A Research Question

We are told, usually by financiers, that 'sophisticated financial instruments' like CDSs and CDOs are essential to the functioning of the economy. Yet the economy seems to have been doing quite alright before they were invented.

The chart above is a log plot of the Dow Jones industrial Average since 1928; '2' is the Dow at 100, '3' is 1,000, and '4' is 10,000.

The trend line sits quite nicely in the data. The R-squared for the trend line is 0.926; in other words a simple exponential growth function accounts for over 92% of the variance in the Dow. Of course high R-squared are normal in this kind of time series data. I also appreciate that small changes at the margin may be worth considerable sums of money. Nonetheless, intuitively the economy as a whole does seem to have been growing at a relatively steady pace for almost a century.

"Ahh" say the financiers, "but just look at the growth they generated in the last 15 years". Suppose we do that:

We do indeed see a sharp increase in the rate of growth. Of course this sharp increase in growth corresponds to the Internet bubble. It's followed by something of a correction. Over a longer period of course is the growth in the use of consumer credit and then, beginning at the turn of the century, the housing bubble. With the collapse of the banking sector and the shrinking availability of credit, the economy has retracted and the Dow has dipped well below its historic trend line.

Of course this is vastly oversimplifies things and, as they say in the advertisements, "the past is not necessarily a guide to the future". Nonetheless there is something rather compelling to the thought that "plus ca change...".

My rather simple view of economics suggest that GDP growth can come from two things: more people, and greater productivity. GDP per capita therefore can only change if productivity changes. I lump two things into productivity: gains from trade and specialization and technology. Leaving trade aside, this upswing in the last 15 years might reflect improvements in productivity from new technology; and new 'sophisticated financial instruments' might be seen as an example of a new 'financial technology'.

We should be wary of this explanation, however, on two counts. First a McKinsey study a few years ago suggested that the gains in productivity from new technology have been vastly overstated. Second, new sophisticated financial instruments might possibly be better thought of as bets or gambles than as technologies.

If they are bets, not useful technologies, then there will be no change to the trend line with their adoption, only movement around that trend over time. If so, the correction (which may be a little overdone) brings us back close to where we should be. More importantly, in the long run the impact of these 'sophisticated financial instruments' may be a wash.

So that's the research question for any budding macro-economists: are these instruments technologies or gambles? So to those who say these instruments are an essential part of the modern economy I would say "show me the data". Demonstrate their contribution to GDP; that is how much smaller, if at all, would the economy be were we not to have these instruments available to us? Some empirical evidence is needed, since all we have at the moment is hype and unsubstantiated assertions from interested parties. And that's never as good as real evidence.