"One word is too often profaned..."
The poet Shelley was of course talking about love!
The word innovation, while undoubtedly more prosaic, could soon be wearing that tag, if we are not careful. The current practice of labeling anything new as an innovation, maybe acceptable literally, but leaves a lot to be desired if we are to capture both the body and soul of the word - not merely something new, but also creating incremental value and welfare for some segment of society.
I have been thinking about this issue for some time now. The trigger was Akerlof and Shiller's excellent book Animal Spirits and Gillian Tett's FT article Lost through destructive creation. Both are truly impressive pieces, but I was uncomfortable with the usage of the word innovation to discuss financial products and practices that had heaped unprecedented ruin on millions of people around the globe. It led me to start a dialogue with some of my academic and corporate collaborators on when is an innovation not an innovation?
Federal Reserve Chairman Ben Bernanke's address in Washington on April 17 on Innovative Financial Services for the Underserved was the nudge we needed to stop discussing and start writing. In his speech, Bernanke admitted that financial innovations can misfire, but appealed for regulation not to prevent innovation. Rather, he recommended, that regulation should ensure that innovations are sufficiently transparent and understandable to allow consumer choice to drive good market outcomes.
Not everything new creates incremental value! So, back to the key question - what characteristics of innovation best capture its literal meaning and its economic soul?
In a single sentence: an innovation is not an innovation, when it produces snake oil! More formally, for an innovation to capture and reflect both its body (literal meaning - new) and soul (economic meaning - incremental value) it needs to pass the following litmus tests.
Is the innovation creating a valued asset?
Credit risk, by definition, is a liability. No amount of packaging and reselling it can convert it into an asset. Furthermore, moving credit risk around in an economic system by selling it and reselling it to a variety of interlinked organizations does not create value; it erodes it.
Is there mutuality of benefits?
But who benefited from the host of credit derivative innovations that are at the center of the current global financial crisis. Not the consumers borrowing, not even the shareholders of the banks doing the lending, only those banks and brokerage institutions that garnered fees at each stage of the slicing, dicing, and lending chain!
Is the process of value creation transparent?
But that was not the case with Enron or the dot-com companies. The innovations in natural gas trading and gas-fired electrical generation systems that allowed Enron to miraculously book ever growing profits were hardly transparent. Valuation systems followed by analysts to forecast and monetize eyeballs in the case of dot-com companies were not transparent either. Nor are innovations, like securitized debt products, that transform mortgages to bonds and allow banks to lend significantly more per unit of capital.
Is the innovation simple to understand?
Simplicity is not part of the vocabulary of financial innovations that have landed us in this mess. These innovations were the result of complex computer-based systems that were imported from elsewhere - usually hard sciences - and designed and operated by statistical decathletes with next to no domain knowledge. Very much like 17-year olds designing CRM systems in their dorm rooms in the valley at the height of the dot-com boom.
Tett is spot on in his assessment when he states that these innovations became so intense that they outran the comprehension of ordinary bankers and regulators. Bernanke too echoes this sentiment when he alluded to complexity and opacity of financial innovations being at the heart of the current financial crisis.
Do claims and puffery totally overshadow substance?
The original developers of credit derivatives wanted us to believe that their creations would promote market completion, or more perfect free markets. Perhaps, but not when they are not traded on the free market! In the case of both Enron and the financial innovations in question, the claims far exceeded the benefits. Far from creating freer markets, they created opaque trading worlds for concentrating risk that few on the outside truly understood.
The word innovation is more than just a label. Greater understanding is required of its essence as a key driver of economic prosperity. Hopefully, this will lead to more discipline in its usage. The word innovation is a merit badge and not every new product or service is worthy of it.
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