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Is innovation related to the current Wall St. crisis, likened by many to 1929?

It is indeed. It is an example of creative destruction, but not in the sense Schumpeter meant.     

From Wikipedia: “The economist Joseph Schumpeter popularized and used the term to describe the process of transformation that accompanies radical innovation. In Schumpeter’s vision of capitalism, innovative entry by entrepreneurs was the force that sustained long-term economic growth, even as it destroyed the value of established companies that enjoyed some degree of monopoly power.”

Financial geniuses created complex new financial instruments with acronyms for names (MBS, CDS, meaning ‘mortgage backed securities’ and ‘credit default swaps’). These instruments were so complex few understood them.

Former Clinton Labor Secretary Robert Reich, an Obama advisor, relates once asking a hedge fund manager to describe the assets in his fund. He laughed, Reich relates, and said he had no idea. That means he had no idea what the risk was. And it turned out to be huge. That manager, if paid like the others, made 19,000 times more, on average, than the average American worker.

This type of financial-engineering innovation results in ‘creative destruction’ – it was creative, but the creativity went toward concealing the risk from other sophisticated players. The Wall St. bonus system meant, as the former vice chair of UBS noted, that the greatest fear was to underperform others (and miss the bonus), hence everything in the innovation system pointed toward taking and creating ever-greater risks.  And it was destructive, because ultimately the system had to collapse. 

No, all those fancy acronyms created a fog of complexity behind which lurked unsustainable and unacceptable risks. It was destructive innovation.

A major lesson: What you do not fully understand, do not invest in.

The greatest living practitioner is Warren Buffett. Ask him. His Berkshire Hathaway has $43 b. in cash. He just bought a major energy company for a song, $4 b., half of what it cost last week, simply because investors are utterly panicking. He buys companies he can understand.

Creative financial destruction was built on complexity. The lesson we learn is to avoid it by demanding simplicity. If we all do,  we will lift the curtain concealing risk and see it clearly enough to avoid it or manage it.

Blog entries written by Prof. Shlomo Maital

Shlomo Maital
September 2008