Great article! The way I interpret your words is that money is the archtype of hayekian spontaneous order.

Great post Steve. Unfortunately, I think your list of "positive financial innovations" needs paring down.

WRT VC and angel investors, I'm going to have to agree with Yves at Nakedcapitalism - these are more the result of greater and greater wealth concentration than of any tangible innovation.

WRT the democratization of financial information, this is the result of technological innovation, not financial innovation. It is merely one class of information, of many, that have been made more readily available due to the rise of the Internet.

WRT democratization of financial market participation through the rise of discount and internet brokerages, discount brokerages have existed since 1971 when Charles Schwab set up shop, and Internet brokerages are a function of the technological advances mentioned above. Not financial innovation per se.

That leaves us with Exchange Traded Funds. I agree that these are in fact a positive innovation. However, given how long we've had stock exchanges, indexes, and mutual funds, it's kind of sad commentary that it's taken this long to come up with the idea of putting together a fund that buys the components of the index and trading the fund on an exchange as if it were an ordinary stock.

Weather derivatives are possibly a beneficial example of financial innovation (if you're willing to call them innovation). Hard to say if they count.

Speaking of weather derivatives (or currency swaps, etc.):

These are financial instruments typically praised (at least in introductory textbooks) as tools that allow an organization to dampen the impact of external volatility (eg: weather, or exchange rate fluctuations) and thereby smooth out its finances...in exchange for fees (or other forms of "cost") that also constrain the range of possibilities for the absolute return.

One issue I've never seen explicitly raised is whether the widespread use of such "smoothing" tools has the systemic result of excessive rigidity, perhaps to the point of (systemic) rigor mortis.

Let me proffer a parable.

Say that Widgets, Inc., is a midsize european company (ie: large enough to take advantage of "smoothers") that mainly supplies capital equipment to USA-based manufacturers of food equipment used in outdoor amusement parks.

Widgets potentially suffers large amounts of weather and exchange-rate risk:
- if the previous year's weather was particularly unfriendly, widgets' customers' customers are going to have less money to spend on new equipment; they'll try and make do with what they already have
- if the Euro is too pricey, Widgets' goods are uncompetitive; if the Euro is too cheap, Widgets' goods may sell for less than desired

Widgets' CFO can certainly ameliorate those risks with a well-chosen basket of weather derivatives and currency swaps. The protection comes at a cost -- possibly some mix of upfront cash outlay and diminished absolute profitability -- but for Widgets, getting those risks nearly-neutralized is clearly a big win: the company can focus on its core competency (making widgets) without too much intrusion from important -- but not really "relevant" -- outside forces.

At an individual level this is a tradeoff most responsible entities would make: sacrificing some higher-risk, higher-payoff opportunities in exchange for a higher expected outcome is almost the definition of prudence.

At a systemic level, though, I wonder: if everyone and their brother is locking-in a few years' worth of outcomes, how much does that slow down the process of creative destruction?

Does the ability to lock in (at a cost) a future you can foresee today leave you:

(a) unable to pursue a better option you discover tomorrow, b/c you've spent money upfront ensuring an outcome (and thus have inadequate money leftover, or just the cost of modifying your previous arrangement shifts the cost/benefit ratio of the new, better option enough to make it unpalatable)?

(b) unmotivated to seek out better options, b/c "eh, I've got my results locked-in already"?

Would Widgets have been better-off investing its funds in r-and-d, business development, and other, similar, opportunities? Possibly.

Systemically, would the system be net better off if more firms spent more on r-and-d, business development, etc., and less on "smoothing" (even if it meant that some firms got clobbered by "preventable" volatility)? Within certain parameters, I'd find it hard to believe that isn't the case.

"The conventional wisdom that long-term savings ought by default be placed in passive stock funds"

Expand?

talboito — Annuites (as investment products) typically hedge the risk of running out of money before you die, which is an important risk to hedge. But they don't hedge the risk that adverse price changes leave you unable to afford to consume what you had expected to consume in retirement. So annuities (of the simple sort, the complicated ones tend to be schemes for ripping off old people, I think) are a useful savings product, but not a sufficient hedge against a hard retirement.

RTD — Re VC, perhaps they are the result of wealth concentration, but they do permit a wider range of entrepreneurs to get somewhat discriminating financing. I would like to see something like micro-vc, things like prosper.com that raised funds for new ventures in crowdsourced small increments. But for now I'll take what I can get. I think the availability of VC financing outside of friends-and-family based connections is an important and good thing.

I'd agree many of the positive innovations are pretty braindead application of technological change to the financial sphere, but they still count as far as I'm concerned. The financial sphere is enormously resistant to positive technological change — there's a lot more brainless automation and disintermediation that could occur than has occurred, and I say bring it on. In a good world, much of the process of "going public", from accounting and disclosure requirements to underwriting in a community of investor capable of supporting small ventures, would be as automated and simple as the process of incorporation has now become.

Gabriel — wh has it. In my view, saving is about hedging future consumption requirements. You are right that this is impossible to do perfectly, the future is inherently risky, if a comet hits the earth, promised future housing will not be provided. But financial markets offer a wide range of insurance products whereby for a price, a third party assumes the risk of fixed performance. Those obviously need to be carefully designed and regulated, and are. Insurance in general is subject to catastrophic, systemic breakdown, but with the exception of regulatory wormholing AIG, it has proven to be a tractable kind of product. There is no reason why, in theory, I should not be able to contract forward for housing in Florida beginning 20 years hence, or purchase a certain level of food service. It'd require a lot of work to define far-future services generally enough to capture inevitable social and technological change, but specifically enough that people on both sides of the contract can understand and fulfill their roles. But I think it could be done, and if it could, it would represent an incredibly useful innovation. Savers could endow themselves with a basic, predictable and near-certain future living standard (and then take on investment risk as they see fit). A lot more information about future consumption plans would be revealed to the market, leading to more productive patterns of real investment. (Yes, from demographics we can predict a lot about future consumption. But not everything — people's preferences about location, tradeoffs between consumption in housing vs food vs travel etc — are not so predictable, but could be expressed in these markets.)

wh — You can speak for me anytime. The issue re rigidity is interesting, but production hedges can be and usually are purchased over time frames "short" relative to social/technological change, but long relative to a business planning cycle. For example, Southwest hedges (at least until recently!) fuel costs, I'm guessing up to about a year forward. That won't prevent SW from having to adapt to a world with higher fuel prices (if that's what's coming), but it does let SW plan for the next 6 months in an environment of reasonable certainty. In a way, this is a rigidity, since in a perfectly dynamic world, all prices and expectations would update instantaneously. But in reality, that's implausible, business plans have to have a certain degree of rigidity, as do consumer expectations, the real world is sticky. So long as the time-scale of production cost hedges roughly corresponds to the "natural" stickiness if the business planning process (defined by informational limitations, menu costs, hard-to-change expectations, etc.), it seems to me that little is lost and much is gained by permit such hedging. It's certainly imaginable that hedges could be taken to extreme, and permit well-hedged wagon-wheel manufacturers to thrive a century too late, but in practice, I don't see that as likely. Neither producers nor their counterparties are eager to go very far into the future. Developing workable far-future hedges, as we see in the savings case, is hard to do, and firms tends to plan over few-year horizons at most. It could become a problem, that firms become so far-sighted that they lose all dynamism. But so far, we have the opposite problem.

rortybomb — Stock is a risky business, however many times you read "Stocks for the Long Run". Sure most cohorts would have succeeded very well, had they with perfect efficiency ploughed mindlessly into equities, reinvested all dividends, and never lost their nerve or suffered a financial crisis at the same time as stocks were down. In real life, stock market downturns correlate with human crises, people reinvest and dollar-cost average imperfectly, they experience fees, and risks associated with the institutional structure of investing (over much of that "long run", investors weren't protected from broker failure, for example). Further, the practice of mindless passive equity buying itself harms the efficiency with which stock markets perform — I claim that the hegemony of this idea and the overall volatility we've seen since the mid-nineties are not unrelated. Mindless equity investing makes stock overvalued, and overvalued markets eventually fall. In general any strategy that becomes the widespread conventional wisdom is vulnerable, as financial markets are places where civilize people try to take one another's money, and to the degree a large group of people share very similar portfolios and behavioral characteristics, someone will figure out a way to shake the crowd's faith for fun and profit. Individually and in aggregate, safety in markets comes through diversity, and if everyone's in the S&P 500 index fund, that doesn't count as diverse.

BTW, I've nothing against index fund investing. But people should understand it is risky business, they are investing, they are subjecting themselves to very dangerous games of which it is hubris to believe one is totally immune, and they should have strategies for dealing with that. (And if your strategy is the same as everyone else's — "stomach of steel!" — you should ask yourself why your steel stomach should be stronger than everyone else's.) I invest in passive, broad equity funds. But I time, I go short as well as long, and I think I'm not doing what I'm doing just when everyone else is.

Felix — I think your attempt to rehabilitate CDS is a bit disingenuous. Not because you are very wrong now — you may well be right that at this point, the CDS market is nearly universally well collateralized and marked-to-market. But the OTC CDS market was poorly designed from the outset, and at best it has slowly and clunkily evolved from being nightmarishly stupid to almost decent. CDS contracts were designed like insurance contracts for holders of the underlying — remember, initially they were almost never cash-settled — but traded like bets that needed no relationship to the underlying. The ad-hoc cash settlements beginning with Delphi and various IDSA evolutions since have helped, but the recovery on a CDS remains a subject of grave and stupid uncertainty until the day ISDA conducts its auctions. If these were insurance contracts, they should have been sold only to those with insurable interest, and regulated like insurance contracts. If they were general instruments for speculating and hedging on credit risk, great!, I have no problem with such instruments, but they should have been designed to behave in a predictable manner.

You also give the CDS market far too easy a pass re credit risk. Yes, at this moment, after Bear and Lehman and a zillion hedge fund implosions, the sprawling network of CDS contracts outstanding may in large be carefully managed to mitifgate counterparty risk. But even now we have no way to know that, other than to take peoples' word, and I would bet you that two years ago, when the only significant default had been Delphi and the Great Moderation was humming along, that was not the case. If Lehman turns out to have been a non-event, it's because a lot of trauma occurred prior to a very major default. If the default had been a sudden storm, if it had been Act I rather than Act III of the crisis, do you think the ripples would have been so placidly absorbed? I don't. Now it is probably right to say AIG is the exception that proves the rule, but two years ago, the exceptions may well have ruled.

Even if I'm wrong, the opacity leaves open the possibility that I'm right, and that creates terrible and unnecessary uncertainty. Do you think Bear would have had to be saved without the CDS market? There is no good reason why we should not know that credit derivatives are well-collateralized with losses fully taken daily.

I do think credit derivatives could belong to the "good innovations" column. But until counterparty risk, and uncertainty about counterparty risk are managed, and until the cashflows associated with the contracts are better defined ex ante, CDS will remain in my "bad" column. I hope we do see better credit derivatives going forward.

Re: long-term savings, the main thing is that there is no right answer. If everyone is doing the same thing, no one can ever be safe. Ideally we would have such a diverse array of personalizable savings instruments (claims in housing in every city, on a wide variety of food contracts, etc) that people would make diverse choices suitable to their preferences. But we don't live in that world yet, so savers who do not want to be investors have to do the best they can. TIPS are a decent option, though they involve the risk that ones own consumption and published CPI don't correlate well over time. Treasuries (or FDIC-insured CDs) are decent, but involve price-stability risk. Indexed equities offer higher expected return, thereby hedging some price stability risk, but a lot of volatility risk, and volatility risk that is likely to be timed against large retirement demographics. Annuities hedge the risk of outliving ones wealth. Long-term care insurance hedges the risk of poverty during chronic illness. All of these are savings vehicles that hedge some risks but leave one exposed to others. Savers should try to define portfolios based not upon expectations about the future market, but based on evaluations of their own risks and how best those risks might be hedges. We collectively should make it easier for people to do this by, yes, innovating. But given the array of savings products that already exists, there are many better, safer, and less predictable strategies than just going all-in with equities and hoping for the best.

Beyond a certain level of wealth, I think it is foolish not to become an investor. That is, I think even modestly wealthy people should develop opinions and bear risk by say, timed purchases and sales of equity. But if what you are doing is saving, if you want to take your current wealth forward while minimizing risk as best you can, investing in equities regardless of their price is simply not a reasonable vehicle. At best, you are gambling on the luck of your cohort. Personally, you are taking on risks that are easily underestimated. Collectively, you are contributing to the mispricing of capital and harming the broad economy.

One problem I see with future-consumption financial products is that they can hardly be less risky than private defined-benefit pension plans, which many workers (often via their union contracts) invested in and are now finding to be under-funded and unable to pay the benefits promised. Some of these plans in fact had a "future consumption" health=care component, which is of course now being eviscerated. I think that even before we try to figure out how to build innovative future-consumption financial products we have to analyze what went wrong with the private defined benefit pension plans we already have, and fix that.

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"Our current system does not serve savers well, because our markets offer inadequate ways of purchasing claims on future consumption"

Something to add to your list of good innovations: Indexed linked bonds (see http://en.wikipedia.org/wiki/Inflation-indexed_bond). Coupon and capital payments are linked to a price inflation index, allowing pension funds (and hence individuals) to effectively hedge indexed-linked liabilities. Without such instruments it is very difficult for financial institutions to offer inflation-linked products (as opposed to production-linked products).

This is the best thing I've read on the financial crisis so far. Simple, obvious.