Monday, March 9, 2009

What is innovation?

While The Economist assesses financial innovation, it may be useful to ask what exactly is innovation?
1. Tang
2. Hot pockets
3. Aeron chair

These can all be considered innovations but how much do they represent progress? Likewise, can all financial innovation be equated with progress? The traditional economics argument would be to let the markets decide. Assuming rationality useful innovations would die or survive based on the public's desire for them. But what if markets are given to bouts of irrationality as evidenced by a bubble in Beanie Babies?

Another feature that some economists would consider being intrinsic to innovation is spillovers (both positive and negative). None of the above cited innovations appear to have spillover effects. Yet the economic concept of positive spillovers is nebulous. It is often asserted rather than proven. (Negative spillovers on the other hand can often be shown, e.g. pollution.) In the macroeconomics literature a spillover is an aggregate technology parameter that leads to increasing returns to scale. In other economic disciplines, a spillover effect is a change in one industry or sector that leads to progress in another sector. An often cited example is the positive spillovers from education - for example, that it leads to an educated populace that can vote in a more informed manner (as opposed to uninformed voting).

Are financial "innovations" really progress? Some would argue that by allowing increased leverage, financial innovations should be considered progress since it expands the technological frontier and thus is evidence of spillover effects. Is the market the best method of deciding whether innovations survive or die when there is irrationality in the market? As can be seen by the financial crisis, the bubble in CDS, MBS, and the economy had more of a negative spillover than a bubble in the Beanie Baby market.

Finally, an analogy albeit imperfect. Innovations in cars have made driving safer. This increases moral hazard - I can drive faster to get to where I want to go quicker. This is a positive externality since I can get more done in a day. But speeding increases the overall risks in the economy. Thus, speed is regulated. Likewise, financial innovations lead to moral hazard in that it allows me to take more risk without considering the rise in overall risks for everyone else.

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