Financial innovation is largely bunk

Here's a conceptual diagram of all the companies listed on the NYSE from September 2006, grouped by sector and sized according to market capitalization (value of the companies).

It is roughly based upon the excellent "map of the market" tool that is available to look at on a daily basis in the "Market Data Center" section of the Wall Street Journal. You can go over right now and see what it is doing today by following this link.

The point of showing the sector weightings from September 2006 is to illustrate the size to which the financial sector had swelled at that point in history -- in fact, to the point that it was the largest sector in the entire economy, by a large margin. In other words, at that particular point in time, the financial sector was 22% of the entire economy by market capitalization, meaning that an awful lot of capital was flowing into that sector -- not only monetary capital which can be measured on a chart of the market capitalization of different companies but also "human capital" in the form of individuals choosing to pursue careers related to finance, and students choosing to pursue degrees related to finance, etc.

As you might imagine based on the world events which have taken place since September 2006, the size of the financial sector has deflated somewhat since the days when its size dominated the rest of the economy by a wide margin. A simple visual inspection of the map of the market using the above link will verify that.

A visit to the data available at Standard & Poor's about the capitalization of the S&P 500 by sector (a slightly different group of companies) reveals that companies categorized as financial now make up only 14% of the economy (as of November 08, 2011). Financials are no longer the largest sector (that honor now belongs to companies categorized as "information technology"), although they are still the second biggest sector, and their relative footprint is now much closer to the third-place sector -- energy -- which used to make up only 9% to financial's 22% and which is now roughly the same size as the financial sector at close to 13%.

We would argue that this is a very revealing exercise, because we believe that the amount of capital (both monetary capital and human capital) that was pouring into the financial sector prior to the collapse of 2008-2009 illustrated a disastrous "over-valuing" of what we might call "innovative" financial products and services (more on that term in a moment). Even with the reduction that has taken place, this sector is probably still too much of the economy, although at least the trend seems to be moving in the right direction.

Now, as professional money managers and therefore members of the financial industry, the above commentary might seem confusing, especially as we just finished explaining how important the ability to buy and sell shares in a public market is to the economy in general, and defending the financial sector's valuable role of enabling pools of capital to become available to entrepreneurs and businesses who need it. We wrote that defense in light of some of the misguided attacks of the Occupy Wall Street movement, which appears to have banks, the exchanges, and the concept of legal personhood for corporations as its prime targets -- all institutions which play a valuable role in the critical allocation of accumulated capital to business.

The argument we are making when we say the financial sector's footprint became way too large and absorbed way too much human capital is the argument that financial companies moved far beyond the connection of capital with business and into all kinds of "financial innovation" and "financial engineering" of dubious value.

Much of this "innovative finance" was not only of dubious value but was harmful and played a role in creating the conditions that led to the financial implosion that followed. We have made this argument in numerous previous posts, including "The ideology of modern finance" and "Professor Amar Bhide and his praise of more primitive finance."

In fact, we think investors might be well served by considering the possibility that finance itself is pretty simple and straightforward, and that its job is to connect capital with innovation rather than try to be innovative itself.

In many ways, the confusion between the two is evident in the turmoil dominating the news of late, including the European crisis, where investors are mainly focused on the woes of the financial sector and are largely missing the root problem, which is the lack of innovation and business growth in the other nine sectors of the economy.

This confusion manifests itself in the breathless worrying over whether Europe's banking woes will cause an economic collapse in the US. The storyline goes something like this: Europe's banks go into a state of shock because loans they made to countries such as Greece and Italy were unwise loans and the borrowers default; US banks which have dealings with European banks are unable to lend because of the crisis in Europe; therefore, US businesses and consumers cannot borrow, and US business and economic growth suffers or goes into another 2008-2009 panic and recession (or worse).

Our response is that, while it is true that finance touches every aspect of the economy because every business needs to use money and every business needs capital, the financial sector is not (or should not be) the dominant sector, and innovations in finance are not (or should not be) the innovations that drive an economy (see the discussion above). US businesses are generally flush with cash and many don't need to borrow a penny in order to grow and continue creating valuable goods and services for their customers. The 2008-2009 recession was not caused by businesses being unable to access capital, but rather by businesses picking up the phone and canceling all their purchasing orders for more inventory in the face of the implosion of Wall Street's financially-engineered innovations and in the face of a Rose-Garden speech from the President of the United States warning of a scenario that sounded like the end of the world (see this previous post for more on our view of the causes of 2008-2009).

There is actually quite a lot of real innovation going on in the US economy right now, innovation of the sort that adds real value and real economic growth, much as the computer innovation of the 80s and 90s added real value and real economic growth. We believe investors should understand the distinctions we are making in this post about the importance of connecting capital to real business innovation, and the dangers of pouring too much capital (monetary and human) into financial innovation.

We believe that over time, the problematic nature of much of what is called "financial innovation" will become more and more widely perceived, and capital will naturally flow towards real innovation and business growth. Investors who want to be there ahead of the crowd should be thinking about these things right now.