discussed earlier, they had a significant economic incentive to rate the bonds as highly as possible to increase their revenues. This is where the investment banks (Goldman Sachs, Morgan Stanley, Bear Stearns, Merrill Lynch, and Lehman Brothers) magnified the misallocation of credit to the housing market. They created a series of financial “innovations” (collateralized debt obligations [CDOs], derivatives, swaps, and others, which I discuss later) that leveraged an already overleveraged product. The explanation typically given for these ultimately very bad decisions by investment bankers is greed. However, there was plenty of greed on Wall Street before the bubble. In fact, in my almost 40-year career in banking, there has always been greed on Wall Street.

See The State of the Nation’s Housing 2009, Joint Center for Housing Studies, Harvard University, http://www.jchs.harvard.edu/publications/markets/son2009/index.htm. 5. In October 2010, as an ex-CEO, Mozilo settled out of court on civil fraud charges for misleading investors on risky mortgages, but Countrywide’s buyer (Bank of America) ended up paying most of the $67 million to the SEC. Bank of America also paid $600 million to settle a class-action lawsuit filed by Countrywide’s robbed shareholders. 6. See Bert Ely, “Financial Innovation and Deposit Insurance: The 100% Cross-Guarantee Concept,” Cato Journal (Winter 1994), pp. 413–445, and Bert Ely, “Regulatory Moral Hazard: The Real Moral Hazard in Federal Deposit Insurance,” Independent Review (Fall 1999), pp. 241–254. 7. See Michael Keeley, “Deposit Insurance, Risk, and Market Power in Banking,” American Economic Review (1980), pp. 1183–1200, and Gary Gorton and Richard Rosen, “Corporate Control, Portfolio Choice and the Decline of Banking,” Journal of Finance (1995), pp. 1377–1420. 8.

Accounting: loan loss reserves, 152–154 principles-based, 109 private accounting systems, 177–178 rules-based, 109 (See also Fair-value accounting) AEI (American Enterprise Institute), 64 Affordable housing efforts, 43, 216 Afghanistan, 198 African Americans, 43, 55 AIG: bailout, 128–130, 164 CDSs of, 126–127 TARP funds for, 168 Ally Financial, 178 Alt-A portfolios, 64 Altruism, 215–218, 222–223, 252 Ambac, 86 American Enterprise Institute (AEI), 64 Antitrust laws, 174–175 Argentina, 8 Arthur Andersen, 109 Asian Americans, 43 Assets, valuation of, 106–108 Atlas Shrugged (Ayn Rand), 225 Auction-rate municipal bond market, 85–87 Authority, of regulatory agencies, 46–47 Auto finance market, 178–180 Bank bailout (see Troubled Asset Relief Program (TARP)) Bank of America, 116, 150, 237 counterparty risk at, 124 credit decisions at, 238 funding of shadow banking system, 120 “too-big-to-fail” firms, 173 Bank runs, 75–76 Banking industry, 67–72 competition with risk-taking financial institutions, 39–40 economic role of, 67–69 and Federal Reserve, 22–23 fractional reserve banking, 69–70 in Great Depression vs. recent financial crisis, 70–72 (See also Shadow banking system) Banking industry reforms, 187–193 Dodd-Frank bill, 193 and Federal Reserve, 187–188 and gold standard, 188–189 reducing risk of economic cycles with, 189–193 Banking regulation, 133–147 in Bush administration, 133–136 effects on small businesses, 144–147 impact of, 147 and lending policies of banks, 138–146 and mathematical modeling for risk management, 136–138 reform of, 190 Bankruptcy, 8, 124 Banks: capital requirements for, 190 economic forecasting by, 28 FDIC and risk-taking by, 38–41 healthy, effects of TARP on, 172–174 lending policies of, 138–146 leverage ratios of, 70–72 misinvestment effects on, 12–14 private, 97–99, 187–188 self-insurance at, 48–52 start-up, 38–39 stress tests for, 171 (See also Investment banks) Barclays Bank, 164 Basel Accords, 51, 71, 125, 137, 151 BB&T Corporation, 23–24 and AIG bailout, 128 auditors of, 134 in auto finance market, 178 bonds of, 76, 84–85 competition with risk-taking financial institutions, 39–40, 98 conservatism of, 30 culture of, 240–241 failed bank takeover by, 38–39, 47–48 financial crisis for, 1–2 and flight to quality, 87, 105 home mortgages by, 97–98 and Lehman Brothers failure, 162–163 and liquidity crisis, 105–106 loan loss reserves of, 153–154 and mathematical modeling, 136–137 and misinvestment in residential real estate, 12–14 mortgage servicing rights, 111–112 and pick-a-payment mortgages, 91–92 post-crisis lending policies, 139–140, 142–145 racial discrimination in lending accusation, 42–45 selling of mortgages by, 113 TARP participation by, 170–172 trader principle of, 223 underwriting standards of, 141 use of derivatives, 122, 123 wellness program of, 202–203 Bear Stearns, 70, 71 bailout of, 104, 162 Cdss on bonds of, 127–128 counterparty risk at, 124 derivatives from, 123 financial “innovations” of, 101 Bernanke, Ben: and 2008 panic, 164, 167 and development of TARP, 76, 169–171 monetary policy of, 27–31, 33, 35, 40, 125, 213 response to financial crisis, 7, 70 Blair, Tony, 164 Bond insurance, 86–87 bonds: auction-rate municipal bond market, 85–87 effects of FDIC for, 40–41 fair-value accounting for, 105 subprime mortgage, 82–84 of Washington Mutual, 75–76 Borrowers: CRA, 56–57 of pick-a-payment mortgages, 90–91 post-crisis treatment of, 142–145 and racial discrimination in lending, 42–45 regulated changes in grading for, 140–141 Borrowing for consumption, 57–58 Boston Federal Reserve bank, 42 Budget, federal, 182–183 Bush, George W., and administration: action in financial panic, 161, 167 banking regulations, 133–136 economic proposals, 15 Patriot Act, 45, 46 regulation of Fannie Mae and Freddie Mac, 63 California, 21, 74, 90 CalPERS (California Public Employees’ Retirement System), 93, 116, 121, 131 Canada, 192 Capital: against GSE loans, 137 and leverage, 70–71 and loan loss reserves, 153 misinvestment of, 9–11, 14 wasting of, 159–160 Capital markets, 85–87, 101 Capital standards: for banks, 190 for loans, 51–52 and TARP, 170–171 Capitalism: crony, 6, 102, 129, 179 and freedom, 253–254 at universities, 231–233 Capitalism (Alan Greenspan), 32 Carter, Jimmy, 161, 179 Cash basis accounting, 110 Cash flows, 106–107, 115 Cato Institute, 201 CDOs (collateralized debt obligations), 124–126 CDSs (credit default swaps), 126–128 CEOs (Chief Executive Officers): behavior of, 2–3 decisions of Federal Reserve vs., 34 and rules-based accounting, 109 wage rates of, 210 China: currency standard, 77 demographics, 205 education, 230 GDP of U.S. vs., 183 government debt in, 200 manufacturing in, 10, 25–26, 161 market-based pricing in, 34 military spending in, 198 stimulus fund use, 181–182 trade with, 204–205 U.S. investment by, 29, 159 Chrysler, 130, 179–180 Citigroup: bailout of, 50, 104, 130, 177 CDOs of, 125–126 credit decisions, 238 crony capitalism, 6 funding of shadow banking system, 120 long-term debt of, 71 and panic during financial crisis, 163 pragmatism at, 217–218 reason at, 245 “too-big-to-fail” firms, 173 Clearing, 104 Clinton, Bill: lending reforms, 42–44, 56 subprime lending requirements, 58–60 Collateralized debt obligations (CDOs), 124–126 Colonial Bank, 47–48 Commercial real estate, 11, 97 Common good, 215–216 Community Reinvestment Act (CRA), 42, 55–57, 59 Compensation, 50, 83–84, 197–198 Confidence, 84–87, 184–185 Conservatives, 108 Consumer compliance, 193 Consumer Price Index (CPI), 26–27 Consumption: borrowing for, 57–58 housing as, 9–12, 54–55, 73–74 Contagion risk, 123 Corporate debt, 107 Counterparty risk, 123, 124 Countrywide: crony capitalism at, 6 and fair-value accounting change, 114, 118 and FDIC insurance, 39, 41, 46 necessary failure of, 159 pick-a-payment mortgages of, 91–93 subprime business at, 99 thrift history of, 98 CPI (see Consumer Price Index) CRA (see Community Reinvestment Act) Creativity, 7, 247 Credit default swaps (CDSs), 126–128 Credit rating agencies (see Rating agencies) Crony capitalism, 6, 102, 129, 179 Cross-guarantor insurance fund, 48–52 Cuba, 34, 247, 252 Cuomo, Andrew, 58 Currency, debasing, 22 Debt, 21–22, 107 Declaration of Independence, 220, 252 Defaults, 90–91, 126–128 Defense spending, 198–199, 227 Deflation, 22 Demand, supply and, 104, 185, 209, 210 Department of Housing and Urban Development (HUD), 15, 58 Deposits, disintermediation of, 120–121 Derivatives, 3, 120, 122–124 Disclosure requirements, 150–152 Dodd, Christopher, 7, 46, 61, 63, 64 Dodd-Frank Wall Street Reform and Consumer Protection Act: deficiencies of, 193 introduction of, 63–64, 183 as misregulation, 147 results of, 130 and TARP, 173, 174 Dollar, U.S., 77, 188, 229 Durbin amendment, 193 Earnings, operating, 103–106 East Germany, 34, 247 Eastern Europe, 34, 252 Economic cycles, 108, 189–193 Economic health, 159–161 Economic recovery, 1, 207–208 Economy, banking industry in, 67–69 Edison, Thomas, 19, 158–159 Education, 230–235, 247 Egypt, ancient, 230 Elitism, 7 Ely, Bert, 48 Employee Retirement Income Security Act (ERISA), 82, 149 Enron, 60, 109, 133, 149 Entitlement programs, reforms for, 199–204 Equal Credit Opportunity Act, 42, 55 ERISA (Employee Retirement Income Security Act), 82, 149 Ethical incentives, lending, 57–58 Euro, 189 European banking crisis, 51–52, 137 Expensing (stock options), 114–117 Experiential learners, 244–245 Fair Housing Act, 55 Fair-value accounting, 103–118 asset valuation in, 106–108 and expensing of stock options, 114–117 and losses on CDSs, 126–127 private accounting systems vs., 177–178 SEC involvement in, 151–152 for selling vs. servicing mortgages, 113–114 Fannie Mae: accounting scandal, 112–113, 149 in current environment, 251 and disintermediation of deposits, 121 failure of, 61–65, 164 and fair-value accounting, 118 in housing policy, 58–61 misallocation of resources by, 14 misleading of rating agencies by, 83 mortgage lending by, 97–101 reforms for, 190–192 selling mortgages to, 113–114 subprime lending by, 58, 99–101 FASB (see Financial Accounting Standards Board) FDIC (see Federal Deposit Insurance Corporation) FDIC insurance, 37–52 and bank liquidity, 171 and failing banks, 140 and fractional reserve banking, 68–69 and pick-a-payment mortgages, 91 reform of, 190 and S&L failures, 97 Federal Deposit Insurance Corporation (FDIC), 37–38 as external auditors, 134 and failing banks, 47–48 misallocation of resources by, 14 and pick-a-payment mortgages, 91 as regulator, 41–48, 143 take over of Washington Mutual, 75–77 Federal Housing Administration (FHA), 15, 190–192, 252 Federal Reserve, 22–23, 102, 189 antitrust policy, 174 bailouts by, 120–121, 190, 192 and banking industry reforms, 187–188 as external auditors, 134 and federal debt, 21–22 and leverage, 72 mathematical modeling by, 136 misallocation of resources by, 14, 208 misleading information from, 46, 83, 101, 125 monetary policy of, 17–20, 31–35, 96 overreaction by, 154 stimulus from, 152, 153, 208 and TARP, 165, 167–168, 171 and unemployment, 213 and Washington Mutual, 75 Federal Reserve Board, 18 Federal Reserve Open Market Committee, 31 Federal Savings and Loan Insurance Corporation (FSLIC), 37–38, 50, 96 FHA (see Federal Housing Administration) Financial Accounting Standards Board (FASB), 105, 106, 114–117 Financial crisis (2007-2009), 1–3, 251–254 banking industry in, 70–72 derivatives in, 122–124 Freddie Mac and Fannie Mae in, 65 free-market response to, 177–186 and Great Depression, 25 lessons from, 251–252 SEC role in, 154–155 Financial reporting requirements, SEC, 150–152 Financial Services Roundtable (FSR), 32, 61–62 First Horizon, 237 Fitch, John Knowles, 150 Fitch Ratings: investor confidence in, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Flat tax, 197 Forbes, Steve, 197 Ford, 179 Foreclosure laws, 77–80 Fractional reserve banking, 69–70 Frank, Barney, 7, 61, 63, 64 Fraud, 109–113 Freddie Mac: accounting scandal, 112–113, 149 current environment, 251 and disintermediation of deposits, 121 failure of, 61–65, 164 in housing policy, 58–61 misallocation of resources by, 14 misleading information from, 83 mortgage lending by, 97–101 reforms for, 190–192 selling mortgages to, 113–114 subprime lending by, 58, 99–101 Free markets: experimentation in, 19 justice in, 92, 177 market corrections in, 157–159 and monetary policy, 31–35 risk taking by banks in, 40–41 wage rates in, 210–211 Free trade, 204–205 Friedman, Milton, 20, 189 FSLIC (see Federal Savings and Loan Insurance Corporation) FSR (Financial Services Roundtable), 32, 61–62 GAAP accounting, 116, 117 Gates, Bill, 216 GDP, 183, 197–199 General Electric, 168, 169 General Motors (GM), 169, 178–180 General Theory of Employment, Interest and Money, The (Keynes), 181 Germany, 52 GM (General Motors), 169, 178–180 GMAC, 168, 169, 178–180 Gold standard: and deflation, 25–26 and economic future of U.S., 188–189 Greenspan’s view of, 32 Golden West, 39, 91, 92, 98, 159 Goldman Sachs, 71, 173 as AIG counterparty, 128–129 bailout of, 104, 164, 179 CDSs of, 126 counterparty risk at, 124 crony capitalism at, 6 financial “innovations” of, 101 Government policy: as cause of financial crisis, 1, 5–6, 251 and residential real estate bubble, 6 (See also Housing policy; Policy reforms) Government regulation, 5–8, 41–48, 204 Government spending, 180–183, 197–199 Government-sponsored enterprises (GSEs), 59, 64–65, 98, 137 (See also Fannie Mae; Freddie Mac) Great Depression: and avoidance of stock market, 74 banking industry in, 70–72 economic policies after, 161 and Federal Reserve, 19–20, 24, 188 and gold standard, 188 and government interference, 170 and Smoot-Hawley Tariff Act, 205 Great Recession, 1, 251–254 and Federal Reserve, 188 Freddie Mac and Fannie Mae in, 65 and interest-rate variation, 33 market corrections and depth of, 160 and monetary policy, 17 and residential real estate, 9–15 Great Society, 6, 55, 96 Greece, 51, 52, 137, 228 Greenspan, Alan, 23–30, 32, 33, 160 Gross domestic product, 183, 197–199 Hamilton, Alexander, 19 Harvard University, 43, 131 Hayek, Friedrich, 31 Health insurance, 201–202 High-net-worth shareholders, 93 Home Builders Association, 60 Home foreclosure laws, 77–80 Homeownership, 53–55 Hoover, Herbert, 24, 161, 205 Housing: as consumption, 9–12, 54–55, 73–74 government support of, 12 Housing policy, 53–65 HUD (Department of Housing and Urban Development), 15, 58 Human Action (von Mises), 238 Immigration, 19, 205–206 India, 10, 25, 205 IndyMac, 39, 75, 98 Inflation: CPI as indicator of, 26–27 and fair-value accounting, 103 and Federal Reserve, 21–22 and prices, 24–25 (See also Monetary policy) Initial public offerings, 150 Insurance: bond, 86–87 cross-guarantor, 48–52 FDIC (see FDIC insurance) health, 201–202 private deposit, 48–52 self-insurance at banks, 48–52 unemployment, 212–213 Interest rates, 26–27, 31–35 Inverted yield curves, 27–29 Investment banks: disclosure requirements for, 151 government bailout of, 162 “innovations” of, 101–102 leverage ratios of, 71–72 IPOs, 150 Iran, 198, 199, 227 Iraq, 198 Ireland, 77 Isaac, Bill, 107–108, 161–162 Italy, 51, 52 Japan, 159, 200, 205 Jefferson, Thomas, 19, 220 Johnson, Lyndon Baines, 6, 55, 96, 161, 188 JPMorgan Chase, 75 and Bear Stearns, 162 and shadow banking system, 120 as “too-big-to-fail” firm, 173 and Washington Mutual, 163 Keynes, John Maynard, 181 Labor: allocation of, 10–11, 14 minimum-wage laws, 209–212 Lehman Brothers, 71, 76, 101, 104, 129, 164 and Bear Stearns bailout, 162–163 corporate debt at, 107 counterparty risk at, 124 derivatives from, 123 Limited government, 182–183, 195, 231, 253 Liquidity: of banks, 68–69 and FDIC insurance, 171 and financial crises, 70–72 and housing prices, 74–75 and TARP, 171–172 Loan loss reserves accounting, 152–154 Loans: capital standards for, 51–52 qualified, 98 substandard, 140–141 Madoff, Bernie, 149, 225 March of Dimes, 241 Market corrections, 157–165 Federal Reserve’s prevention of, 23, 32 prevention of, 13 residential real estate, 78 and response to financial crisis, 177–180 Market discipline, 21, 38 Market-based monetary policy, 31–35 Market-clearing price, 209 Mathematical modeling: for loan loss reserves, 152–153 by ratings agencies, 82–83 for risk management, 136–138 MBIA, 86 Medicaid, 6, 55, 201 Medicare, 6, 8, 55, 201, 203 Meltdown (Michaels), 35 Merrill Lynch, 101, 124–125 Michaels, Patrick J., 35 Microsoft, 217 Military spending, 198–199, 227 Minimum-wage laws, 209–212 Mises, Ludwig von, 34, 238 Monetary policy, 17–35 of Bernanke, 27–31, 33, 35, 40, 125, 213 and federal debt, 21–22 and Federal Reserve, 17–23 of Greenspan, 23–27 market-based, 31–35 and unemployment, 208–209 Money market mutual funds, bailout of, 120–121, 192 Money supply, 21–22, 24, 189 Moody, John, 83, 150 Moody’s, 81–87 investor confidence in, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Morgan Stanley, 71, 101, 124, 173 Mortgage lending, 95–102 by Fannie Mae and Freddie Mac, 97–101 and investment bank innovations, 101–102 prime, 59, 97–99 by private banks, 97–99 savings and loan industry in, 95–97 subprime, 43, 56–57, 99–101 Mortgages: by BB&T Corporation, 97–98 jumbo, 62 pick-a-payment (see Pick-a-payment mortgages) selling vs. servicing, 113–114 Mozilo, Angelo, 46 Multiplier effect, 181 Naked shorting, 127–128, 151 Nationally recognized statistical rating organizations, 82 Negative real interest rates, 26–27 Neo-Keynesian response to financial crisis, 185–186 Neutral taxes, 197 New Deal, 53, 170, 232 Nixon, Richard, 96, 161, 188 North Korea, 34, 198, 227, 247, 252 NRSROs, 82 Obama administration, 142–144: and Dodd-Frank Act, 64 economic policies of, 15, 161 healthcare bill, 183, 201 and Patriot Act, 45 stimulus plan, 181–182 Office of the Comptroller of the Currency (OCC), 40, 154 Office of Thrift Supervision, 40, 41, 45–46 Operating earnings, 103–106 OTS, 40, 41, 45–46 Panics, 137–138, 161–165 Patriot Act, 45, 46, 48, 133–136, 147 Paulson, Henry: in 2008 panic, 164, 167 and AIG bailout, 128, 129 credibility of, 164 development of TARP, 76, 168–170, 172 Pick-a-payment mortgages, 89–93 borrowers using, 90–91 and FDIC, 91 and rise of Fannie Mae/Freddie Mac, 98 Policy reforms, 195–206 for entitlement programs, 199–204 and free trade, 204–205 and government regulations, 204 for government spending, 197–199 for immigration, 205–206 for political system, 206–207 and tax rate, 196–197 Politics: in banking regulation, 42–46 and crony capitalism, 129 and failure of Fannie Mae/Freddie Mac, 59–62 and Federal Reserve appointments, 18 policy reforms for, 206–207 Poor, Henry Varnum, 150 Portugal, 51 Price fixing, 31, 193 Price setting, 31–32 Prime lending, 59, 97–99 Prince, Charlie, 217 Principles-based accounting, 109 Privacy Act, 133, 135 Private accounting systems, 177–178 Private banks, 97–99, 187–188 Private deposit insurance, 48–52 Public schools, 228, 233–235 Racial discrimination (in lending), 42–45 Raines, Frank, 59 Rand, Ayn, 225, 231 Rating agencies, 81–87 investor confidence in, 84–87 mathematical modeling by, 136 and subprime mortgage bonds, 82–84 and “too-big-to-fail” firms, 173 and SEC, 81–82, 149–150 Real estate: commercial, 11, 97 residential (see Residential real estate market) Recessions, 28, 29, 160 Recovery (see Economic recovery) Reforms: banking industry (see Banking industry reforms) government policy (see Policy reforms) Regions Bank, 237 Regulation: of banking industry (see Banking regulation) by government (see Government regulation) Reporting, financial, 150–152 Reserve currency, U.S. dollar as, 77, 188, 229 Residential real estate market: economics of, 73–74 misinvestment in, 9–15 Residential real estate market bubble, 73–80 and government policy, 6 international impact of, 77 and job creation, 80 and state home foreclosure laws, 77–80 Risk: contagion, 123 counterparty, 123, 124 with derivatives, 122–124 diversification of, 67–69 and economic cycles, 189–193 and FDIC insurance, 38–41 and government regulation, 50–51 liquidity, 68–70 mathematical modeling for, 136–138 and “originate and sell” model, 100 systemic, 50–51 RMBS (residential mortgage-backed securities), 81 Roman empire, fall of, 230 Roosevelt, Franklin D., 24, 37, 103, 161 Rules-based accounting, 109 Russia, 198 Samuelson, Paul, 238 Sarbanes-Oxley Act, 133–134 and fair-value accounting, 106 and Fannie Mae/Freddie Mac, 99 misregulation by, 48, 147 and SEC, 150 violations of, 136 SARs (Suspicious Activity Reports), 136 Satchwell, Jack, 57 Savings and loan (S&L) industry, 95–97, 110, 191 Securities and Exchange Commission (SEC), 149–155 capital ratio guidelines, 71–72 and complexity of accounting rules, 116–117 and expensing of stock options, 114, 115 loan loss reserves accounting for, 152–154 misallocation of resources by, 14 and rating agencies, 81–82, 149–150 requirements for shorting stock, 127–128, 151 and rules-based accounting, 109, 110 and Sarbanes-Oxley Act, 150 Self-insurance, 48–52 Selgin, George, 189 Senate Banking Committee, 46 Shadow banking system, 119–131 and AIG bailout, 128–130 credit default swaps in, 126–128 and derivatives, 122–124 Federal Reserve’s role in, 30 losses from, 131 S&L industry, 95–97, 110, 191 Small businesses, 144–147, 183–184 Smoot-Hawley Tariff Act, 205 Social Security, 8, 199–204 South Financial, 237 South Korea, 247 Soviet Union, 34, 195–196, 252, 254 S&P (see Standard & Poor’s) Spain, 51, 52, 77 Spitzer, Eliot, 71, 134–135, 151 Stagflation, 181, 208 Standard & Poor’s (S&P), 81–87 investor confidence, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Standard of living, 6–7, 10, 161, 177 Start-up banks, 38–39 State home foreclosure laws, 77–80 Stimulus plan, 181–182 Stock options, expensing of, 114–117 Stocks, shorting, 127–128, 151 Stress tests, banks, 171 Subprime lending: and CRA, 56–57 by Fannie Mae and Freddie Mac, 99–101 and racial discrimination in lending study, 43 Subprime mortgage bonds, 82–87 Substandard loans, 140–141 SunTrust, 152, 237 Suspicious Activity Reports (SARs), 136 Tails (mathematical models), 137 TARP (see Troubled Asset Relief Program) Tax rate, 196–197 Tea Party Movement, 218, 231 Technology industry, 5 “Too-big-to-fail” firms, 130, 173, 193 Trader principle, 92, 223–224 Troubled Asset Relief Program (TARP), 167–175 and 2008 panic, 165 and FDIC, 37 Underwriters Laboratories, 117, 150 Unemployment, 207–213 in economic recovery, 207–208 and minimum-wage laws, 209–212 and misinvestment in residential real estate, 10–11 and monetary policy, 208–209 Unemployment insurance, 212–213 Unions, 179, 180, 212 United Auto Workers, 179, 180 United States: demographic problem in, 228 economic future of, 8, 227–230, 252–253 educational system of, 230–235 founding concepts of, 219–220 as free trade zone, 204–205 GDP of China vs., 183 mixed economy of, 5–6 public schools of, 233–235 university system of, 230–233 United Way, 224, 241 University system, 230–233 U.S.


pages: 322 words: 87,181

Straight Talk on Trade: Ideas for a Sane World Economy by Dani Rodrik

3D printing, airline deregulation, Asian financial crisis, bank run, barriers to entry, Berlin Wall, Bernie Sanders, blue-collar work, Bretton Woods, BRICs, business cycle, call centre, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, carried interest, central bank independence, centre right, collective bargaining, conceptual framework, continuous integration, corporate governance, corporate social responsibility, currency manipulation / currency intervention, David Ricardo: comparative advantage, deindustrialization, Donald Trump, endogenous growth, Eugene Fama: efficient market hypothesis, eurozone crisis, failed state, financial deregulation, financial innovation, financial intermediation, financial repression, floating exchange rates, full employment, future of work, George Akerlof, global value chain, income inequality, inflation targeting, information asymmetry, investor state dispute settlement, invisible hand, Jean Tirole, Kenneth Rogoff, low skilled workers, manufacturing employment, market clearing, market fundamentalism, meta analysis, meta-analysis, moral hazard, Nelson Mandela, new economy, offshore financial centre, open borders, open economy, Pareto efficiency, postindustrial economy, price stability, pushing on a string, race to the bottom, randomized controlled trial, regulatory arbitrage, rent control, rent-seeking, Richard Thaler, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, Sam Peltzman, Silicon Valley, special economic zone, spectrum auction, Steven Pinker, The Rise and Fall of American Growth, the scientific method, The Wealth of Nations by Adam Smith, Thomas L Friedman, too big to fail, total factor productivity, trade liberalization, transaction costs, unorthodox policies, Washington Consensus, World Values Survey, zero-sum game, éminence grise

How much information should they reveal about their trades? Should executives’ compensation be set by directors, with no regulatory controls? What should the capital and liquidity requirements be? Should all derivative contracts be traded on exchanges? What should be the role of credit-rating agencies? And so on. A central trade-off here is between financial innovation and financial stability. A light approach to regulation will maximize the scope for financial innovation (the development of new financial products), but at the cost of increasing the likelihood of financial crises and crashes. Strong regulation will reduce the incidence and costs of crises, but potentially at the cost of raising the cost of finance and excluding many from its benefits. There is no single ideal point along this trade-off. Requiring that communities whose preferences over the innovation-stability continuum vary all settle on the same solution may have the virtue that it reduces transaction costs in finance.

But in the years leading up to the crisis, many economists downplayed these models’ lessons in favor of models of efficient and self-correcting markets, which resulted in inadequate government oversight over financial markets. There was too much Fama, not enough Shiller. “Economics is a science of thinking in terms of models,” Keynes once said, “joined to the art of choosing models which are relevant.” It was the art that fell short in this instance. Economists (and those who listen to them) became overconfident in their preferred models of the moment: markets are efficient, financial innovation transfers risk to those best able to bear it, self-regulation works best, and government intervention is ineffective and harmful. They forgot that there were many other models that led in radically different directions. Hubris creates blind spots. The science of the profession was fine—its craft and sociology, not so much. Economists and the Public Noneconomists tend to think of economics as a discipline that idolizes markets and a narrow concept of (allocative) efficiency at the expense of ethics or social concerns.

The uneasy implication is that capital controls may need to be blunt and comprehensive rather than surgical and targeted to be truly effective. The second complication with presuming convergence toward free capital mobility is that even advanced countries with well-developed institutions are moving toward different models of financial regulation. Along the efficient frontier of financial regulation, one needs to consider the trade-off between financial innovation and financial stability. The more we want of one, the less we can have of the other. Some countries will opt for greater stability, imposing tough capital and liquidity requirements on their banks, while others may favor greater innovation and pursue a lighter regulatory touch. Free capital mobility poses a severe difficulty here. Borrowers and lenders can resort to cross-border financial flows to evade domestic controls and erode the integrity of regulatory standards at home.


pages: 1,242 words: 317,903

The Man Who Knew: The Life and Times of Alan Greenspan by Sebastian Mallaby

"Robert Solow", airline deregulation, airport security, Andrei Shleifer, anti-communist, Asian financial crisis, balance sheet recession, bank run, barriers to entry, Benoit Mandelbrot, Bretton Woods, business cycle, central bank independence, centralized clearinghouse, collateralized debt obligation, conceptual framework, corporate governance, correlation does not imply causation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, energy security, equity premium, fiat currency, financial deregulation, financial innovation, fixed income, Flash crash, forward guidance, full employment, Hyman Minsky, inflation targeting, information asymmetry, interest rate swap, inventory management, invisible hand, Kenneth Rogoff, Kickstarter, Kitchen Debate, laissez-faire capitalism, Long Term Capital Management, low skilled workers, market bubble, market clearing, Martin Wolf, money market fund, moral hazard, mortgage debt, Myron Scholes, new economy, Nixon shock, Northern Rock, paper trading, paradox of thrift, Paul Samuelson, plutocrats, Plutocrats, popular capitalism, price stability, RAND corporation, rent-seeking, Robert Shiller, Robert Shiller, rolodex, Ronald Reagan, Saturday Night Live, savings glut, secular stagnation, short selling, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, trade liberalization, unorthodox policies, upwardly mobile, WikiLeaks, women in the workforce, Y2K, yield curve, zero-sum game

“With all the thought and work and good intentions, which we provided, we achieved absolutely nothing . . . we collected money from a lot of poor devils and gave it over to the four winds.”2 Three quarters of a century later, an idea that could be thought of as the opposite of the gold standard was similarly tarnished. It consisted of a broad faith in financial innovation: the conviction that a few spectacular mishaps notwithstanding, the paraphernalia of tradable risks and income streams was a force for progress. Whereas the gold standard had promised sober discipline—it would prevent governments and private lenders from creating money and credit promiscuously—modern finance promised exhilarating license. By isolating risks and dispersing them, it would allow companies and families to borrow more, and safely: the primitive straitjacket of gold would be displaced by the permissive elegance of risk-measurement models. But just as the progold consensus of 1918 led to disaster, so the modern tolerance for financial innovation turned out to be too trusting. Alan Greenspan, the revered chairman of the Fed and chief personifier of the new instruments, would see his reputation suffer—although he would never quite match Norman in declaring his life’s work to have been futile.

In the view of most commentators, Greenspan resisted tougher regulation because he naïvely believed that markets were efficient. He trusted financiers too much, failing to imagine that their dazzling inventions could destabilize the economy. But the truth is more subtle and more complex than this account implies. Greenspan never was a simple efficient-market believer, and he sometimes voiced grave doubts about the risks in financial innovation.13 If he nonetheless welcomed the advent of options, swaps, and newfangled securities, it was partly because he felt he had no choice. The inflation of the late 1960s had destroyed the comforting system of fixed exchange rates and regulated caps on bank interest rates; meanwhile, technological change and globalization made it impossible to resist the explosion of trading in derivatives. To cite just one telling illustration, between 1970 and 1990 the cost of the computer hardware needed to price a mortgage-backed security plummeted by more than 99 percent.

In 1978, Greenspan explained that the opening up of the mortgage hose was causing consumer price inflation. Fannie and Freddie were creating spending power that had already pushed CPI inflation back above 8 percent a year, and the effect was all the more powerful because the Federal Reserve was too weak willed to counter it. With a clarity that is ironic in hindsight, Greenspan described how the Fed was falling down on the job. Rather than pushing back against the stimulus from financial innovation by raising short-term interest rates more, the Fed was letting the financial system have its way, with the result that there was “a huge excess of credit in the system.”33 When the Fed finally got tough, the party would stop. But the longer it delayed, the more the bursting of the housing bubble would be painful. “A recession is almost surely going to occur,” Greenspan concluded in his Utah speech of October 1978.


Manias, Panics and Crashes: A History of Financial Crises, Sixth Edition by Kindleberger, Charles P., Robert Z., Aliber

active measures, Asian financial crisis, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Black Swan, Bonfire of the Vanities, break the buck, Bretton Woods, British Empire, business cycle, buy and hold, Carmen Reinhart, central bank independence, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, Corn Laws, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency peg, death of newspapers, debt deflation, Deng Xiaoping, disintermediation, diversification, diversified portfolio, edge city, financial deregulation, financial innovation, Financial Instability Hypothesis, financial repression, fixed income, floating exchange rates, George Akerlof, German hyperinflation, Honoré de Balzac, Hyman Minsky, index fund, inflation targeting, information asymmetry, invisible hand, Isaac Newton, joint-stock company, large denomination, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, new economy, Nick Leeson, Northern Rock, offshore financial centre, Ponzi scheme, price stability, railway mania, Richard Thaler, riskless arbitrage, Robert Shiller, Robert Shiller, short selling, Silicon Valley, South Sea Bubble, special drawing rights, telemarketer, The Chicago School, the market place, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, tulip mania, very high income, Washington Consensus, Y2K, Yogi Berra, Yom Kippur War

Rational investors buy more stocks or real estate in this environment of increases in anticipated profits and lower real interest rates. (The Fisher and Wicksell explanations were effective descriptions of the changes in nominal and real interest rates in the 1970s.) This model relies on the ad hoc assumption that two groups of market participants systematically differ in their susceptibility to money illusion. Too low an interest rate is a special case of what is perhaps a wider phenomenon – the pricing of financial innovations. Initially these innovations may be under-priced as ‘loss leaders’ so they will be more readily accepted, but the low price also may lead to excess demand. Alternatively, undue risks may be taken by recent entrants in an industry as they reduce their selling prices to increase their market shares. One notable example is that of Jay Cooke, the last prominent banker of the early 1870s to back a railroad, the Northern Pacific.16 Other examples include Rogers Caldwell in the municipal bond market of the late 1920s,17 Bernard K.

By 1890 the French syndicate owned 60,000 tons of high-priced copper plus contracts to buy more; the older mines were reworked and firms began to process scrap while the copper price was declining rapidly. The collapse of the copper price from £80 to £38 a ton in 1889 almost took with it the Comptoir d’Escompte, which was saved by an advance of 140 million francs from the Bank of France, reluctantly guaranteed by the Paris banks.50 Financial innovation in the form of deregulation or liberalization has often been a shock. In the early 1970s Ronald McKinnon led an intellectual attack on ‘financial repression’, that is, the segmentation of financial markets in developing countries that led to preferential treatment of government borrowers that were involved in foreign trade, and large firms.51 The message appealed particularly to Latin American countries already influenced by the Chicago doctrine of liberalism.

The banks that sold these offshore deposits used the funds to make US dollar loans to American and non-American firms that they might otherwise have made from one of their US offices. The firms that borrowed US dollar funds from the offshore banks in London were as likely to spend these funds in the United States as if they had borrowed the US dollar funds in New York or some other US city. Should the US dollar deposits produced in London and other offshore banking centers be included in the US money supply? The home-equity credit line is a recent financial innovation; banks and other lenders offer to lend homeowners an amount that may be equal to the value of the equity in their homes or in some cases a modestly larger amount. (At an earlier period the loans that used the equity in the home as collateral were known as second mortgages; a home-equity credit line represents potential borrowing until the homeowner draws on the line, while the second mortgage was an actual loan.)


pages: 484 words: 136,735

Capitalism 4.0: The Birth of a New Economy in the Aftermath of Crisis by Anatole Kaletsky

"Robert Solow", bank run, banking crisis, Benoit Mandelbrot, Berlin Wall, Black Swan, bonus culture, Bretton Woods, BRICs, business cycle, buy and hold, Carmen Reinhart, cognitive dissonance, collapse of Lehman Brothers, Corn Laws, correlation does not imply causation, creative destruction, credit crunch, currency manipulation / currency intervention, David Ricardo: comparative advantage, deglobalization, Deng Xiaoping, Edward Glaeser, Eugene Fama: efficient market hypothesis, eurozone crisis, experimental economics, F. W. de Klerk, failed state, Fall of the Berlin Wall, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, George Akerlof, global rebalancing, Hyman Minsky, income inequality, information asymmetry, invisible hand, Isaac Newton, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, Kickstarter, laissez-faire capitalism, Long Term Capital Management, mandelbrot fractal, market design, market fundamentalism, Martin Wolf, money market fund, moral hazard, mortgage debt, Nelson Mandela, new economy, Northern Rock, offshore financial centre, oil shock, paradox of thrift, Pareto efficiency, Paul Samuelson, peak oil, pets.com, Ponzi scheme, post-industrial society, price stability, profit maximization, profit motive, quantitative easing, Ralph Waldo Emerson, random walk, rent-seeking, reserve currency, rising living standards, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, South Sea Bubble, sovereign wealth fund, special drawing rights, statistical model, The Chicago School, The Great Moderation, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, The Wealth of Nations by Adam Smith, Thomas Kuhn: the structure of scientific revolutions, too big to fail, Vilfredo Pareto, Washington Consensus, zero-sum game

Four, a financial revolution resulted from the adoption of a free-market philosophy, the buildup of savings in the rapidly growing Asian economies, and the stability created by globalization and successful demand management. With risks of bankruptcy and unemployment diminished in the stabilized economies of the 1990s, businesses and consumers felt that they could borrow more than ever before and banks were more willing to lend. Meanwhile, the demystification of money meant that debt ceased to be a moral or theological issue and became just another consumer product. Financial innovation also meant that savings previously locked up in property and other illiquid assets could be used as collateral to support consumer and business borrowing. This attractive new feature of property, summed up in the saying “my home is an ATM machine,” led to an increase in the value of homes in relation to other more traditional investments such as stocks and bonds. The result of this revolution was that ordinary homeowners and small businesses gained opportunities to smooth their spending over their entire lifetimes and to manage their finances in ways that had been available only to large multinational companies and wealthy family trusts.

Prolonged stability caused by the Great Moderation suppressed financial risk, as explained by Minsky, and thereby transformed expectations, creating the herd behavior and reflexive changes in reality described by Soros. At the same time, the long period of low interest rates due to excess savings in Asia encouraged Austrian-style malinvestment in low-income housing, as well as the aggressive financial innovation predicted by Minsky. This happened despite the fact that low-income consumers and homeowners were becoming less creditworthy because of the widening income inequality anticipated by Kalecki and the New Keynesians. The boom in finance, meanwhile, interacted with the ideological super-bubble described by Soros and, through the process of reflexivity, created an excessive faith in markets that changed political realities.

If that sounds like a parody from the Academy in Laputa in Gulliver’s Travels,15 consider the following tribute to Friedman’s theories about inflation and monetary growth. It was delivered, appropriately enough, to celebrate the fiftieth anniversary of Free to Choose, Friedman’s political credo, which could be described as the intellectual bible of Capitalism 3.3. The speaker was one of the world’s top academic economists, one Ben Bernanke: “For reasons of financial innovation and institutional change, the rate of money growth does not seem to be an adequate measure of the stance of monetary policy, and hence a stable monetary background for the economy cannot necessarily be identified with stable money growth. Nor are there other instruments of monetary policy whose behavior can be used unambiguously to judge this issue . . . Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation.


pages: 607 words: 133,452

Against Intellectual Monopoly by Michele Boldrin, David K. Levine

"Robert Solow", accounting loophole / creative accounting, agricultural Revolution, barriers to entry, business cycle, cognitive bias, creative destruction, David Ricardo: comparative advantage, Dean Kamen, Donald Trump, double entry bookkeeping, en.wikipedia.org, endogenous growth, Ernest Rutherford, experimental economics, financial innovation, informal economy, interchangeable parts, invention of radio, invention of the printing press, invisible hand, James Watt: steam engine, Jean Tirole, John Harrison: Longitude, Joseph Schumpeter, Kenneth Arrow, linear programming, market bubble, market design, mutually assured destruction, Nash equilibrium, new economy, open economy, peer-to-peer, pirate software, placebo effect, price discrimination, profit maximization, rent-seeking, Richard Stallman, Silicon Valley, Skype, slashdot, software patent, the market place, total factor productivity, trade liberalization, transaction costs, Y2K

Thompson, B. (1847), Inventions, Improvements, and Practice of Benjamin Thompson, in the Combined Character of Colliery Engineer and General Manager. Newcastle. Thurston, R. (1878), “A History of the Growth of the Steam-Engine,” in The Cambridge History of Science, Vol. 4, ed. R. Porter et al., 854. New York: Cambridge University Press. Tirole, J. (1988), The Theory of Industrial Organization. Cambridge, MA: MIT Press. Tufano, P. (1989), “First-Mover Advantages in Financial Innovation,” Journal of Financial Economics 3, 350–70. Tufano, P. (2003), “Financial Innovation,” in The Handbook of the Economics of Finance, ed. G. Constantinides, M. Harris, and R. Stulz. Amsterdam: North Holland. Urban, T. N. (2000), “Agricultural Biotechnology: Its History and Future,” available at http://www.dieboldinstitute.org. U.S. Patent and Trademark Office (1994), “USPTO Public Hearings,” available at http://www.uspto.gov/web/offices/com/hearings/index.html.

The rapid pace of innovation in financial securities prior to 1998 is well documented, for example by Tufano.17 Tufano estimates that roughly 20 percent of new security issues involve an innovative structure. He reports P1: KNP head margin: 1/2 gutter margin: 7/8 CUUS245-03 cuus245 978 0 521 87928 6 May 8, 2008 13:56 58 Against Intellectual Monopoly developing a list of some 1,836 new securities over a twenty-year period and remarks: [This] severely underestimate[s] the amount of financial innovation as it includes only corporate securities. It excludes the tremendous innovation in exchange traded derivatives, over-the-counter derivative stocks (such as the credit derivatives, equity swaps, weather derivatives, and exotic over-the-counter options), new insurance contracts (such as alternative risk transfer contracts or contingent equity contracts), and new investment management products (such as folioFN or exchange traded funds.)18 Three features of this market particularly deserve note.

It excludes the tremendous innovation in exchange traded derivatives, over-the-counter derivative stocks (such as the credit derivatives, equity swaps, weather derivatives, and exotic over-the-counter options), new insurance contracts (such as alternative risk transfer contracts or contingent equity contracts), and new investment management products (such as folioFN or exchange traded funds.)18 Three features of this market particularly deserve note. The first is that innovating in the financial securities industry is very costly, as those that create new securities are highly paid individuals with Ph.D.’s in economics, mathematics, and theoretical physics. The second is that competitors quickly imitate financial innovations. The third is that there is a pronounced advantage of being first, with the innovator retaining a market share between 50 percent and 60 percent even in the long run. Accounts in the popular press of investment banking in the 1980s, such as Lewis’s vivid portrayal, also document that innovation was widespread, despite the complete lack of intellectual monopoly. We are all well aware that, for good or for bad, but mostly for the first, the investment banking industry grew tremendously between the late 1970s and the late 1990s, bringing economic growth to the whole of the nation and increased welfare to millions of consumers.


No Slack: The Financial Lives of Low-Income Americans by Michael S. Barr

active measures, asset allocation, Bayesian statistics, business cycle, Cass Sunstein, conceptual framework, Daniel Kahneman / Amos Tversky, financial exclusion, financial innovation, Home mortgage interest deduction, income inequality, information asymmetry, labor-force participation, late fees, London Interbank Offered Rate, loss aversion, market friction, mental accounting, Milgram experiment, mobile money, money market fund, mortgage debt, mortgage tax deduction, New Urbanism, p-value, payday loans, race to the bottom, regulatory arbitrage, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, the payments system, transaction costs, unbanked and underbanked, underbanked

Department of the Treasury, and he was a key architect of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. his career to finding it.” k SHEILA BAIR, former chair of the Federal Deposit Insurance Corporation “It is inspiring to see such a thoughtful analysis of the deep financial problems that make life miserable for so many people, and to see that many of these problems can be solved with suitable behaviorally informed financial innovations. Barr faces the real subtlety and complexity of the problems that leave so many people with no slack.” k ROBERT SHILLER, Arthur M. Okun Professor of Economics, Yale University “In many respects the American economy is too financialized. But as Michael Barr highlights in this important book, millions lack access to basic financial services and protections. Barr draws on his unmatched combination of academic expertise and policy experience to define the challenge and suggest ways to meet it.

Department of the Treasury, and he was a key architect of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. his career to finding it.” k SHEILA BAIR, former chair of the Federal Deposit Insurance Corporation “It is inspiring to see such a thoughtful analysis of the deep financial problems that make life miserable for so many people, and to see that many of these problems can be solved with suitable behaviorally informed financial innovations. Barr faces the real subtlety and complexity of the problems that leave so many people with no slack.” k ROBERT SHILLER, Arthur M. Okun Professor of Economics, Yale University “In many respects the American economy is too financialized. But as Michael Barr highlights in this important book, millions lack access to basic financial services and protections. Barr draws on his unmatched combination of academic expertise and policy experience to define the challenge and suggest ways to meet it.

It could conduct ongoing testing of compliance with the opt-out regulations and disclosure requirements. Through these no-action letters, safe harbors, supervision, and other regulatory guidance, the CFPB could develop a body of law that would increase compliance across the diverse financial sectors involved in mortgage lending, while reducing the uncertainty facing lenders from the new opt-out requirement and providing greater freedom for financial innovation. Restructuring Broker Incentives One can reduce market incentives to exploit behavioral biases by restructuring brokers’ duties to borrowers and reforming broker compensation schemes. Mortgage brokers have dominated the subprime market. Brokers generally have been compensated with yield spread premiums (YSP) for getting borrowers to pay higher rates than those for which the borrower would qualify (Jackson and Burlingame 2007; Guttentag 2000).


pages: 261 words: 64,977

Pity the Billionaire: The Unexpected Resurgence of the American Right by Thomas Frank

Affordable Care Act / Obamacare, bank run, big-box store, bonus culture, business cycle, collateralized debt obligation, collective bargaining, commoditize, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Deng Xiaoping, financial innovation, housing crisis, invisible hand, Kickstarter, money market fund, Naomi Klein, obamacare, payday loans, profit maximization, profit motive, road to serfdom, Robert Bork, Ronald Reagan, shareholder value, strikebreaker, The Chicago School, The Myth of the Rational Market, Thorstein Veblen, too big to fail, union organizing, Washington Consensus, white flight, Works Progress Administration

Those were the golden years of libertarianism, a time when our choice and master spirits agreed on the uselessness of big government and took the benevolent rationality of markets for granted. And while they did so, the American financial establishment proceeded to cheat the world to the very edge of the abyss. Indeed, what brought the nation down were the very aspects of business practice that our choice and master spirits admired the most—the financial innovation and risk-taking that were routinely described as America’s unique offerings to the world. We didn’t manufacture much anymore, but we could sure dream up awesome ways to securitize debt and slice up the risk in every imaginable situation. One testament to the zesty innovativeness of markets was the industry that had sprung up to supply credit to “subprime” borrowers, selling off the loans thus made to the investment banking industry on Wall Street.

But now this comatose, money-hole of a corporation—AIG was being kept alive only so its bad bets could be unwound in an orderly way—showed us that the bonus-grabbing culture of the trader would not die. It was an inconceivable ripoff. The people who had nearly succeeded in shoving the world off a cliff were now going to walk away rich. Wall Street pay, we suddenly understood, had never been a reward for “performance” or a grateful recognition of what financial innovation did for the nation—it was strictly about what Wall Streeters could get away with. The AIG bonus scandal thus became a symbol for the larger scandal of the crisis/bailout, another one of those moments that shreds people’s faith. The public’s disgust was volcanic this time; it seemed to erupt more violently with each passing day. A Bloomberg story that appeared on March 18 observed that “Americans want to see heads roll.

., The Great Depression (Englewood Cliffs, NJ: Prentice-Hall, 1960), p. 125. A South Dakota participant in the farm strike told Studs Terkel in 1970 that “it was close in spirit to the American Revolution.” Hard Times: An Oral History of the Great Depression (New York: Pantheon, 1970), p. 256. Chapter 2. 1929: The Sequel 1. Joshua Cooper Ramo, “The Three Marketeers,” Time, February 15, 1999. 2. On financial innovation and its application to real estate, see Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (New York: Pantheon, 2010), pp. 105–13. 3. These examples are all drawn from the first eighty pages of the Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (New York: Public Affairs, 2011). 4.


pages: 504 words: 143,303

Why We Can't Afford the Rich by Andrew Sayer

accounting loophole / creative accounting, Albert Einstein, anti-globalists, asset-backed security, banking crisis, banks create money, basic income, Boris Johnson, Bretton Woods, British Empire, business cycle, call centre, capital controls, carbon footprint, collective bargaining, corporate raider, corporate social responsibility, creative destruction, credit crunch, Credit Default Swap, crony capitalism, David Graeber, David Ricardo: comparative advantage, debt deflation, decarbonisation, declining real wages, deglobalization, deindustrialization, delayed gratification, demand response, don't be evil, Double Irish / Dutch Sandwich, en.wikipedia.org, Etonian, financial innovation, financial intermediation, Fractional reserve banking, full employment, G4S, Goldman Sachs: Vampire Squid, high net worth, income inequality, information asymmetry, Intergovernmental Panel on Climate Change (IPCC), investor state dispute settlement, Isaac Newton, James Dyson, job automation, Julian Assange, Kickstarter, labour market flexibility, laissez-faire capitalism, land value tax, low skilled workers, Mark Zuckerberg, market fundamentalism, Martin Wolf, mass immigration, means of production, moral hazard, mortgage debt, negative equity, neoliberal agenda, new economy, New Urbanism, Northern Rock, Occupy movement, offshore financial centre, oil shale / tar sands, patent troll, payday loans, Philip Mirowski, plutocrats, Plutocrats, popular capitalism, predatory finance, price stability, pushing on a string, quantitative easing, race to the bottom, rent-seeking, Ronald Reagan, shareholder value, short selling, sovereign wealth fund, Steve Jobs, The Nature of the Firm, The Spirit Level, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, transfer pricing, trickle-down economics, universal basic income, unpaid internship, upwardly mobile, Washington Consensus, wealth creators, WikiLeaks, Winter of Discontent, working poor, Yom Kippur War, zero-sum game

Yet Apple is famously quick to litigate against any companies who borrow or appear to borrow Apple’s ideas. As Ferguson puts it, ‘Most of us have no problem with copying (as long as we’re the ones doing it).’27 In recent decades, the scope of ‘intellectual property’ claims has expanded these sources of rent extraction, most notably in seeds,28 software and business methods and in so-called ‘financial innovations’ such as new types of derivatives. Whereas patent law protected specific inventions, software claims can be much looser and broader in their coverage as designers have sought to expand the range of their claims. Sixty-two per cent of all patent disputes are now over software. As intellectual property rights have grown, litigation has itself become big business, not only extracting huge rents but stifling the emulation and adaptation of ideas that are so important for the growth of knowledge and culture.29 You can come up with an idea and sue someone for reproducing it, even if you had no intention of using it yourself.

But although there has certainly been extraordinary irresponsibility, mismanagement, irrational exuberance, not to mention greed and indeed criminality, the basic causes go back decades, and they weren’t all to do with finance. The problems are not merely technical, to be fixed by an engineering approach that takes for granted the legitimacy and rationality of the basic institutions and practices and merely identifies malfunctions. The crisis is also a product of economic injustice. To understand it requires more than the usual narrative of who did what in a sequence of financial innovation and euphoria followed by disaster: we need to identify the basic mechanisms of wealth extraction that are involved. TWELVE The roots of the crisis There are scores of different accounts of the origins of the crisis. The causes are complex, and different experts give different emphasis to them. Many of the elements are mutually reinforcing so it’s often hard to say what came first:1 but I will at least provide a sketch of the main elements and processes, highlighting the role of the rich.

It was introduced in a series of reports, the last of which was called The Plutonomy Symposium – Rising Tides Lifting Yachts.143 It was sent only to Citigroup’s wealthiest customers, but leaked to the press. It claims that the US, Canada, UK and Australia are the only plutonomies; much of continental Europe and Japan, which haven’t experienced such major upturns in wealth controlled by the rich, are ‘the Egalitarian Bunch’. According to the report, plutonomies have three key characteristics: 1. They are all created by ‘disruptive technology-driven productivity gains, creative financial innovation, capitalist friendly cooperative governments, immigrants … the rule of law and patenting inventions. Often these wealth waves involve great complexity exploited best by the rich and educated of the time.’ 2. There is no ‘average’ consumer in Plutonomies. There is only the rich ‘and everyone else’. The rich account for a disproportionate chunk of the economy, while the non-rich account for ‘surprisingly small bites of the national pie’.


pages: 524 words: 155,947

More: The 10,000-Year Rise of the World Economy by Philip Coggan

"Robert Solow", accounting loophole / creative accounting, Ada Lovelace, agricultural Revolution, Airbnb, airline deregulation, Andrei Shleifer, anti-communist, assortative mating, autonomous vehicles, bank run, banking crisis, banks create money, basic income, Berlin Wall, Bob Noyce, Branko Milanovic, Bretton Woods, British Empire, business cycle, call centre, capital controls, carbon footprint, Carmen Reinhart, Celtic Tiger, central bank independence, Charles Lindbergh, clean water, collective bargaining, Columbian Exchange, Columbine, Corn Laws, credit crunch, Credit Default Swap, crony capitalism, currency peg, debt deflation, Deng Xiaoping, discovery of the americas, Donald Trump, Erik Brynjolfsson, European colonialism, eurozone crisis, falling living standards, financial innovation, financial intermediation, floating exchange rates, Fractional reserve banking, Frederick Winslow Taylor, full employment, germ theory of disease, German hyperinflation, gig economy, Gini coefficient, global supply chain, global value chain, Gordon Gekko, greed is good, Haber-Bosch Process, Hans Rosling, Hernando de Soto, hydraulic fracturing, Ignaz Semmelweis: hand washing, income inequality, income per capita, indoor plumbing, industrial robot, inflation targeting, Isaac Newton, James Watt: steam engine, job automation, John Snow's cholera map, joint-stock company, joint-stock limited liability company, Kenneth Arrow, Kula ring, labour market flexibility, land reform, land tenure, Lao Tzu, large denomination, liquidity trap, Long Term Capital Management, Louis Blériot, low cost airline, low skilled workers, lump of labour, M-Pesa, Malcom McLean invented shipping containers, manufacturing employment, Marc Andreessen, Mark Zuckerberg, Martin Wolf, McJob, means of production, Mikhail Gorbachev, mittelstand, moral hazard, Murano, Venice glass, Myron Scholes, Nelson Mandela, Network effects, Northern Rock, oil shale / tar sands, oil shock, Paul Samuelson, popular capitalism, popular electronics, price stability, principal–agent problem, profit maximization, purchasing power parity, quantitative easing, railway mania, Ralph Nader, regulatory arbitrage, road to serfdom, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, savings glut, Scramble for Africa, Second Machine Age, secular stagnation, Silicon Valley, Simon Kuznets, South China Sea, South Sea Bubble, special drawing rights, spice trade, spinning jenny, Steven Pinker, TaskRabbit, Thales and the olive presses, Thales of Miletus, The Great Moderation, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, The Rise and Fall of American Growth, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Malthus, Thorstein Veblen, trade route, transaction costs, transatlantic slave trade, transcontinental railway, Triangle Shirtwaist Factory, universal basic income, Unsafe at Any Speed, Upton Sinclair, V2 rocket, Veblen good, War on Poverty, Washington Consensus, Watson beat the top human players on Jeopardy!, women in the workforce, Yom Kippur War, zero-sum game

Productivity can be enhanced by relatively simple new gadgets, such as the cotton gin developed by Eli Whitney, which removed seeds and waste from the cotton buds (although, by boosting the cotton crop, this invention perpetuated the US slavery system). But output can also be improved by new ways of organising production, such as the moving assembly line that allowed Henry Ford to produce cars more cheaply. Financial innovation, such as letters of credit, or legal reforms like the creation of the limited liability company, made it easier for traders to take risks and expand their operations. Perhaps the most important area of innovation has been agriculture. Thomas Malthus, an 18th-century vicar, is famed for his gloomy forecasts about the dangers of population growth. He spotted the underlying problem of civilisation until that time: the limits on the ability to produce more food.

A failed voyage is the centrepiece of the plot of Shakespeare’s The Merchant of Venice, while the phase “when my ship comes in” stems from the idea that the safe arrival of a cargo was a welcome bonus. For the investor, the answer, where possible, was to split one’s capital among as many voyages as possible. In Venice, ownership of the ships and cargoes were divided into shares called loca. A wide range of citizens could invest; individuals could hold one-24th of a locum.10 Ownership of a locum could be pledged as security for loans. Another Italian financial innovation was public debt. Venice set up a loan office called the Monte Vecchio in the 13th century. Rich citizens were compelled to make loans to the city but they received an annual interest rate of 5% in return. The debt was tradable and citizens bought the loans as a home for their savings; a 5% yield at a time of zero long-term inflation was a pretty good deal. The bonds were traded (along with commodities) at an exchange in the central area called the Rialto.

Indeed, many traders would be both buying and selling, so they would probably have to lug their coins back on the return journey. So bankers operated at the fairs, acting as clearing houses for all the trades; a merchant would end up with a credit or debit that could be settled later, or simply rolled over to the next fair. In this way, credit allowed more trade to occur; as one author wrote, “credit enabled a small investment of hard cash to go to work simultaneously at more than one place”.14 Financial innovation thus lowered transaction costs, allowed cash that would otherwise be hoarded to be put to work, and allowed merchants to take more risk. Without it, trade would not have flourished as it did. There was a general shortage of coins in Europe in the Middle Ages. At the start of the period, Europe was surviving with the help of coins from the Byzantine and Islamic worlds. Eventually the Italian cities developed the wealth and confidence to issue their own gold coins, starting with Genoa and Florence in 1252,15 while Venice followed with the ducat in 1284.


pages: 397 words: 112,034

What's Next?: Unconventional Wisdom on the Future of the World Economy by David Hale, Lyric Hughes Hale

affirmative action, Asian financial crisis, asset-backed security, bank run, banking crisis, Basel III, Berlin Wall, Black Swan, Bretton Woods, business cycle, capital controls, Cass Sunstein, central bank independence, cognitive bias, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, corporate social responsibility, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, debt deflation, declining real wages, deindustrialization, diversification, energy security, Erik Brynjolfsson, Fall of the Berlin Wall, financial innovation, floating exchange rates, full employment, Gini coefficient, global reserve currency, global village, high net worth, Home mortgage interest deduction, housing crisis, index fund, inflation targeting, information asymmetry, Intergovernmental Panel on Climate Change (IPCC), invisible hand, Just-in-time delivery, Kenneth Rogoff, Long Term Capital Management, Mahatma Gandhi, Martin Wolf, Mexican peso crisis / tequila crisis, Mikhail Gorbachev, money market fund, money: store of value / unit of account / medium of exchange, mortgage tax deduction, Network effects, new economy, Nicholas Carr, oil shale / tar sands, oil shock, open economy, passive investing, payday loans, peak oil, Ponzi scheme, post-oil, price stability, private sector deleveraging, purchasing power parity, quantitative easing, race to the bottom, regulatory arbitrage, rent-seeking, reserve currency, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, sovereign wealth fund, special drawing rights, technology bubble, The Great Moderation, Thomas Kuhn: the structure of scientific revolutions, Tobin tax, too big to fail, total factor productivity, trade liberalization, Washington Consensus, Westphalian system, WikiLeaks, women in the workforce, yield curve

Louis-Vincent Gave notes that Asian stock markets are now discounting high growth expectations, and thus are trading at premiums to traditional OECD markets. Gave reviews the four key factors that have driven economic performance in the West over the past decade, and suggests that some of the factors are still driving Asian growth. These factors are the emergence of three billion new producers, creation of a global economy, and the great moderation of steady low-inflation economic growth, and financial innovation. The financial revolution that drove markets in New York and London is still evolving in East Asia. East Asia is also free of two problems that now loom over the old industrial countries—a legacy of private debt that financed asset inflation and large fiscal deficits. Gave’s new concern is that China could soon confront labor shortages. He is also concerned that China has excess savings, but understands how the excess has resulted from robust profits, not just deferred consumption.

And in Europe, that limit may well be exceeded in the coming years, both because of an overly aggressive fiscal tightening and because of an overcautious response by the ECB. Monetary Policy in Europe Is Tighter and Less Pragmatic Than in the United States While it is widely believed that monetary policy has “always” been traditionally tighter in Europe than in America, the figures do not bear this out. In the years before the crisis, the ECB was generally somewhat more expansive than the Fed, probably because Europe was experiencing a slower rate of financial innovation and remained more of a cash economy. Money supply grew more rapidly in Europe whether attention focused on the monetary base, which is directly controlled by central banks, or at broad money, which is the monetary gauge that has correlated best with long-term inflation and GDP growth (see Figure 5.8). After the crisis, however, this relationship abruptly reversed. While the Fed did its utmost to provide monetary stimulus for more than a year after Lehman, the ECB reversed course much more quickly—encouraging both the monetary base and broad money to contract from the middle of 2009.

• A Financial Revolution: This resulted from the adoption of a free-market philosophy, the buildup of savings in the rapidly growing Asian economies, and the stability created by globalization and successful demand management. With risks of bankruptcy and unemployment diminished in the stabilized economies of the 1990s, businesses and consumers felt that they could borrow more than ever before, and banks were more willing to lend. Meanwhile, the demystification of money meant that debt ceased to be a moral or theological issue and became just another consumer product. Financial innovation also meant that savings that were previously locked up in property and other illiquid assets could be used as collateral to support consumer and business borrowing. This attractive new feature of property, summed up in the saying “My home is an ATM machine,” led to an increase in the value of homes relative to other more traditional investments such as stocks and bonds. The result of this revolution was that ordinary home-owners and small businesses gained opportunities to smooth their spending over their entire lifetimes and to manage their finances in ways that had been available only to large multinational companies and wealthy family trusts.


pages: 297 words: 84,009

Big Business: A Love Letter to an American Anti-Hero by Tyler Cowen

23andMe, Affordable Care Act / Obamacare, augmented reality, barriers to entry, Bernie Sanders, bitcoin, blockchain, Bretton Woods, cloud computing, cognitive dissonance, corporate governance, corporate social responsibility, correlation coefficient, creative destruction, crony capitalism, cryptocurrency, dark matter, David Brooks, David Graeber, don't be evil, Donald Trump, Elon Musk, employer provided health coverage, experimental economics, Filter Bubble, financial innovation, financial intermediation, global reserve currency, global supply chain, Google Glasses, income inequality, Internet of things, invisible hand, Jeff Bezos, late fees, Mark Zuckerberg, mobile money, money market fund, mortgage debt, Network effects, new economy, Nicholas Carr, obamacare, offshore financial centre, passive investing, payday loans, peer-to-peer lending, Peter Thiel, pre–internet, price discrimination, profit maximization, profit motive, RAND corporation, rent-seeking, reserve currency, ride hailing / ride sharing, risk tolerance, Ronald Coase, shareholder value, Silicon Valley, Silicon Valley startup, Skype, Snapchat, Social Responsibility of Business Is to Increase Its Profits, Steve Jobs, The Nature of the Firm, Tim Cook: Apple, too big to fail, transaction costs, Tyler Cowen: Great Stagnation, ultimatum game, WikiLeaks, women in the workforce, World Values Survey, Y Combinator

Still, in the broader historical view, siding with banking and finance has meant siding with economic development and with the unfolding of the glories of civilization more broadly, be it the arts, philosophy, or the growth of the modern nation-state. Yale finance professor William N. Goetzmann makes this point in his book Money Changes Everything: How Finance Made Civilization Possible. Had banking and financial innovation not been allowed to proceed, the Western world would be a far less developed, creative, and indeed happy place. A few hundred years from now, our descendants probably will look back and say the same. But since the financial crisis of 2007–2008, attitudes have swung in the other direction and critics have hit the financial sector with virulent attacks. The 2016 campaign of Bernie Sanders, which got much further than almost anyone expected, focused like a laser on banking and finance, as has Senator Elizabeth Warren.

There is today plenty of online lending, I would say with mixed results and probably a fair amount of misrepresentation. I think of this as a nascent market, a bit like junk bonds, still going through its teething phase and not quite ready for prime time. But someday it will be, and online lending will be a permanent part of the financial landscape, as is already the case in China. Some of today’s most significant financial innovations are relatively invisible. Consider Stripe, a payments company based in San Francisco, founded by two Irish entrepreneurs, brothers Patrick and John Collison. Among other services, such as making it easier to accept payments over the internet, it supplies back-end information storage to merchants. Stripe solves a problem that many business owners have: how to accept customer credit cards and then hold and store this information in a secure fashion, given the risks of being hacked or simply experiencing a mishap.

Bernstein, Elizabeth best sellers See also publishing Bezos, Jeff See also Amazon Big Brother See privacy Big Data Big Pharma Big Tech disappearance of competition impact on intelligence innovation and loss of privacy and overview Bing Bird, Larry Bitcoin Black, Leon BlackBerry Blackstone blockchain Bloxham, Eleanor Blue Cross/Blue Shield brand loyalty Brexit Brin, David Brooks, Nathan bubbles, financial sector Bullshit Jobs: A Theory (Graeber) Burger King cable TV cable companies cable news Capital One capitalism “creative destruction” and Friedman on logic of market churn and media and public’s view of short-termism venture capitalists workers and young people and See also crony capitalism Capitalism for the People, A (Zingales) Carr, Nicholas Carrier CEOs deaths of increases in salary overview pay for creating value short-termism and skill set China American manufacturing and Apple and facial recognition technology financial innovations financial institutions multinational corporations and productivity retail and tech companies and See also Alibaba Cialdini, Robert Cisco Citibank Citizens United decision See also Supreme Court Civil War Clark, Andrew E. class Clinton, Hillary Coase, Ronald cognition cognitive dissonance cognitive efficiency cognitive strengths Collison, Patrick and John compensating differential conspiracy theories control firms co-ops copyright corporations attempts to sway public opinion downside of personalization public dislike of Countrywide “creative destruction” credit cards credit card information credit card system privacy and crony capitalism business influence on government class and multinational corporations overview privilege and state monopoly status quo bias See also capitalism cryptocurrencies See also Bitcoin Csikszentmihalyi, Mihaly Curry, Stephen CVS cybersecurity “daily effective experiences” See also Kahneman, Daniel; Krueger, Alan Daley, William Damaske, Sarah Damore, James daycare defense spending DejaNews Democratic Party Desan, Mathieu Deutsche Bank discrimination Dollar General Dow Scrubbing Bubbles Dream of the Red Chamber DuckDuckGo Dying for a Paycheck (Pfeffer) eBay education email employment/unemployment European Union ex post Exxon eyeglass companies Facebook advertising and AI and “anti-diversity memo” censorship and China and competition and complaints about employees “filter bubble” income inequality and information and innovation and monopoly and News Feed politics and privacy and Russian-manipulated content venture capital and See also Zuckerberg, Mark facial recognition technology “fake news” See also media Fama, Eugene fast-food Fehr, Ernst Ferguson, Niall financial crisis financial sector America as tax and banking haven American stock performance banks “too big” global importance of US growth information technology and intermediation overview venture capital and American innovation Financial Times fintech flow Ford Motor Company Foreign Corrupt Practices Act Foroohar, Rana fraud, businesses and CEOs in laboratory games comparative perspective cross-cultural game theory nonprofits vs. for-profits overview research on corporate behavior spread of information and tax gap trust and free trade French, Kenneth Friedman, Milton Friendster Fritzon, Katarina fundraising Gabaix, Xavier Gates, Bill GDP General Agreement on Tariffs and Trade General Electric General Motors Gilens, Martin Glass-Steagall Act Gmail Goetzmann, William N.


pages: 552 words: 168,518

MacroWikinomics: Rebooting Business and the World by Don Tapscott, Anthony D. Williams

accounting loophole / creative accounting, airport security, Andrew Keen, augmented reality, Ayatollah Khomeini, barriers to entry, Ben Horowitz, bioinformatics, Bretton Woods, business climate, business process, buy and hold, car-free, carbon footprint, Charles Lindbergh, citizen journalism, Clayton Christensen, clean water, Climategate, Climatic Research Unit, cloud computing, collaborative editing, collapse of Lehman Brothers, collateralized debt obligation, colonial rule, commoditize, corporate governance, corporate social responsibility, creative destruction, crowdsourcing, death of newspapers, demographic transition, disruptive innovation, distributed generation, don't be evil, en.wikipedia.org, energy security, energy transition, Exxon Valdez, failed state, fault tolerance, financial innovation, Galaxy Zoo, game design, global village, Google Earth, Hans Rosling, hive mind, Home mortgage interest deduction, information asymmetry, interchangeable parts, Internet of things, invention of movable type, Isaac Newton, James Watt: steam engine, Jaron Lanier, jimmy wales, Joseph Schumpeter, Julian Assange, Kevin Kelly, Kickstarter, knowledge economy, knowledge worker, Marc Andreessen, Marshall McLuhan, mass immigration, medical bankruptcy, megacity, mortgage tax deduction, Netflix Prize, new economy, Nicholas Carr, oil shock, old-boy network, online collectivism, open borders, open economy, pattern recognition, peer-to-peer lending, personalized medicine, Ray Kurzweil, RFID, ride hailing / ride sharing, Ronald Reagan, Rubik’s Cube, scientific mainstream, shareholder value, Silicon Valley, Skype, smart grid, smart meter, social graph, social web, software patent, Steve Jobs, text mining, the scientific method, The Wisdom of Crowds, transaction costs, transfer pricing, University of East Anglia, urban sprawl, value at risk, WikiLeaks, X Prize, young professional, Zipcar

He concludes that “An open mathematical algorithm, or even published software, would far better describe the waterfalls, and associated payment structures.” This is not such a crazy idea, and other serious players agree. Rick Bookstaber was the former head of risk management for Salomon Brothers and Moore Capital, and is the author of A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation.10 He currently has a fulltime job at the SEC as a senior policy adviser for risk, strategy, and financial innovation and knows as much about the weird, opaque world of derivatives as anyone. Bookstaber calls for opening up derivatives to understand their value. “If we want to go down the path of standardized valuation and comparability in these complex portfolios, we need open derivatives models,” he says. “One thing we should have learned from the rating agency debacle is that even if we put aside the issues of monopoly power and conflict of interest, we cannot stop with having the proprietor of such models say, ‘Trust me, I know what I’m doing.’”

Those that are willing to subject their valuations to public vetting will be trusted, and those that are not will soon find their cost of funds increasing and their customers going someplace else. Banks once spoke of their fiduciary responsibilities, and through that their behavior established trust. Today it will take actions, not words. A process such as that proposed by Open Models to vet complex assets could go a long way toward restoring confidence in the system. Indeed, if financial innovation got the industry into trouble in the first place, perhaps forward-thinking initiatives such as Open Models may show a way out by challenging long-standing practices and assumptions. To be sure, Open Models is facing an uphill battle and success is far from assured. But any amount of transparency and openness that permeates the modus operandi of the industry will have a positive influence.

And it’s an alternative to the whack-a-mole game that regulators are forced to play in the ever changing financial services landscape. Innovators such as Open Models, VenCorps, and the myriad of P2P lenders are just the first sign of what’s to come. Opportunities for wikinomics-style collaborations abound. Financial regulators, investors, entrepreneurs, and banking customers are increasingly seeing the benefits of transparency, openness, and sharing. While financial innovation earned a bad name during the crisis, we feel that at the end of the day innovation will help the industry overcome its current challenges. As Gord Nixon puts it, “developing new products where you lend money to people who don’t have income is not innovation, that’s just bad risk management and faulty regulation. Developing new products to find better and less expensive ways to service your customers, that to me is innovation.” 4.


pages: 726 words: 172,988

The Bankers' New Clothes: What's Wrong With Banking and What to Do About It by Anat Admati, Martin Hellwig

Andrei Shleifer, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, bonus culture, break the buck, business cycle, Carmen Reinhart, central bank independence, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, diversified portfolio, en.wikipedia.org, Exxon Valdez, financial deregulation, financial innovation, financial intermediation, fixed income, George Akerlof, Growth in a Time of Debt, income inequality, information asymmetry, invisible hand, Jean Tirole, joint-stock company, joint-stock limited liability company, Kenneth Rogoff, Larry Wall, light touch regulation, London Interbank Offered Rate, Long Term Capital Management, margin call, Martin Wolf, money market fund, moral hazard, mortgage debt, mortgage tax deduction, negative equity, Nick Leeson, Northern Rock, open economy, peer-to-peer lending, regulatory arbitrage, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Satyajit Das, shareholder value, sovereign wealth fund, technology bubble, The Market for Lemons, the payments system, too big to fail, Upton Sinclair, Yogi Berra

In the 1980s in Latin America and again since 2010 in Europe, banks have found that even governments can have problems paying their debts if they cannot print the money they owe. In Latin America in the 1980s, support for debtor countries from the IMF got most of the banks off the hook. In Europe, support from the IMF and from other Eurozone countries since 2010 has also limited the damage. The Belgian-French bank Dexia and Germany’s Hypo Real Estate, however, would have been insolvent without direct government support.39 Financial Innovation to the Rescue? As we have seen, the traditional model of deposit banking has important weaknesses. Activities might be disrupted by runs, the renewal of funding might be impossible or too costly, or returns from investments might not be sufficient to pay depositors. Deposit insurance has all but eliminated the problem of runs by depositors, but it has not addressed the other problems. From the 1930s to the early 1970s, these problems did not play much of a role, but since then the economy has become less stable and interest rates have become much more volatile.

Banks’ risks from changes in refinancing costs and from changes in returns on loans and other investments have increased.40 In the early 1980s and again in the late 1980s, traditional depository institutions turned out to be very vulnerable to these risks. In this risky new world, the 3-6-3 model of specialized savings banks that take deposits and make mortgage loans was no longer viable.41 In this much riskier world, the needs of savings banks like the Bailey Building and Loan Association drove financial innovations in the 1980s and 1990s. Many tools were developed to transfer risks from savings banks to other investors. In this context a major role was played by what is called securitization, a procedure that allows commercial banks and savings banks to sell their loans and mortgages to other investors. The word securitization refers to the fact that a group of loans that are not directly tradable in a market can be bundled together and turned into bonds, that is, securities that are tradable.

For several reasons, however, this is problematic. First, the equity levels of recent decades were artificially low because banks and their creditors had become used to the government safety net. Second, the increases in the intensity of competition in financial markets that we have seen since the 1970s have decreased the banks’ ability to withstand shocks. Third, the high degree of interconnectedness in the system that has come with financial innovation and with globalization has magnified the potential fallout from the failure of a systemically important financial institution for the global economy. Moreover, institutions tend to be exposed to the same shocks and therefore run into trouble at the same time. All these concerns lead to the conclusion that the levels of equity banks have had in recent decades do not provide appropriate guidance as to what bank equity should be.55 Since 2010, when we became more outspoken about the need for an ambitious reform of capital regulation, we have engaged in many discussions on the subject, yet we have never received a coherent answer to the question of why banks should not have equity levels between 20 and 30 percent of their total assets.56 (A caveat on providing specific ratios is that their meaning will depend on accounting conventions.)


pages: 515 words: 126,820

Blockchain Revolution: How the Technology Behind Bitcoin Is Changing Money, Business, and the World by Don Tapscott, Alex Tapscott

Airbnb, altcoin, asset-backed security, autonomous vehicles, barriers to entry, bitcoin, blockchain, Blythe Masters, Bretton Woods, business process, buy and hold, Capital in the Twenty-First Century by Thomas Piketty, carbon footprint, clean water, cloud computing, cognitive dissonance, commoditize, corporate governance, corporate social responsibility, creative destruction, Credit Default Swap, crowdsourcing, cryptocurrency, disintermediation, disruptive innovation, distributed ledger, Donald Trump, double entry bookkeeping, Edward Snowden, Elon Musk, Erik Brynjolfsson, Ethereum, ethereum blockchain, failed state, fiat currency, financial innovation, Firefox, first square of the chessboard, first square of the chessboard / second half of the chessboard, future of work, Galaxy Zoo, George Gilder, glass ceiling, Google bus, Hernando de Soto, income inequality, informal economy, information asymmetry, intangible asset, interest rate swap, Internet of things, Jeff Bezos, jimmy wales, Kickstarter, knowledge worker, Kodak vs Instagram, Lean Startup, litecoin, Lyft, M-Pesa, Marc Andreessen, Mark Zuckerberg, Marshall McLuhan, means of production, microcredit, mobile money, money market fund, Network effects, new economy, Oculus Rift, off grid, pattern recognition, peer-to-peer, peer-to-peer lending, peer-to-peer model, performance metric, Peter Thiel, planetary scale, Ponzi scheme, prediction markets, price mechanism, Productivity paradox, QR code, quantitative easing, ransomware, Ray Kurzweil, renewable energy credits, rent-seeking, ride hailing / ride sharing, Ronald Coase, Ronald Reagan, Satoshi Nakamoto, Second Machine Age, seigniorage, self-driving car, sharing economy, Silicon Valley, Skype, smart contracts, smart grid, social graph, social intelligence, social software, standardized shipping container, Stephen Hawking, Steve Jobs, Steve Wozniak, Stewart Brand, supply-chain management, TaskRabbit, The Fortune at the Bottom of the Pyramid, The Nature of the Firm, The Wisdom of Crowds, transaction costs, Turing complete, Turing test, Uber and Lyft, uber lyft, unbanked and underbanked, underbanked, unorthodox policies, wealth creators, X Prize, Y2K, Zipcar

Clippinger, CEO, ID3, Research Scientist, MIT Media Lab Bram Cohen, Creator, BitTorrent Amy Cortese, Journalist, Founder, Locavest J-F Courville, Chief Operating Officer, RBC Wealth Management Patrick Deegan, CTO, Personal BlackBox Primavera De Filippi, Permanent Researcher, CNRS and Faculty Associate at the Berkman Center for Internet and Society at Harvard Law School Hernando de Soto, President, Institute for Liberty and Democracy Peronet Despeignes, Special Ops, Augur Jacob Dienelt, Blockchain Architect and CFO, itBit and Factom Joel Dietz, Swarm Corp Helen Disney, (formerly) Bitcoin Foundation Adam Draper, CEO and Founder, Boost VC Timothy Cook Draper, Venture Capitalist; Founder, Draper Fisher Jurvetson Andrew Dudley, Founder and CEO, Earth Observation Joshua Fairfield, Professor of Law, Washington and Lee University Grant Fondo, Partner, Securities Litigation and White Collar Defense Group, Privacy and Data Security Practice, Goodwin Procter LLP Brian Forde, Former Senior Adviser, The White House; Director, Digital Currency, MIT Media Lab Mike Gault, CEO, Guardtime George Gilder, Founder and Partner, Gilder Technology Fund Geoff Gordon, CEO, Vogogo Vinay Gupta, Release Coordinator, Ethereum James Hazard, Founder, Common Accord Imogen Heap, Grammy-Winning Musician and Songwriter Mike Hearn, Former Google Engineer, Vinumeris/Lighthouse Austin Hill, Cofounder and Chief Instigator, Blockstream Toomas Hendrik Ilves, President of Estonia Joichi Ito, Director, MIT Media Lab Eric Jennings, Cofounder and CEO, Filament Izabella Kaminska, Financial Reporter, Financial Times Paul Kemp-Robertson, Cofounder and Editorial Director, Contagious Communications Andrew Keys, Consensus Systems Joyce Kim, Executive Director, Stellar Development Foundation Peter Kirby, CEO and Cofounder, Factom Joey Krug, Core Developer, Augur Haluk Kulin, CEO, Personal BlackBox Chris Larsen, CEO, Ripple Labs Benjamin Lawsky, Former Superintendent of Financial Services for the State of New York; CEO, The Lawsky Group Charlie Lee, Creator, CTO; Former Engineering Manager, Litecoin Matthew Leibowitz, Partner, Plaza Ventures Vinny Lingham, CEO, Gyft Juan Llanos, EVP of Strategic Partnerships and Chief Transparency Officer, Bitreserve.org Joseph Lubin, CEO, Consensus Systems Adam Ludwin, Founder, Chain.com Christian Lundkvist, Balanc3 David McKay, President and Chief Executive Officer, RBC Janna McManus, Global PR Director, BitFury Mickey McManus, Maya Institute Jesse McWaters, Financial Innovation Specialist, World Economic Forum Blythe Masters, CEO, Digital Asset Holdings Alistair Mitchell, Managing Partner, Generation Ventures Carlos Moreira, Founder, Chairman, and CEO, WISeKey Tom Mornini, Founder and Customer Advocate, Subledger Ethan Nadelmann, Executive Director, Drug Policy Alliance Adam Nanjee, Head of Fintech Cluster, MaRS Daniel Neis, CEO and Cofounder, KOINA Kelly Olson, New Business Initiative, Intel Steve Omohundro, President, Self-Aware Systems Jim Orlando, Managing Director, OMERS Ventures Lawrence Orsini, Cofounder and Principal, LO3 Energy Paul Pacifico, CEO, Featured Artists Coalition Jose Pagliery, Staff Reporter, CNNMoney Stephen Pair, Cofounder and CEO, BitPay Inc.

The first era of the Internet, rather than bringing transparency and impairing violations, seems to have done little to increase security of persons, institutions, and economic activity. The average Internet user often has to rely on flimsy passwords to protect e-mail and online accounts because service providers or employers insist on nothing stronger. Consider the typical financial intermediary: it doesn’t specialize in developing secure technology; it specializes in financial innovation. In the year that Satoshi published his white paper, data breaches at such financial firms as BNY Mellon, Countrywide, and GE Money accounted for over 50 percent of all identity thefts reported that year, according to the Identity Theft Resource Center.24 By 2014, that figure had fallen to 5.5 percent for the financial sector, but breaches in medical and health care jumped to 42 percent of the year’s total.

Masters said, “The entire life cycle of a trade including its execution, the netting of multiple trades against each other, the reconciliation of who did what with whom and whether they agree, can occur at the trade entry level, much earlier in the stack of process, than occurs in the mainstream financial market.”25 Greifeld put it this way: “We currently settle trades ‘T+3’ (that is, three days). Why not settle in five to ten minutes?”26 Wall Street trades in risk, and this technology can materially reduce counterparty risk, settlement risk, and thus systemic risk across the system. Jesse McWaters, financial innovation lead at the World Economic Forum, told us, “The most exciting thing about distributed ledger technology is how traceability can improve systemic stability.” He believes these “new tools allow regulators to use a lighter touch.”27 The blockchain’s public nature—its transparency, its searchability—plus its automated settlement and immutable time stamps, allow regulators to see what’s happening, even set up alerts so that they don’t miss anything.


The End of Accounting and the Path Forward for Investors and Managers (Wiley Finance) by Feng Gu

active measures, Affordable Care Act / Obamacare, barriers to entry, business cycle, business process, buy and hold, Claude Shannon: information theory, Clayton Christensen, commoditize, conceptual framework, corporate governance, creative destruction, Daniel Kahneman / Amos Tversky, discounted cash flows, disruptive innovation, diversified portfolio, double entry bookkeeping, Exxon Valdez, financial innovation, fixed income, hydraulic fracturing, index fund, information asymmetry, intangible asset, inventory management, Joseph Schumpeter, Kenneth Arrow, knowledge economy, moral hazard, new economy, obamacare, quantitative easing, quantitative trading / quantitative finance, QWERTY keyboard, race to the bottom, risk/return, Robert Shiller, Robert Shiller, shareholder value, Steve Jobs, The Great Moderation, value at risk

In particular, economists recorded a shift in the mid-1980s toward stabilization of economic activity: It has been estimated that, since 1984, the variance (a statistical measure of volatility) of GDP growth has declined by an astounding 50 percent. The search for a full understanding of this phenomenon goes on, but stabilizing factors like improved inventory management by companies, better control of firms’ operations brought about by information technology, smarter government interventions in crises, and the increased use by companies of stabilizing (risk hedging) financial innovations are among the volatility-reducing factors already identified. And what about the substantial business disruptions caused by the 2007−2008 crisis, you ask? Just a hiccup. A 2014 study by Furman shows that the pre-crisis declining volatility was resumed after the financial crisis (“ . . . but overall volatility still appears to be at a lower level than in the past.”)9 So, our documented declining usefulness of financial information cannot be blamed on an increasingly turbulent business environment.

See Financial Accounting Standards Board Field, Marshall 4 Financial Accounting Standards Board (FASB) 6, 18, 181, 222 regulatory record, examination 213–214 Financial capital 82 Financial crisis, real estate (depression) 32–33 Financial data estimates 124 relevance, decrease 36 Financial indicators, impact (share) 36f 252 Financial information basis, problems 35–36 damage, accounting/nonaccounting (impact) 90 deterioration, accounting estimates (impact) 98–100 interpretation, experts (usage) 62 irrelevance 37 market, competition 41–42 quality 68 role 37 stock prices, contrast 29 usefulness decline 56, 67–68, 206 loss, investor interest 68–70 measurement 29–31 Financial innovations 71 Financial reporting direction, change 214 purpose (FASB) 30 Financial reports 46f contextual role 47 contribution 47 estimation, statistical methodology (usage) 44–45 economic condition 62 estimate-related terms, frequency (increase) 99f indicators, role 67 opaqueness 86–87 performance 62 performance-related information source 44 structure, freezing 8 structure/information, similarity 2 timelines, measurement 43–45 Firm operations, bottom line 154 Firm-specific errors 54 First-in-class product (Pfizer) 169–170 Follow-on patenting 166 Footprint size 187 Ford, Henry 52, 116 Ford Motor Company, car production 1 Forecasts, verification (enabling) 220–221 Fortune Global 500 Companies, 180 SUBJECT INDEX Full revelation, economic principle 202 Fundamentals 51 Funds decrease 69–70 sources 32 uses 32 Future earnings (prediction), earnings reporting ability (decline) 55f Geico advertising 147 brand, re-creation (impossibility) 148 General Electric, earnings per share (EPS) uncertainty/vagueness 94–95 Generally accepted accounting principles (GAAP) 96, 115 information 204 mandate 217 non-GAAP customer information 137 non-GAAP disclosure, problem 169 non-GAAP earnings, merits 205 non-GAAP measure 176 reforming 218 ROE 216 total sales, relevance (limitation) 174–175 Gilead, product pipeline 170–171 Goldman Sachs, investment dominance 83 Goodwill 109 GAAP mandate 217 value, impairment 61 write-offs 96, 219 Google car streaming market 140 intangible investment, increase 85 Great Depression 71 Great Moderation 71 Gross Domestic Product (GDP) growth 232 Gross margin ratio 154 Hedge fund managers, returns 17 Hewlett-Packard, Autonomy acquisition 84 Historical values 96–98 Subject Index Human capital, development 86–87 Hurricane Sandy claims 158 I/B/E/S data 23–24 First Call 48 IBM shares, decline 20 turnaround 122 IFRS.

See Financial information backward-looking information 52 company-related information sources 44 competition/litigation concerns 205–206 contribution 44 disagreement 63 quantification 63–65 importance 42 increase, requirement 87–88 intermediaries 62 manager cooperation 204–205 problems 84–86 proposed information, elicitation process 199–200 regulatory burden, lightening 206–208 253 SEC role 203 sources 68–69 alternative 70 ranking 30 theory (communication theory) 42 timelines, issue 43 uniformity 169 usefulness, measurement 30 uselessness 32 vagueness 63 Infringement 123 In-line products box 169–170 Innovation 166, 168 disruption 123 financial innovations 71 investment 164–165 revenues 176 In-process-R&D (IPRD) 96 balance sheet value 97 Insurance company operations 154f operations, risk 158 Intangible assets accounting problems 83–84 relevance, loss 88–90 rules, change (demand) 90 treatment 77–78 acquisition 85–86 amortization 216 asset treatment 214–217 capitalization 216 conspiracy of silence, application 86 disclosure, improvement 217–219 economic role, increase 37 emergence 37–38 increase 81–83 information increase, requirement 87–88 problems 84–86 investment, Google increase 85 nontradability 87–88 revolution 82f treatment, problem 78 uniqueness 87–88 valuation 215 254 Intangible capital increase 83 U.S. private sector investment 82f Intangible investments, expensing 216 Intellectual assets, economic role (increase) 37 Intellectual capital reports 113 Internal controls, gross inadequacies 123–124 International Financial Reporting Standard (IFRS) 217 Internet chat rooms 7 Internet service providers, patents 234 Inventory account 233 contribution 78 improvement 72 taking 233–235 Investments 156 efficiency 122 mapping 121–123 returns 18–19 risk, diversification 158 Investors agreement 63 contribution, example 45–46 decisions erosion 37–38 reported financial information, role 37 triggering 30 disagreement 63 fault 50 importance 119 information contribution 46f demand, SEC role 203 needs 114 relevance 185 investor-relevant information system 159 irrationality 50–51 necessity 142–144 operating instructions, Strategic Resources & Consequences Report issue 197, 230 SUBJECT INDEX reaction, measurement 43–44 usefulness 122 valuation process 219–220 IPRD.


pages: 339 words: 95,270

Trade Wars Are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace by Matthew C. Klein

Albert Einstein, Asian financial crisis, asset allocation, asset-backed security, Berlin Wall, Bernie Sanders, Branko Milanovic, Bretton Woods, British Empire, business climate, business cycle, capital controls, centre right, collective bargaining, currency manipulation / currency intervention, currency peg, David Ricardo: comparative advantage, deglobalization, deindustrialization, Deng Xiaoping, Donald Trump, Double Irish / Dutch Sandwich, Fall of the Berlin Wall, falling living standards, financial innovation, financial repression, fixed income, full employment, George Akerlof, global supply chain, global value chain, illegal immigration, income inequality, intangible asset, invention of the telegraph, joint-stock company, land reform, Long Term Capital Management, Malcom McLean invented shipping containers, manufacturing employment, Martin Wolf, mass immigration, Mikhail Gorbachev, money market fund, mortgage debt, New Urbanism, offshore financial centre, oil shock, open economy, paradox of thrift, passive income, reserve currency, rising living standards, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, Scramble for Africa, sovereign wealth fund, The Nature of the Firm, The Wealth of Nations by Adam Smith, Tim Cook: Apple, trade liberalization, Wolfgang Streeck

Investment boomed in the high-tech industries of railways, steamships, and telegraph cables, while the United States led a revolution in the production of agricultural commodities. The strong growth in the real economy coincided with another burst of financial innovation. In the United States, Treasury secretary Salmon P. Chase marketed bonds to middle-class Americans in the North to finance the Civil War with the help of banking newcomer Jay Cooke & Company. France under Emperor Louis Napoleon created the first universal investment banks: Crédit Industriel et Commercial (1859), Crédit Lyonnais (1863), and Société Générale (1864). These developments radically improved the banking system’s ability to collect and channel middle-class household savings into new investment projects. By the mid-1860s, Paris was beginning to rival London as a market for new international loans.21 Financial innovation was not limited to France and the United States. Germany also saw a similar expansion of its banking system and in the creation of joint-stock corporations.

At other times, changes in financial conditions led to savage busts as savings retrenched from the periphery. These financial flows necessarily corresponded to trade flows, and large changes in the financial account were always accompanied by equal and opposite shifts in the trade account. History of global financial cycles To put it differently, trade flows were determined by financial flows. The financial innovations that led to massive British capital outflows to Latin America in the early 1820s, for example, were directly connected to Britain’s massive trade surpluses with Latin America during the same period. These trade relations cannot be explained by analyses of British manufacturing efficiency or the comparative advantages of Latin American producers. The better explanation is that financial flows across borders transformed economies and pushed them to adjust how much they imported and exported.


pages: 140 words: 91,067

Money, Real Quick: The Story of M-PESA by Tonny K. Omwansa, Nicholas P. Sullivan, The Guardian

BRICs, business process, business process outsourcing, call centre, cashless society, cloud computing, creative destruction, crowdsourcing, delayed gratification, dematerialisation, disruptive innovation, financial exclusion, financial innovation, financial intermediation, income per capita, Kibera, Kickstarter, M-Pesa, microcredit, mobile money, Network effects, new economy, reserve currency, Silicon Valley, software as a service, transaction costs

The idea is not just to maintain or acquire customers but to deliver sufficient value to stores that are acting as cash merchants, and to businesses managing employees and supply chains. Without a broader perspective that includes ecosystem development, most providers will not have the wherewithal to drive mobile money or branchless banking forward at sufficient scale and speed. SCALING THE NETWORK Historically, financial innovations have been adopted slowly. Credit cards in the developed world, for example, were first introduced in the 1950s, but it wasn’t until the 1980s that credit cards began to reach critical mass. In 30 years, microcredit has extended loans to a mere 200 million people. Mobile money is moving much faster than that, thanks to familiarity with airtime scratch cards and transfer, and has reached 40 million people in seven years (16 million of which are through M-PESA).

[Excerpted from Cash In, Cash Out Kenya: The Role of M-PESA in the Lives of Low-Income People, Cohen, Monique and Stuart, Guy, Financial Services Assessment, July 2011] ******ebook converter DEMO Watermarks******* ******ebook converter DEMO Watermarks******* ACKNOWLEDGEMENTS This book was made possible by a generous grant from The Rockefeller Foundation, initiated by Wiebe Boer in 2010 when he was director of the foundation’s office in Nairobi, Kenya. The primary mandate was to write a “journalistic, narrative-driven story” about the birth and development of MPESA, and to chart its “seismic impact on the lives of ordinary Kenyan people.” A secondary mandate was to show how “the ubiquity of mobile allows the potential for financial innovation in developing countries, especially among those at the base of the pyramid.” The grant was to the GSMA Development Fund (the global mobile phone association). Chris Locke, director of the Development Fund, administered and split the grant between the two authors. The authors’ research and writing was accelerated by matching Bellagio Fellowships from The Rockefeller Foundation, which allowed us to work together for a month at the Foundation’s Bellagio Center (Villa Serbelloni) in Bellagio, Italy, a (quasi) midpoint meeting spot between Nairobi and Boston.


pages: 296 words: 87,299

Portfolios of the poor: how the world's poor live on $2 a day by Daryl Collins, Jonathan Morduch, Stuart Rutherford

Cass Sunstein, clean water, failed state, financial innovation, financial intermediation, income per capita, informal economy, job automation, M-Pesa, mental accounting, microcredit, moral hazard, profit motive, purchasing power parity, RAND corporation, randomized controlled trial, The Fortune at the Bottom of the Pyramid, transaction costs

Both involve steady, incremental pay-ins—saving week after week in small amounts, say, or paying back loans week after week in small amounts. The same is true of the way that common informal devices are designed, like the local savings and credit clubs described below—and, indeed, it is similar to the way that many richer people pay for insurance or contribute to pensions. It is one of the features that microcredit pioneers adapted to form new financial innovations. We pay attention to this and other special features of the devices and strategies used by the diary households. We focus first on the borrowing side (the “accelerators”) and then turn to the various savings devices (the “accumulators”). In both their borrowing and their lending, households have discovered ways to deal with the economic, psychological, and social forces that make the job of amassing large sums of money so difficult. accelerators We started this chapter with the idea that large sums are formed by patching together resources—putting luck, skill, and assets together to amass a needed lump.

In Bangladesh the purpose of microfinance has always been seen as the eradication of poverty, and its microfinance providers remain focused on the poor. They have shown an astonishing capacity to develop products and take them quickly to scale. That combination—a focus on poverty plus the capacity to scale up quickly—should enable them to exploit new ideas and technologies that can improve quality and build on the foundations laid by Grameen II, again providing a model of financial innovation from which the rest of the world can learn. 173 Chapter Seven BETTER PORTFOLIOS N ot having enough money is only one part of what it is to be poor. Households like those who feature in our diaries face many challenges of poverty that go beyond the lack of money. They may face discrimination because of their ethnicity or class, find that their legal rights are poorly enforced, or have to struggle with low-quality public services and low skill levels.

See World Bank 2008, chap. 1. 3. Foreign investment in microfinance, for example, more than tripled between 2004 and 2006, to $4 billion. See Reille and Forester 2008. 4. For a review of early experiences with branchless banking, see Ivatury and Mas 2008. 5. New field research adapts methods from medical research, particularly the use of randomized controlled trials, to test the value and logic of financial innovations. Recently, the Financial Access Initiative, a consortium of researchers at New York University, Yale, Harvard, and Innovations for Poverty Action, has been formed to extend field trials in Latin America, Africa, and Asia. Working with microfinance providers, researchers are investigating, for example, how sensitive borrowers are to changes in interest rates, the value of structured savings devices, and the impact of business training alongside credit.


pages: 371 words: 98,534

Red Flags: Why Xi's China Is in Jeopardy by George Magnus

3D printing, 9 dash line, Admiral Zheng, Asian financial crisis, autonomous vehicles, balance sheet recession, banking crisis, Bretton Woods, BRICs, British Empire, business process, capital controls, carbon footprint, Carmen Reinhart, cloud computing, colonial exploitation, corporate governance, crony capitalism, currency manipulation / currency intervention, currency peg, demographic dividend, demographic transition, Deng Xiaoping, Doha Development Round, Donald Trump, financial deregulation, financial innovation, financial repression, fixed income, floating exchange rates, full employment, Gini coefficient, global reserve currency, high net worth, hiring and firing, Hyman Minsky, income inequality, industrial robot, Internet of things, invention of movable type, Joseph Schumpeter, Kenneth Rogoff, Kickstarter, labour market flexibility, labour mobility, land reform, Malacca Straits, means of production, megacity, money market fund, moral hazard, non-tariff barriers, Northern Rock, offshore financial centre, old age dependency ratio, open economy, peer-to-peer lending, pension reform, price mechanism, purchasing power parity, regulatory arbitrage, rent-seeking, reserve currency, rising living standards, risk tolerance, smart cities, South China Sea, sovereign wealth fund, special drawing rights, special economic zone, speech recognition, The Wealth of Nations by Adam Smith, total factor productivity, trade route, urban planning, Washington Consensus, women in the workforce, working-age population, zero-sum game

Nevertheless, in general the liberalisation of China’s financial markets has helped to spawn innovation, greater inter-connectedness between institutions, and more sophisticated financial products. These changes are widely viewed as a positive to the extent that they lower transaction and financing costs, enhance the flow of credit, and strengthen the process of intermediation, or transference of deposits into productive use. On the other hand, we also know that financial innovation has often been the harbinger of instability, and of complex challenges for the regulatory authorities. China is witnessing both the positive and negative aspects of such innovation. Between 2015 and 2017, the central bank and regulatory authorities had to deal with a stock-market crash, exchange-rate instability, currency-reserve depletion and capital flight, and then they had to backtrack on many of the liberalisation initiatives as they proceeded to implement a regulatory crackdown in 2017.

They and regular banks engage in transactions in the shadow banking markets which are often ‘off-balance-sheet’, that is, they are not recorded on the formal statement of assets and liabilities, where they would be subject to conventional capital adequacy and liquidity regulations, and they can be hidden away from the eyes of regulatory agencies. While it is certainly true that shadow banking can be an agent of financial innovation and economic growth, our experience of the financial crisis has taught us to fear its other capacity, which is as an agent of systemic instability and financial and economic crisis. The biggest shadow banks are trust banks, which were once local investment funds set up by provincial governments, and which became very active after the stimulus programme was announced in 2008. The shadow finance system, though, is a ‘market’ in which all banks, asset managers, hedge funds and insurance companies come together to lend and borrow in cash, derivatives and complex financial products, along with companies specialising in securities, interbank and market trading, broking, financial leasing, microfinance, and pawn shops, peer-to-peer and underground lenders.

(i) Butterfield and Swire Group (i) C929 (i) Cairncross, Sir Alec (i) Calcutta (i) Calomiris, Charles (i) Cambodia (i), (ii), (iii), (iv) Cameroon (i) Canada Chinese investment (i) immigration rates and WAP (i) TPP (i), (ii) US steel imports (i) Canton (i) Canyon Bridge Capital Partners (i) capital, movement of Asian crisis (i), (ii) insecurity manifested (i) problems with (i) reasons for and control of (i) Shanghai free trade zone (i) vigilance and restrictions (i) Caribbean (i) cars (i), (ii) Carter, Jimmy (i) Caucasus Mountains (i) Census Bureau (US) (i) Central Asia (i), (ii), (iii) central bank (i) see also banks Central Commission for Discipline Inspection (i), (ii), (iii) Central Military Commission (i), (ii), (iii) centralisation (i), (ii) ‘century of humiliation’ (i), (ii), (iii), (iv) CFIUS (Committee on Foreign Investment in the United States) (i) Chamber of Commerce (US) (i) Chengdu (i) Chiang Kai-shek (i) children (i) Chile (i), (ii) China (under Xi Jinping) economic contradictions (i) international relations divergence (i) politics back in command (i) Socialism with Chinese Characteristics for a new Era (i) technology divergence from the West (i) ‘China 2030’ (World Bank and Chinese State Council) (i) China Banking Regulatory Commission (CBRC) created (i) merger (i), (ii) national financial security campaign (i) new rules issued (i) WMPs (i) China Construction Bank (i), (ii), (iii) China Development Bank (i), (ii) China Development Forum (i) ‘China Financial Markets: A US Retreat on Global Trade Will Not Lead to a Shift in Power’ (Michael Pettis) (i) n12 China Foreign Exchange Trade System (i) China–Hong Kong Bond Connect Scheme (i) China Household Finance Survey (i) China Insurance Regulatory Commission (i), (ii), (iii), (iv) China Investment Corporation (i), (ii) n7 China Labour Bulletin (i) China Minsheng Bank (i) China Mobile (i) China–Pakistan Economic Corridor (i), (ii), (iii) China Railway Group (i) China Securities Regulatory Commission chief of dismissed (i) corporate governance guidance by (i) created (i) local government financing and (i) national financial security campaign (i) new rules issued (i) permission to use homes as security (i) stock market crash (i) China Telecom (i) China Unicom (i) ChinaChem (i) Chinalco (i) Chinese Academy of Social Sciences (i) Chinese Dream (i), (ii), (iii), (iv) Chinese People’s Political Consultative Conference (i) Chongqing (i), (ii), (iii), (iv) Christchurch (Dorset) (i) Christians (i), (ii), (iii) Cirque du Soleil (i) Cisco (i) Clinton, Bill (i) Clinton, Hillary (i) cloud, the (i), (ii), (iii) Club Med (i) CNR (i) Coalbrookdale (Shropshire) (i) colonialism (i) Columbus, Christopher (i) Comac C919 (i) Commerce, Department of (i), (ii), (iii) Commercial Bank of China (i) Communist Party see also Party Congresses in numerical order at head of index Belt and Road Initiative promises (i) Cultural Revolution’s effect (i) Deng’s commitment to (i) Department of Propaganda (i) destructive policy under Mao (i) embryo of (i) founding members (i) grip on power (i), (ii) legitimacy of (i), (ii), (iii) primacy of (i) movement towards (i) social and economic model of (i) SOEs and (i) state control, maintenance of (i) usurping machinery of government (i) vested interest opposed to reform (i) Xi and: anti-corruption campaigns (i); centralisation of power (i); National Financial Work Conference (i); position as head of (i); power derived from (i); socialism Chinese style (i); Xi reboots (i) Comprehensive and Progressive Agreement for Trans-Pacific Partnership (i), (ii) Comprehensive Economic Dialogue (i), (ii) Conference Board (i) Confucius (i), (ii), (iii), (iv) Congress (US) (i) Connaught Street (Hong Kong) (i) constitution (i) consumption trends (i), (ii) cooperatives (i) Corporation Law (1993) (i) Corruption Perception Index (i) see also anti-corruption campaigns credit gaps (i) credit intensity (i) CSR (i) Cultural Revolution cause of instability and suffering (i) macroeconomic effects (i) Mao’s legacy (i) Western mission following (i) Xi and (i) currencies (i), (ii), (iii), (iv) see also Renminbi currency reserves (i) current accounts (i) Czech Republic (i) Dalai Lama (i) Dalian (i), (ii) Dalian Wanda (i), (ii) data protection (i) Davos (i), (ii), (iii), (iv) de Gaulle, Charles (i) debt and finance (i) see also banks; shadow banks bad debt (i) bank assets and liabilities (i), (ii) debt crisis (i) debt trap (i), (ii) efficiency of investment (i), (ii) GDP and debt (i) government debt (i) growth and size of debt (i), (ii), (iii) household debt (i) LGFVs (i) systemic risk (i) ‘Decision on Major Issues Concerning Comprehensively Deepening Reforms, The’ (18th Congress of the Central Committee) (i) Democratic Republic of Congo (i) demographics age-related spending (i) demographic dividends (i), (ii) effects of one-child policy abandonment (i) fertility and one-child policy (i) labour force trends (i) macroeconomic essence of ageing (i) Dempsey, Martin (i) Deng Xiaoping cat quotation (i) commitment to Communist Party (i) Cultural Revolution comment (i) economic reforms (i), (ii), (iii), (iv) enrichment under (i) inspirational but ageing (i) ‘last action’ of (i) low profile for China (i) market-based systems (i) Party and state (i) ‘Reform and Opening Up’ (i), (ii) Southern Tour (i), (ii), (iii) Xi, Mao and (i) Denmark (i), (ii) Design of Trade Agreements Database (i) Deutsche Bank (i) Deutschmark (i) Development Research Center (State Council) (i), (ii) Diamer-Bhasha dam (i) Diaoyu islands (i), (ii), (iii) dim sum bonds (i) disease (i) Djibouti (i), (ii), (iii), (iv) Document 9 (2013) (i) Doha round (i) Duterte, Rodrigo (i) East Africa (i) see also Africa East China Sea (i), (ii) East India Company (i) East Wind Train (i) eastern Europe (i), (ii) economic freedom (i) economic traps (i), (ii) education (i), (ii), (iii) EEC (i) see also European Union Egypt (i) energy (i) Enlightenment, the (i) environment, the (i) Environmental Protection, Ministry of (i) Equatorial Guinea (i) Ericsson (i) ‘Essay on Universal History, The Manners and Spirit of Nations, An’ (Voltaire) (i) Estonia (i) Ethiopia (i) Euro (i) Europe (i), (ii) see also European Union; individual countries; West, the European Central Bank (i) European Commission (i) European Union Chinese investment (i) currencies (i) data protection regulation (i) frictions and insecurities (i), (ii) MES (i) pensions and healthcare spending (i) renewable energy comparison (i) TTIP (i) Eurozone (i) exchange rates (i), (ii), (iii) Export–Import Bank of China (i), (ii) exports (i), (ii) external surpluses (i) Facebook (i) failures, banks (i) family structures (i) Federal Reserve (i) Fenby, Jonathan (i) fertility rates (i), (ii), (iii) Finance Ministry (i), (ii) financial innovation (i) financial policy (i) financial stability (i) Finland (i) First Five-Year Plan (1953–57) (i) First Opium War (i), (ii), (iii) First World War (i), (ii), (iii) fiscal control (i) Fists of Righteous Harmony (i) Five-Year Plans see 1st Five-Year Plan; 13th Five-Year Plan Florida (i) Foochow (i), (ii) Ford, Henry (i) Foreign Affairs, Ministry of (i), (ii) foreign trade and investment (i) investment tensions (i) standing up for globalisation (i) TPP and US withdrawal (i) trade tensions with US (i) Forsea Life Insurance (i) Fort Meyers, Florida (i) Fosun International (i), (ii) four economic traps (i), (ii) Four Seasons Hotel (Hong Kong) (i) Foxconn (i) Fragile by Design (Charles Calomiris and Stephen Haber) (i) France Boxer Rebellion (i) early attempts in China (i), (ii) falling fertility (i) immigration rates (i) Qing dynasty and (i) treaty ports controlled by (i) Frankfurt (i) Fraser Institute (i) Free and Open Indo-Pacific Strategy (i) free trade agreements (FTAs) (i) Freedom House (i) freight trains (i) see also high-speed rail; transport Friedman, Milton (i) FTZs (free trade zones) (i) Fu Chengyu (i) Fujian (i), (ii), (iii) Fuzhou (i) see also Foochow G20 (i) Gate of Heavenly Peace (i) Gateway terminal (London) (i) GATT (General Agreement on Trade and Tariffs) (i) GDP 1st century to 18th century (i) 19th century (i) 2017 (i) assets and liabilities (i) bank assets and (i) budgetary revenues (i) changes in production (i) consumption share (i) credit growth and (i) credit intensity of (i) data bias (i) debt (i), (ii), (iii) economic stimulus package (i) education spending (i) Eurasia (i) exports and imports (i) external surpluses (i) government revenues (i) growth of financial assets (i) industrial investment share (i) investment rate (i) local government and (i) pensions and health care (i), (ii) problem with targeting (i) productivity increases (i) public sector debt (i) real estate (i) research and development (i) residential housing investment (i) service sector (i) shadow sector (i) SOEs (i) stimulus package (i) trade surplus (i) TVEs share (i) General Data Protection Regulation (EU) (i) General Motors (i) geo-economics (i) geography (i) Geography of Peace, The (Nicholas John Spykman) (i) George III, King (i) Germany Boxer Rebellion (i) claims and spheres of influence (i) control of treaty port (i) Deutschmark (i) research and development (i) robots (i) Gewirtz, Julian (i), (ii) n16 Gilgit-Baltistan (i) Gill, Indermit (i) Gini coefficients (i) Global Innovation Index (i) global leadership (i) global reserves (i) Global Trade Alert (i) globalisation (i), (ii), (iii), (iv) Goldman Sachs (i) Google (i) governance (i), (ii), (iii) ‘Governance Indicators’ (World Bank) (i) government departments see under name of department GPs (medical general practitioners) (i) GPT (general purpose technology) (i), (ii) Grand Canal (i), (ii) Grand Chip GmbH (i) Great Divergence (i) Great Divergence, The: China, Europe and the Making of the Modern World Economy (Kenneth Pomeranz) (i) Great Leap Forward (i), (ii), (iii), (iv) Great Wall of China (i) Greece (i), (ii), (iii), (iv) Green, Michael (i) Groningen Growth and Development Centre (i) growth (i) see also GDP Guangdong (i), (ii), (iii) Guangxi (i) Guangzhou free trade zone (i) growing importance of (i) real estate prices (i) SOEs in (i) Sun Zhigang (i) treaty ports (i) ‘Guidelines on AI Basic Research Urgent Management Projects’ (National Natural Science Foundation) (i) ‘Guiding Opinions of the Central Committee of the Communist Party of China and the State Council on Deepening State-Owned Enterprise Reform’ (i) Guizhou-Cloud Big Data (i) Guo Shuqing (i), (ii) Gutenberg, Johannes (i) Gwadar (i), (ii) Haber, Stephen (i) Hague, The (i) Hambantota (i) healthcare (i) Hebei province (i), (ii), (iii) Hewlett Packard (i) high-speed rail (i) see also freight trains; transport Hilton Hotels (i) Himalayas (i) HNA (i), (ii) Holland (i) Hong Kong ageing population (i) Asian Tiger economies (i) development of Western technology by (i) exports and insurance (i) fertility rates (i) handover anniversary (i) high growth maintained (i) importance of British era (i) middle- to high-income (i) Mutual Fund Connect (i) Renminbi bonds (i) separatism issue (i), (ii) Shanghai and China Hong Kong Bond Connect Schemes (i) Shanghai stock market and (i) trade with China (i) Treat