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Is Financial Innovation Good for the Economy?

Simon Johnson and James Kwak, “Is Financial Innovation Good for the Economy?,” in Josh Lerner and Scott Stern, eds., Innovation Policy and the Economy, NBER Book Series, Volume 12 (University of Chicago Press, 2012), chap. 1.

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Johnson and Kwak (2012) Is Financial Innovation Good for the Economy

Executive Summary

There has been a great deal of financial innovation in recent decades but its social value is unclear. In the run-up to 2008, banks took large amounts of risk relative to the size of the economy. This approach was made possible by and sometimes justified in terms of “innovation.” But it also created a great deal of downside risk for the economy—including widespread job losses and a big increase in the fiscal deficit.

Innovation is among the most powerful forces that shape human society. The improvements in the material standard of living enjoyed by most (though not all) Americans are largely due to innovation. One of the principal arguments for free-market capitalism is that it is the economic system that most encourages innovation, because it allows innovators to capture a significant part of the benefits of their work.

Today, financial innovation stands accused of being complicit in the financial crisis that has created the first global recession in decades. (See, e.g., Johnson and Kwak 2010, 105–9). The very innovations that were celebrated by former Federal Reserve chairman Alan Greenspan earlier this decade—negative-amortization mortgages, collateralized debt obligations (CDOs) and synthetic CDOs, credit default swaps, and so forth—either amplified or caused the crisis, depending on your viewpoint.

However, the conventional wisdom is coalescing around the idea that financial innovation is basically good, but just needs to be watched a little more carefully. As Ben Bernanke said in a speech in May 2007: “We should also always keep in view the enormous economic benefits that flow from a healthy and innovative financial sector. The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it can be most productive. The dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks. When proposing or implementing regulation, we must seek to preserve the benefits of financial innovation even as we address the risks that may accompany that innovation” (Bernanke 2007).

Intellectual conservatives and bankers have mounted a more fervent defense of financial innovation. Niall Ferguson (2009) argued recently, “We need to remember that much financial innovation over the past 30 years was economically beneficial, and not just to the fat cats of Wall Street.”

But where is the evidence?

It may seem obvious that if innovation promotes economic growth, financial innovation must also promote economic growth. But that does not necessarily follow. To understand this, we need to think about what we mean by innovation and how recent—and likely future—financial innovations affect concentration and risk in our financial system.

The benefits of recent financial innovations have frequently been overstated. And to the extent that these innovations have encouraged or facilitated a high degree of leverage among very big institutions—and more devastating spill-overs in the event that a big bank or other highly leveraged firm fails—we need to reassess potential and realized costs and risks.

The Value of Connections in Turbulent Times

Daron Acemoglu, Simon Johnson, Amir Kermani, James Kwak, and Todd Mitton, “The Value of Connections in Turbulent Times: Evidence from the United States,” Journal of Financial Economics 121, no. 2 (August 2016): 368–91.

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November 2015 version: Value of Connections in Turbulent Times (2015-11)

Link to published version (free download, expires on 9/4/2016)

Abstract

The announcement of Timothy Geithner as nominee for Treasury Secretary in November 2008 produced a cumulative abnormal return for financial firms with which he had a prior connection. This return was about 6% after the first full day of trading and about 12% after ten trading days. There were subsequently abnormal negative returns for connected firms when news broke that Geithner’s confirmation might be derailed by tax issues. Personal connections to top executive branch officials can matter greatly even in a country with strong overall institutions, at least during a time of acute financial crisis and heightened policy discretion.

 

Reducing Inequality with a Retrospective Tax on Capital

James Kwak, “Reducing Inequality with a Retrospective Tax on Capital,” Cornell Journal of Law and Public Policy 25, no. 1 (Fall 2015): 191–244

Abstract

Inequality in the developed world is high and growing: in the United States, 1% of the population now owns more than 40% of all wealth. In Capital in the Twenty-First Century, the economist Thomas Piketty argues that inequality is only likely to increase: invested capital tends to grow faster than the economy as a whole, causing wealth to concentrate in a small number of hands and eventually producing a society dominated by inherited fortunes. The solution he proposes, an annual wealth tax, has been reflexively dismissed even by supporters of his overall thesis, and presents a number of practical difficulties. However, a retrospective capital tax — which imposes a tax on the sale of an asset based on its (imputed) historical values — can reduce the rate of return on investments and thereby slow down the growth of wealth inequality. A retrospective capital tax mitigates or avoids the administrative and constitutional problems with a simple annual wealth tax and can reduce the rate of return on capital more effectively than a traditional income tax. This Article proposes a revenue-neutral implementation of a retrospective capital tax in the United States that would apply to only 5% of the population and replace most existing taxes on capital, including the estate tax and the corporate income tax. Despite conventional wisdom, there are reasons to believe that such a tax could be politically feasible even in the United States today.

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Kwak (2015) Reducing Inequality with a Retrospective Tax on Capital

Incentives and Ideology

James Kwak, “Incentives and Ideology,” Harvard Law Review Forum 127, no. 7 (May 2014): 253–58

Abstract

This is a response to Adam Levitin’s article, The Politics of Financial Regulation and the Regulation of Financial Politics: A Review Essay, 127 Harv. L. Rev. 1991 (2014). Levitin discusses various reasons for regulatory capture and highlights several potential solutions that aim to change the political governance of financial regulation. In this response, I highlight the importance of ideology (in this case, the ideology of free financial markets) in producing regulatory outcomes that are good for industry, and therefore the need for solutions that mitigate ideological capture.

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Kwak (2014) Incentives and Ideology

Cultural Capture and the Financial Crisis

James Kwak, “Cultural Capture and the Financial Crisis,” in  Daniel Carpenter and David Moss, eds., Preventing Capture: Special Interest Influence in Legislation, and How To Limit It (Cambridge University Press, 2013)

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Kwak (2013) Cultural Capture and the Financial Crisis (draft)

“Social Insurance,” Risk Spreading, and Redistribution

James Kwak, “‘Social Insurance,’ Risk Spreading, and Redistribution,” in Daniel Schwarcz and Peter Siegelman, eds., Research Handbook in the Law and Economics of Insurance (Edward Elgar, 2015)

Abstract

Social Security, Medicare, unemployment insurance, and a poorly defined group of similar programs are often called “social insurance.” Social insurance is most often thought of as (a) insurance schemes in which workers make payroll tax contributions and receive benefits following certain insured events or (b) government responses to failures in private insurance markets. Both of these conceptualizations, however, fail to accurately describe some of the programs that are generally considered as social insurance. In this paper, I show that these programs have the following property: in the short term, they are clearly redistributive because we know the relevant outcomes and therefore who will make contributions and who will receive benefits; but in the long term (over one’s lifetime), they spread risk because we do not know what outcomes will occur and therefore who will benefit from the insurance they provide. I propose a new conceptualization of social insurance as government interventions in insurance markets that are redistributive in the short term but that, seen from a lifetime perspective, most people would choose to participate in because of their insurance value. At the margins, it is difficult to define the limits of social insurance. At one extreme, government regulation of automobile liability insurance and individual health insurance imposes risk spreading and redistribution that would not occur in a private market; at the other, public assistance programs such as Medicaid have insurance value for people who do not know what income category they will fall in. The definition of social insurance will always be politically contested because there is no clearly correct timeframe to use when evaluating these programs; proponents can frame social insurance as long-term insurance that benefits most participants, while opponents can frame it as naked redistribution from “makers” to “takers,” without either being obviously wrong.

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June 2014 version: Kwak, Social Insurance, Risk Spreading, and Redistribution (2014-06)

Corporate Law Constraints on Political Spending

James Kwak, “Corporate Law Constraints on Political Spending,” North Carolina Banking Institute Journal 18 (2014): 251–95

Abstract

Corporations currently can participate in electoral politics in the United States through various means: affiliated PACs, super PACs, 501(c)(6) organizations like the Chamber of Commerce, 501(c)(4) “social welfare” organizations, and traditional 501(c)(3) charitable organizations. Corporate law, as generally interpreted by the courts, places few constraints on the ability of corporate insiders to engage in politics as they choose. I argue that existing statutes and case law could be interpreted to impose greater constraints on corporate political activity. Political contributions should be reviewed as potential violations of the duty of loyalty whenever they could provide personal benefits to board members and executives (e.g., by making a cut in their individual income tax rates more likely). The simplest standard would be to require that insiders must reasonably believe that political contributions (and “charitable” contributions to organizations that engage in politics) will result in a net benefit to the corporation — not just some arbitrary benefit that could be worth less than the value of the contribution itself. This standard would be more consistent with the rest of corporate law, according to which insiders are not allowed to expend shareholder assets without at least some belief that they are doing so for the good of the corporation.

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Kwak (2013) Corporate Law Constraints on Political Spending