Financial innovation

Financial innovation is defined as "the act of creating and then popularizing new financial instruments, technologies, institutions, markets, processes and business models - including the new application of existing ideas in a different market context" (World Economic Forum, 2012, p. 16).

Merton and Bodie (1995) and Tufano (2003) provide categorizations of financial innovations according to the functions they have been serving, throughout history, in terms of reducing financial markets imperfections such as transaction costs (including asymmetric information), missing markets, and the existence of taxes and regulation. As a result, financial innovations have facilitated trade and provided ways of managing risk. By contrast, the conceptualization of financial innovation presented by heterodox eco- nomics is grounded in the separation between financial and industrial capital (see Niggle, 1986). This separation can be traced back at least to Karl Marx and is germane to the duality of the role of finance, which may be "extraordinarily powerful in mobilising and allocating finance for the purpose of real investment. But, by the same token, it can both trigger and amplify monumental crises" (Fine, 2007, p. 4).

The key thinker about the crucial role played by innovation is Joseph A. Schumpeter, who associated it with the famous expression "creative destruction" (Schumpeter, 1942,

p. 82). Schumpeter kept the separation between industrial and financial capital epito- mized by the entrepreneur and the banker respectively, emphasized the role of bankers in the provision of credit to finance new ventures, but denied that financial innovation can play the role of prime mover in the business cycle (see Leathers and Raines, 2004). However, owing to entrepreneurs' spending for their new ventures, positive expectations of increasing incomes and investment expenditure continue to rise, causing a "secondary wave" that is mainly speculative, as it does not have "any impulse from the real driving force" (Schumpeter, 1961, p. 226). Productive debt finances innovations and business expansion that is productivity-enhancing, while unproductive debt is used for consump- tion, speculative business and financial speculation, which induce a vicious cycle of credit expansion and price increases.

Innovations not only make several sectors redundant; they also reduce production costs, owing to productivity-enhancing processes. This gives rise to a widespread down- ward pressure on prices, which is amplified when unproductive debt is predominant, and when individual bankers reduce their lending causing further liquidations.

We owe a systematic approach to uncertainty to John Maynard Keynes. When organized security markets provide liquidity for investors committed to durable assets, the uncertainty faced by investors is contained. In a nutshell, for Keynes, in an uncertain world, financial innovations shift investors' preferences from analysis of long-run earning prospects of physical capital investments, to speculation in short-term movements in securities prices. This causes, ultimately, a destabilizing effect on the economy as a whole (see Carter, 1992; Carvalho, 1997).

A different way to consider the role of financial innovation in the interaction between financial and industrial capital is to consider that the investment process is originated when the finance provided to investors is spent, which supports new transactions and initiates a multiplier process and an increase in aggregate income that guarantees that savings will be sufficient to fund debt (Carvalho, 1997).

In a Minskyian framework, the working of the mechanism explained above is not independent of the financial structure of the economy: the widespread availability of an extended range of financial products after the deregulation processes in the 1980s has encouraged investors to finance capital formation with short-term instruments. These maturity mismatches make balance sheets more fragile to shocks. According to Minsky (1986), however, the financial structure has evolved endogenously through history: today's money-manager capitalism emerged as "a consequence of insti- tutional innovations and the growth of private pensions that supplemented social security" (Minsky and Whalen, 1996-97, p. 158). Because capitalism evolves with its ever-changing predominant financial structure, these transformations challenge the barriers to contain instability represented by the regulatory structure. For this reason, it is essential that the legislated institutional structure evolves to keep pace with the dynamics of the financial structure; but regulation can, on the other hand, even trigger financial innovation.

In summary, the role of financial innovation is relevant in a dynamic economy. Neoclassical economics focuses on how it serves to correct market imperfections, while heterodox economics contextualizes it within the relation between industrial and finan- cial capital in an uncertain world. In this respect, financial innovation may enhance allocative efficiency and serve capital formation or may exacerbate or even trigger crises.

See also:

Asymmetric information; Financial crisis; Marx, Karl; Minsky, Hyman Philip; Money and credit.