The Perils of Financial Innovation, or Not

Michael Giberson

I’m about half way through Richard Bookstaber’s book, A Demon of Our Own Design, subtitled “Markets, Hedge Funds, and the Perils of Financial Innovation.” Bookstaber was among the MIT-trained economists lured from academia to Wall Street in the 1980s. If you’ve read about portfolio insurance and the stock market crash of 1987 or the failure of Long-Term Capital Management, then you will be familiar with much of the ground Bookstaber covers. So far the book has spent a little too much time detailing who worked where when, and less on the nature of the financial innovations propagated, but it has been interesting enough to keep me going.

While the book’s title has the wiff of journalistic exposé to it, instead we’re treated to an insider’s account. At mid-book the author is just now beginning to explain his concerns over how various financial innovations are more tightly linking markets together, how increasing complexity of instruments practically ensures that unanticipated failures will occur, and how the combination of highly complex and tightly linked markets nearly guarantees periodic market meltdowns.

As I said, I’m only half way, so Bookstaber may yet provoke me out of my biases, but so far as I can tell while the occasional market meltdowns of the last twenty or thirty years may have cost some traders their jobs and some investors their money, the real economy has been more stable over the same period. In general, it seems, it is a natural result of allowing markets to allocate risk to persons better positioned to manage it.

Bookstaber spent a lot of the last twenty years as chief risk officer for large financial institutions, so it is clear that complexity and uncertainty made his life difficult. (Of course, it is also why firms ended up hiring MIT-trained PhD’s for the work. So it Bookstaber just wishing, in retrospect, that he could get have been paid all that money but without all the high-pressure and headaches that comes with trying to assess and control the risk profiles of multi-billion dollar global financial firms?)

The book flap teaser promises that Bookstaber will defend his calls for less complexity and looser coupling of markets, and I’m looking forward to those defenses. But if his prescriptions would have the effect of shifting risk back into the real economy (i.e., onto low and middle income workers and consumers, relatively speaking, rather than investors and other willing risk-takers), then I’d have to oppose.

(It is odd to post a ‘review’ when I’m only half way through the book. I sat down this morning with the intent to react to a recent news story about financial innovation, but the Bookstaber book comment came out first. Now I don’t have time to tell you what I think about the possibility of “legal insider trading.”)