Innovations and Limitations
Where financial innovation went wrong, and how to set it right


This is remarkable, because this is the very period in which finance became more democratic. It became much easier and cheaper for individuals and small businesses to get capital. Corporate finance — raising funds through equity (in which the investor buys a piece of a company) or issuing debt (through which an investor lends money to a company and is promised a series of payments) — had existed for centuries, but new ideas and technology meant it became much more important in this period. This made it much cheaper and easier for firms of all sizes to get capital to fund their growth. According to Thomas Philippon of New York University’s Stern School of Business, starting in the 1970s, investment opportunities shifted from large, older firms that used their own cash to young, smaller firms that raised money by issuing debt or equity. He believes this explains most of the growth in the finance industry from the post-war period up until 2000.

Nonetheless, if democratization of finance was good for America, you’d expect it to help more than a handful of talented entrepreneurs. But rising income inequality does not mean America did not benefit from financial innovation. The root of growing income inequality in America goes much deeper than financial innovations; it has more to do with disparities in education. Also, while income stagnated, increased globalization and entrepreneurship provided a broader range of goods to American households at cheaper prices. This was made possible by financial innovations that made trade and international finance less risky and entrepreneurship cheaper.

Innovation is usually associated with rich, sophisticated investors. But a notable aspect of recent financial innovation is how much more accessible financial markets became. Investing in American and foreign companies became easier and safer for the average person because of the availability of mutual and index funds. Before, few people owned stock, and if they did, they usually had shares in five or fewer companies.

Robert Litan of the Brookings Institution and the Kauffman Foundation recently assessed the value of many post-war financial innovations. He argues that many — credit cards, money-market funds, mutual funds, and credit scoring — have been beneficial for the American economy, and not just for people who work in finance. These innovations were instrumental in expanding the average American’s access to credit and capital markets. He also found that private equity and venture-capital markets were extremely important to the growth of the technology sector. Even though many useful financial innovations were not complex products that relied on rocket science, Litan notes, most financial derivatives, such as options, forward contracts, swaps, and even credit-default swaps, have been beneficial to the American economy by making capital cheaper and the market more liquid.

Financial derivatives are the most controversial aspect of financial innovation, because they are less comprehensible to the average person than a straightforward stock or bond. The market for derivatives took off in the early 1970s, when Fischer Black, Myron Scholes, and Robert Merton created and solved the Black-Scholes formula, which is a tractable way to price options. Soon after, Texas Instruments developed a calculator that used this formula to calculate that price in seconds. Derivatives had been traded for centuries before this, but they were priced using arbitrary strategies that differed from investor to investor. The ability to derive a common price made it possible for a vibrant and liquid market of derivatives to evolve. This not only made international trade and investment easier, because investors could hedge currency and foreign-asset risk, it also changed the nature of corporate finance. The derivatives market provided a new set of tools for firms to raise the capital they needed to be globally competitive.

Some have criticized derivatives models for relying on assumptions that are too simple and do not adequately account for very bad outcomes. But since the 1970s, models like Black-Scholes have proven to be quite flexible and robust under a range of different assumptions. Using these models requires knowing how to apply them and what assumptions to make. Using any financial model when investing is like going on a car trip with a road atlas. The map gives you a sense of where you are going and how your destination relates to other major landmarks. But your skill as a driver is still necessary to avoid accidents and unpredictable hazards, or to travel on a new road if your atlas is out of date. The existence of the road atlas means more people are on the road and not driving around aimlessly in circles. But it does not guarantee a perfectly safe journey.

October 3, 2011    |     Volume LXIII, No. 18

Books, Arts & Manners
  • Matthew Continetti reviews Keeping the Republic: Saving America by Trusting Americans, by Mitch Daniels.
  • Claire Berlinski reviews The Bond: Our Kinship with Animals, Our Call to Defend Them, by Wayne Pacelle.
  • Harvey Klehr reviews American Dreamers: How the Left Changed a Nation, by Michael Kazin.
  • Quin Hillyer reviews The Man in the Middle: An Inside Account of Faith and Politics in the George W. Bush Era, by Timothy S. Goeglein.
  • Ross Douthat reviews Contagion.
  • John Derbyshire gears up.
The Long View  .  .  .  .  .  .  .  .  
Athwart  .  .  .  .  .  .  .  .  
Poetry  .  .  .  .  .  .  .  .  
Happy Warrior  .  .  .  .  .  .  .  .  
The Bent Pin  .  .  .  .  .  .  .  .