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Financial Innovation

Financial Innovation: Too Much or Too Little?

edited by Michael Haliassos
Copyright Date: 2013
Published by: MIT Press
Pages: 280
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  • Book Info
    Financial Innovation
    Book Description:

    In assigning blame for the recent economic crisis, many have pointed to the proliferation of new, complex financial products--mortgage securitization in particular--as being at the heart of the meltdown. The prominent economists from academia, policy institutions, and financial practice who contribute to this book, however, take a more nuanced view of financial innovation. They argue that it was not too much innovation but too little innovation--and the lack of balance between debt-related products and asset-related products--that lies behind the crisis. Prevention of future financial crises, then, will be aided by a regulatory and legal framework that fosters the informed use of financial innovation and its positive effects on the economy rather than quashing it entirely. The book, which includes two contributions from Robert Shiller as well as a discussion of Shiller's "MacroMarkets" tool, considers the key ingredients of financial innovation from both academia and industry; the positive potential but also the risks of financial innovation and the influence of producers on consumers; rationality- and behavioral-based viewpoints on the causes of the recent crisis; the link between the cycle of financial innovation and financial crisis; and how future innovation-linked crises might be avoided.

    eISBN: 978-0-262-30549-5
    Subjects: Economics, Finance

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-vi)
  3. Financial Innovation and Economic Crisis: An Introduction
    (pp. vii-xxii)
    Michael Haliassos

    This collective volume is about financial innovation, its history, and its potential to cause or to prevent financial crises. It conveys the message that financial innovation is typically not inherently beneficial or harmful but derives its qualities from the uses to which it is put. Contrary to often voiced opinions, the book promotes the view that it was too little and too unbalanced rather than too much financial innovation that lay behind the global financial crisis that began in 2007. Correspondingly, preventing future financial crises neither requires nor is assisted by regulation that stifles financial innovation but is aided by...


    • 1 Inventors in Finance: An Impressionistic History of the People Who Have Made Risk Management Work
      (pp. 3-14)
      Robert J. Shiller

      It may seem inopportune to talk about the creations of finance at the present time. After the biggest financial crisis since the Great Depression, which started in 2007 with the subprime crisis, was worsened after 2010 with the European sovereign debt crisis, and is still smoldering today, there is great anger and disappointment in our financial institutions. But I think we must keep to a larger perspective so that we can understand that our financial institutions are ultimately the support of our entire economy today, and of the many great things that are happening. This financial crisis might even be...

    • 2 Psychology and the Financial Crisis of 2007–2008
      (pp. 15-28)
      Nicholas C. Barberis

      The field of behavioral finance investigates whether certain financial phenomena are the result of less than fully rational behavior on the part of some agents in the economy. For guidance onhowpeople deviate from full rationality, it advocates a close reading of research in psychology. The field has focused, with some success, on three areas of application: the pricing of financial assets, the portfolio choice and trading decisions of investors, and the behavior of firm managers.

      Can behavioral finance offer a useful perspective on the financial crisis of 2007–2008? In particular, can ideas from psychology help us make...

    • 3 Understanding Inflation-Indexed Bond Markets
      (pp. 29-70)
      John Y. Campbell, Robert J. Shiller and Luis M. Viceira

      In recent years, government-issued inflation-indexed bonds have become available in a number of countries and have provided a fundamentally new instrument for use in retirement saving. Because expected inflation varies over time, conventional, nonindexed (nominal) Treasury bonds are not safe in real terms, and because short-term real interest rates vary over time, Treasury bills are not safe assets for long-term investors. Inflation-indexed bonds fill this gap by offering a truly riskless long-term investment (Campbell and Shiller 1997; Campbell and Viceira 2001, 2002; Brennan and Xia 2002; Campbell, Chan, and Viceira 2003; Wachter 2003).

      The UK government first issued inflation-indexed bonds...

    • 4 Crisis and Innovation in the Housing Economy: A Tale of Three Markets
      (pp. 71-102)
      Susan J. Smith

      The global financial crisis that emerged between 2006 and 2008 has still to be adequately explained. Most agree that it was triggered by events in the housing economy, and that these in turn were precipitated by a round of financial innovation that failed. The source of the problem is generally located in the loosely regulated integration of housing, mortgage, and financial markets. Analysts refer, in particular, to the indiscriminate securitization of risky home loans; the advent of opaque, mortgage-heavy, collateralized debt obligations; and the failure of credit derivatives to insure overly optimistic investors. A common reaction is to argue that...

    • 5 Style Investing
      (pp. 103-148)
      Nicholas C. Barberis and Andrei Shleifer

      One of the clearest mechanisms of human thought is classification, the grouping of objects into categories based on some similarity among them (Rosch and Lloyd 1978; Wilson and Keil 1999). We group countries into democracies and dictatorships based on features of political systems within each group. We classify occupations as blue collar or white collar based on whether people work primarily with their hands or with their heads. We put foods into categories such as proteins and carbohydrates based on their nutritional characteristics.

      The classification of large numbers of objects into categories is also pervasive in financial markets. When making...

    • 6 MacroMarkets and the Practice of Financial Innovation
      (pp. 149-170)
      Robin Greenwood and Luis M. Viceira

      MacroMarkets LLC was founded in 2001 by Yale University economist Robert J. Shiller and Samuel Masucci III with the aim of opening markets for illiquid assets around the world, with a particular emphasis on residential housing.¹ The founders believed that financial markets lacked risk-sharing products designed for some of consumers’ biggest risks, such as falling housing prices for existing home owners. According to Shiller, every home owner was required to have fire insurance, yet “fires were a big problem hundreds of years ago. Houses were burning down all the time. Now we’ve developed a different problem—the residential housing market...

    • 7 Robert J. Shiller: Innovator in Financial Markets, Winner of the 2009 Deutsche Bank Prize in Financial Economics
      (pp. 171-182)
      Karl E. Case

      I began graduate school at Harvard in the fall of 1971, and I drew Richard Musgrave as an adviser. Richard was born in Königstein, a few miles west of Frankfurt; he was educated at Heidelberg and Munich; and without doubt he should have been awarded the Nobel Prize in Economics before his death in 2007.

      Richard was a member of the Fiscal Policy Seminar at Harvard in the late 1930s and 1940s, run by Alvin Hansen and John Williams. He debated with his contemporaries Paul Samuelson, Seymour Harris, and others the causes of the Great Depression and ways of preventing...


    • 8 Systemic Risk and the Role of Financial Innovation
      (pp. 185-190)
      Otmar Issing

      It is now more than three years since the world was first confronted with a financial crisis of a dimension that has not been seen since 1929. This is common judgment. However, there is disagreement over whether this crisis is even more severe, and whether it is limited to the financial sector or affects the capitalistic market system as a whole.

      Interestingly enough, economics as a science has also suffered in a comparable way. The reputation of economists in general was undermined as they were blamed for not having warned of the situation. The theory of efficient markets in particular...

    • 9 Financial Markets: Productivity, Procyclicality, and Policy
      (pp. 191-212)
      Alexander Popov and Frank R. Smets

      During the decades-long debate on the link between financial markets and the real economy, academics have tended to side either with Joseph Schumpeter’s view of the ability of well-developed financial systems to stimulate economic growth or with Joan Robinson’s observation that “where enterprise leads, finance follows” (Robinson 1952). The experience of the past several decades in emerging as well as industrialized countries has mostly confirmed the first claim, namely, that deeper domestic financial markets improve economic efficiency, lead to better allocation of productive capital, and increase long-term economic growth.² A similar case has been made for international financial integration, which...

    • 10 Financial Innovation: Balancing Private and Public Interests
      (pp. 213-230)
      Josef Ackermann

      In the wake of the recent financial and economic crisis, innovation that led to the development of complex financial instruments has come under heightened scrutiny. Banks and other financial intermediaries have been criticized for developing financial instruments that work to the detriment of financial and economic stability and of society in general. A pointed yet thought-provoking critique in this respect was voiced by Paul Volcker, who stated that the only useful innovation to come out of banking in recent decades was the automated teller machine.¹

      From a general perspective, Volcker’s critique reflects the perception that financial innovation, like every other...

    • 11 Market Efficiency, Rational Expectations, and Financial Innovation
      (pp. 231-244)
      Maria Vassalou

      While the financial crisis that intensified around the time of the Lehman Brothers collapse has dominated discussions in academic, policy, and practitioners’ circles, a by-product of these events has been a rigorous debate over the implications of the crisis for market efficiency, the rationality of investors, and the merits of financial innovation. Since much of the discussion that dominated the media has been against market efficiency and critical of financial innovation, in what follows, I venture to make the case in support of market efficiency and the merits of financial innovation, as well as provide my own views.

      The market...

  6. Contributors
    (pp. 245-246)
  7. Name Index
    (pp. 247-248)
  8. Subject Index
    (pp. 249-252)