I’ve been silent for much on much of the financial innovation debate. I respected the arguments of Mike Konzcal, Felix Salmon and others that financial innovation had been a loser, but I was never fully convinced.
Without some agreed upon standards we have what amounts to a complexity tax financial markets. That’s a tax produced by complexity, not a tax on complexity.
What confused me was the notion that firms could be generating excess profits in what appeared to be a highly competitive market. Yet its not that firms refuse to compete by providing consumers the best products – its that they cannot compete in this way because consumers will naturally gravitate towards products which are bad for them.
That is, if you are offering a product that is just the same as the standard vanilla product but has some hidden tail risk then you can necessarily offer it a lower price. This implies that you will dominate the market until the tail event occurs. Thus consumers will be consistently taking on more risk than they realize.
They could simply recoil from the financial market all together. That is, they understand this sort of market for lemons problem and so they refuse to buy at all. However, the costs of doing this are high. The marginal benefit of financial products can be extremely high. What happens instead is that there is an implicit tax in financial markets because of the lemons problem.
Over time competition of the Lemon’s rent drives an increasing wedge, leading to a reduced number of suppliers, very high profits for existing suppliers and very high risks and increasing social loss.
The key here is that the innovation creates economic rents but its not produced by collusion or even market power. Its better thought of as a tax on consumers that is collected by those able to produce the most opaque products.