Tuesday, September 23, 2008

Creative Destruction in Finance

Economists and economics professors talk about something called, "creative destruction." The phrase may appear to be a contradiction but it basically means that something is dismantled, torn down or otherwise destroyed in the process of creating something better or more efficient that takes its place. Although there is destruction, it is all in the name of building something better

Boarded Up Video Rental Store
via Flickr
I would use the example of the disappearance of my local video rental shop in recent years. When renting DVDs by mail or watching video online hit a critical mass of consumers, it was no longer necessary to have these rental stores in our neighborhoods since it wasn't nearly as efficient as video by mail or online. So my local video rental place is now a dry-cleaner. A business was destroyed (in-person video rental) to make way for a new way of doing business (delivery by mail or streaming video). Undoubtedly some decent, hard-working people lost jobs because of this, but the economic theory goes that they would then get jobs in the newly-created business or fill jobs that were vacated by people taking the newly-created jobs, etc.

I wonder if we aren't seeing creative destruction in the financial meltdown that the capital markets are now facing. For many years borrowing, lending, investing and depositing money in a bank were done in a particular way. There were restrictions both legal and geographic for most financial services consumers. But things began to look different a decade or so ago. I can't say that I'm an expert in the field, but I do know that the industry changed a good deal.

One characteristic was that the products and services offered to investors became more sophisticated. Loans (which basically represent an interest-generating investment to the lender) were bought and sold much more easily than before and were packaged together so that people could buy financial instruments that consisted of dozens of individual loans packaged together.

At one time not too long ago, the general perception was that only rich people owned stocks, mutual funds and bonds. Before 1980 or so, if I mentioned I owned stocks or bonds, you would assume I was a wealthy man. But in the last two decades of the century, investing became more democratized. Mutual funds proliferated, were heavily marketed and had low initial investment requirements. Anyone could own a diversified portfolio of investments with as little as $1000--sometimes less. Additionally, individual retirement plans invested widely in the stock market and still more of us became unwitting market players.

It probably seemed to many of the "old money" investors that their party had been crashed by the masses of uncouth and uneducated small-time players. The exclusivity of earning money by investing it was eroded. And this wave of common folk was now holding the same securities they were and it probably rubbed some of them the wrong way. So the super rich moved on to hedge funds, derivatives and other complicated investments that required a large capital outlay to join and that therefore excluded a broad swath of the middle class from participating.

Maybe it's time for these old financial instruments (common stock, mutual funds, individual corporate or government bonds) to be replaced by new products that are more efficient and more desirable.

Just as with any new technology or product, regulation is often a few steps behind. Consider the Internet or the automobile: it was some time before governments saw the abuses that could take place with these new things and they had to step in and try to protect some people from themselves. Well . . . that may be what we're witnessing now with these highfalutin' securities investments.

But it may be that a larger picture is emerging. Maybe capitalism, which requires credit markets to survive, is changing permanently and that the old form that we all knew will cease to exist soon. I can't say what will take its place, but I can only assume that creative destruction will put to rest the existing system of borrowing and lending from large institutions with a promise of return over and above the loan amount.

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