The Trouble With Innovation

Preview of 2010 Investment Innovation Conference.

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imagesAs the keynote speaker at this month’s Investment Innovation Conference in Arizona (November 30 – December 2), Ed Kane, professor of finance, Boston College, will be sharing his views on financial innovation and distaff side. In advance of the conference, we asked him to answer questions on how regulation is gamed by financial innovators and how that can be prevented. To find out more about Ed’s presentation and the Investment Innovation Conference, click here.

Q: How does regulation either hinder or enhance the social value of financial innovation?

A: Ideally, government regulation is supposed to promote social value, but incentive conflicts in government interfere with this. The naïve view of innovation is that it is a process in which people looking for profits produce useful services for society and this process generates lasting increases in jobs and consumer welfare.

But there’s a vital distinction to be made. Some innovations are designed mainly either to avoid taxes or to circumvent regulatory burdens. That kind of innovation is potentially harmful if in fact the tax and regulatory burdens being avoided are socially beneficial.

Q: What example can you give of an innovation primarily designed to avoid taxes?

A: Secrecy provided by Swiss banks is a perfect example. The U.S. tax courts are full of cases challenging whether innovators have invented something that lacks any legitimate economic reason except to reduce taxes. There was a famous case in which a Nobel Prize winner, Myron Scholes, invented insurance contracts that the courts ultimately found to lack any larger economic purpose.

Many insurance contracts are designed so that wealth can be accumulated without being taxed. Most loopholes are produced and protected through lobbying. Firms and trade associations lobby for a law that creates a loophole for a product designed to take advantage of the loophole they helped to install. Of course, not all tax-circumventing products are necessarily harmful to society. Some are meant to encourage retirement savings, on the hypothesis that people are inherently myopic and will, without incentives, underprovide for their later years. These subsidies can be socially productive.

But to return to the main point, financial firms are heavily regulated for a good reason and so regulation-induced innovation is a huge governmental problem. It can seriously undermine financial stability. Last year, Forbes magazine rated the top 10 innovations of the last 30 years. It is striking that none of them were examples of financial engineering. Given the range of new financial products invented, I think that is very telling.

Many financial innovations do traditional things in a different way and are to a very large degree regulation-induced. A major problem underlying the current crisis is that such innovations were protected by financial-industry lobbying. Lobbyists exaggerated the existence of size and scope economies. They extolled mega-mergers and the value of liquefying traditional elements of the bank balance sheet. The benefits they painted were greatly exaggerated, but it has always been difficult for regulators to challenge industry claims effectively because of incentive conflicts in government.

Q: How would you describe those incentive conflicts?

A: One of the issues is short horizons. You can readily see this in the Bush Administration. When this crisis started to develop, they could see that the odds of their party’s being returned to office were becoming increasingly slim. Their decisions in the fall of 2008 were made with the probability that in January they would be turning over the mess not only to someone else, but to political adversaries. And so they passed TARP, and other poorly conceived bailout plans, and  left the consequences behind them for their successors to attack.

One of the points I want to make vis-à-vis Canada and the U.S., is that in 1998 the Canadian minister of finance explicitly acknowledged and addressed the dangers of allowing mega-mergers. He turned down two proposed mergers of giant banks. On the other hand, in the U.S., authorities praised the virtues of  the mega- mergers among financial firms. It wasn’t that academic economists like myself failed to explain that these mergers were dangerous to taxpayers. Merging firms became more politically powerful, more complicated and messier for U.S. regulators to deal with.  U.S. economists recognized that every megamerger would increase the safety net benefits that post-merger firms could extract from taxpayers by mispricing risk and assuring  lighter supervision.

Q: How does the financial social safety net come into play and how does it affect intergenerational tax burdens?

A: There are two principal issues in managing the safety net. One is detecting and avoiding insolvency – by forcing loss-making to recapitalize institutions before they become insolvent. The second is to develop and execute a reasonable program for resolving insolvencies that are not detected in time. Within this second set of concerns is the problem of crisis management. Crisis management generates income transfers from low-income to high-income taxpayers as well as some nasty intergenerational effects. What saddens me is the government’s claim that the U.S. has done a great job in resolving its financial problems. The safety net has been expanded substantially and huge uncertainty exists about what the tax structure is going to be going forward. Safety-net growth subsidizes loans to overly risky activities at the expense of safe and sure investments and  on the other side of the market expanding the safety net fosters a reluctance by business and households to invest in safe and sure projects until tax uncertainty is cleared up.

To learn more about the Investment Innovation Conference, visit the events section of the website. If you are interested in attending the event, please email Garth Thomas to be considered, as limited space available.

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