There is no more certain way of being labelled a “Luddite” than to oppose innovation – any sort of innovation. When it comes to financial innovation, I’ll take the risk of being thought of as a reactionary. History, both in the distant past and more recently during the global financial crisis, support my contention that financial innovation can be extremely dangerous.
Back in the eighteenth century, there were two examples of financial innovation—perhaps the first time that novel financial products were offered to the market. In the early years of the eighteenth century, the South Sea Bubble was a means for investors to get a piece of the action from profits from a monopoly of English trade in Latin America. The other example I’d like to cite is the Mississippi Bubble (Banque Royale) in France in which Scot John Law convinced the French to invest in the swamps of Louisiana.
In the early days, the architects of these companies found honest trade hard-going, and they soon started to buy up government debt as a pathway to easy profits. With little idea of how these companies made their money, investors bought up stock with the expectation that it would increase in value. And so it did, as a speculative frenzy drove the share price up to unsustainable levels. In the case of the South Sea Bubble, shares increased over 1000 percent in just nine years.
In 1720, both companies spectacularly collapsed. Fortunes were lost. Even the greatest mind of the age, Isaac Newton, was caught in the speculative bubble. He lost £20,000, which prompted him to remark: “I can calculate the motions of the heavenly bodies, but not the madness of people.”
There are examples of useful financial innovations, such as futures markets which allow farmers to have a guaranteed income from the sale of their produce. However, the majority of these products are mere vehicles for making money (or more likely losing it) through speculation. My favourite example is the bright spark who created “A company for carrying on an undertaking of great advantage, but nobody to know what it is”. Yes, that is what it was called. For a modest outlay of £2, investors were promised £100 per annum. When he opened trade at 10 am, he was confronted by a crowd wanting to buy shares; and when he closed his door at 3 pm he had collected just on £2,000. That same evening he set off for the Continent, never to be seen again in England. At least he proved that for at least one person that the name of his company was not totally deceptive.
To restore confidence in markets and in the value of money, the French and English governments passed legislation that prevented fanciful innovations from wreaking havoc in the future. These laws stood for a little over one hundred years until memories faded and laissez-faire economists, the progenitors of modern neoliberals, successfully prevailed on legislators and allowed them to conjure up a new generation of financial products.
During the 1990s, a new generation of financial instruments appeared – derivatives – with exotic names like Collatorized Debt Obligations, Broad Index Secured Trust Offerings, extinguishable FX swaps, Credit Default Swaps and other exotic-sounding products. Derivatives were supposed to reduce financial risk, but they were really another means of encouraging investors to play the financial casino, as Professor Lynn Stout who lectures on corporate governance and finance at the University of California (Los Angeles), explains.
Derivatives are not really “products” and they are not really “traded.” They are simple bets on the future—nothing less, and nothing more. Just as you might bet on which horse you expect to win a horse race and call your betting ticket your “derivative contract,” you can bet on whether interest rates on bank deposits will rise or fall by entering an interest rate swap contract, or bet on whether a bond issuer will repay its bonds by entering a credit default swap contract.
Their very complexity cannot be understood without the aid of sophisticated mathematical models; and oblivious to their ignorance of what risks lay behind these shiny new products, investors spent billions to get part of the action.
The game for investment banks was to generate trades. As volumes went up, so did their commissions and so the derivatives market generated rivers of gold in which bankers were able to extract outrageous bonuses.
In 2008, we all discovered, just as Isaac Newton did three hundred years earlier, that their complexity served the purpose of fooling investors who thought that they were buying AAA assets, when they were simply speculating. Most derivatives were deliberately complicated in order to gull investors (or should I say speculators) to dive into the deep end. The sub-prime property market underpinned many of these derivatives until it collapsed in 2008, bringing down large parts of the global financial system.
At least in the eighteenth century, legislators took action to deal with the flaws in the marketplace that had allowed naked and destructive speculation. The same has not happened following the most recent global financial crisis. In part two of this post, I will explore how new financial innovations—super-fast computer trading—could trigger another meltdown.