Felix Salmon has been at the center of a discussion on the merits and value-add of financial innovation. He notes:
Then there's the more purely financial innovation. There are good things here too -- fractional reserve banking, factoring, common-stock limited-liability companies, tradable fungible bonds, stock-market index funds, that sort of thing. But on this front I think the low-hanging fruit was plucked decades if not centuries ago, and that we've long since entered a world of diminishing returns when it comes to the positive developments. Meanwhile, the negative developments, from portfolio insurance to CDO-squareds, have been arriving at an ever-accelerating pace.
When intermediation related operations go north of 1/3 of your economy something is out of whack. In Knowledge and the Wealth of Nations David Warsh points out that economists have had great difficulties in explaining economic growth and rising productivity from the beginning of the profession with Adam Smith. Innovation is an exogenous parameter outside of their models. Societies such as the Syracuse of Archimedes or Song China may have had the engines of technological innovation ready to go, that critical bridge between science and engineering, but the cultural matrix was not going to facilitate any mass revolution catalyzed by gains from productivity due to technology. Utopia in the pre-modern age was egalitarian primary production, not mass affluence and endless horizons of innovation and increased material wealth. Double-entry bookkeeping, the printing press and a shift toward rule of law and representative government may have allowed for technologically driven economic lift-off which reshaped our perceptions of the possible, and generated a virtuous feedback loop. It seems though today that the legal, financial and institutional scaffolding around the engine of technological innovation is possibly growing so thickly that we are in jeopardy of reverting back to the state of pre-modern economic stasis.
Addendum: Also, it seems to me that most contemporary financial "innovation" is actually just trying to extract more juice out of the orange; gains of efficiency, as opposed to ground-breaking game changers (such as double-entry bookkeeping or the joint-stock corporation). At some point when there's no juice to be extracted you're going to just end up redistributing the juice to the benefit of the "innovators," if you know what I mean....
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"the cultural matrix was not going to facilitate any mass revolution catalyzed by gains from productivity due to technology"
still true today, alas. My story also includes anger spurring innovation.
I and my buddy got angry at the appalling state of the User Interfaces and utility of MIDI networking devices, back in the late 1980's. After many months of consoling ourselves with the idea that "They" must be doing something about it, we realized there was no "They" there, and it was up to us. So we set about the rather complex task of solving that particular problem, and solve it we did, quite nicely if I say so myself. Nice enough to be nominated for an AES Tech Award. We thought our meat-and-potatoes market would be the professional rental music studio, because our product made it so much easier to manage a large and complex studio setup with multiple performers. Did they bite? Not on your nellie! Apparently, they charge by the hour and did not see any advantage in cutting back on the billable hours. Oh, there were a few notable sales, like INXS, ELP, several movie score writers, but they exist only on the tiny little pointy tip of that marketing pyramid, and there are only a couple of hundred of them.
The irony? Even today, those pros who see our work rave about it, and what is out there on the market is still essentially as crippled and as crippling as it was in 1989.
So if somebody comes to you with a proposal for some incredible new technology, and a marketing plan that is essentially "build it and they will come", smile at them, say "we'll call you", and slip quietly away. As Bill and IBM demonstrated, it's the 80% solution that garners the big bucks. The last 20% has an uphill fight all the way.
Gary's story points out a quite valuable point. Real-world markets very often do not actually incentivize actual productivity. Financial markets doubly so, since the "market" is dominated by middle-men with actual producers and consumers (of capital) almost as an afterthought.
The LLC (and it's kin) are a pet peeve of mine. When the LLC was first invented, it was restricted to cases where it was in the interest of the sovereign to facilitate some very large nominally private endeavor. Stuff like founding colonies and world spanning trade "tea" companies.
An LLC provides legal status and protection of owners which are really exceptional, and only make sense for the state to grant in exceptional cases where the payoff to society at large is worth it.
A huge amount of financial instability would be smoothed out if governments actually started requiring real justification before granting incorporated status. That is to say nothing of tamping down the rampant legal and moral (amoral) shenanigans which corporations routinely engage in due to their perverse incentives and lack of liability for owners.
Talking about "perverse incentives", I think it might be interesting to peruse a few of same. What follows is a bit of a rambling rant, but the way the economic system is set up just plain bothers me.
The "Bottom Line" and Executive Fiscal Responsibility.
Right here we have a major disconnect between the common good for society and the bank accounts of the members of the Board of Directors.
Forcing Factor #1: All actions directed by the Executive Team or any member thereof must be taken in good faith that it will increase, or at least not reduce, the share price of the company. If the price drops as a result and good faith can not be plainly demonstrated, the culprits are open to legal action by the shareholders and the loss of their job. At least. The "Good Faith" bit is a major loophole in itself, but in a way that just makes things worse for us. (I've been on a Board of Directors. I've had the legal advice. It all sucks. Wanting to be a "good citizen corporation" is all very well but is probably illegal and is certainly counter to fiscal responsibility.)
Forcing factor #2: Executive pay raises and bonuses, when not automatic like those of AIG etc seem to be, are tied to stock price performance. Note that this may well be very different than sales or profits. It certainly encourages hiding costs.
Category Error #1: Stockholders, as a class, have no relationship to individuals as members of society. What is "good" for a stockholder can be very bad for that same person as a member of society, but only the stockholder entity is considered or protected, and that only insofar as the value of their stock is concerned.
Category Error #2: Waste products are a cost center and the costs are minimized only to the extent required by law (if the law is even enforced). Not to ethical guidelines. Not by minimizing waste. Just cost.
So the min-max computations of the large corporation have no choice but to work against the common good. We have set it up that way.
Two examples:
Retirement plan money is typically invested in big business. Such as strip mining, or Merck, or Shell Oil, or whoever. The logical stockholder is typically a working slob trying to live in the hills where his family have lived for generations. The value of the stock may go up, but he is out of a home and a healthy environment. Business decisions that might go the way of helping the individual are not made because they would typically reduce profits and stock value.
Slurry can be dumped in lakes because the lake is not owned by the company and they have no legal requirement to maintain it. Well, some, but not really. The surrounding environment is typically regarded as a bottomless sink for business purposes. And since it is not costed with the rest of the business, there is no accounting and the true cost to society is falsely reported and charged. Yes, the past 50 years have seen some amount of staggering towards true protection, but as the mountain top destruction currently in progress demonstrates, not really.
The two examples are related to each other, a double whammy. But it happens because the stock price goes up if the costs can be discounted. Yet the real cost to the shareholder as a human being with commons dependencies is - I hypothesize - far higher than the profit that pays his retirement in his guise as a member stockholder.
I am not claiming forces of evil at work, just normal folks working the system to their self-interested advantage. As humans will. The evil, if there is such a thing, is the way the system works.
The Bottom Line has to be enlarged to include the Common Good. Business practices have to change accordingly. And yes, I am the guy with the blue face. I do not expect to see it change much in the remainder of my life.
While on economics, I do not understand what are the incentives for regular army personnel in charge of say classifying veteran benefit eligibility to deny benefits on spurious grounds, seemingly with sympathy and gratitude as foreign concepts? Things like denying stipends or college tuition payments by rotating soldiers out one day short of their vesting period? Who actually makes money off that? Or is it just another one of those optimization for the wrong parameter things again?
Personally, though I have never served in the armed forces (by a fluke of timing), I believe that anyone who signs up, voluntary or draft, is giving We the People the control over their living or dying. And for that we owe those who survive, or their surviving dependents, support for the rest of their life. Include: shelter, food, clothing, medical, education for their children, at a minimum. Enough for a basic standard of living. With no penalties for earning more by working. I'd be happy and proud to pay taxes to support that. But I'm ashamed to see my tax money used to deny benefits, to leave vets on the street (I see them every day in Seattle), to not even consider any post-service support beyond maybe some tuition money and contentious health maintenance. They give us their life, it becomes out responsibility to protect and nurture that life till it ends. That simple. And to not set up the parameters so the legally mandated fiscally responsible optimization is a premature end.
[/rant] and thanks for your indulgence.