Higher Savings, Lower Returns: The Unacknowledged Externalities of Financial Innovation

As a result of the recent financial crisis, many individuals have become wary of the idea of financial innovation and the risk lurking in complex financial products that continue to grow in prevalence. Still, the larger aims of financial innovation are primarily positive: to make capital cheaper and more accessible.

Why have interest rates in developed countries declined since the early 1980s, along with expected returns for US stocks, despite increasing investment volumes? A recent paper by Felipe S. Iachan, Plamen T. Nenov, and Alp Simsek offers an explanation for the trends of high savings and low returns. They argue that financial innovation that expands an investor’s portfolio choice might also be related to declines in investments’ rates of return.

Findings show that the increased ability to customize portfolios increases demand for savings, while raising asset prices. Individuals often purchase assets to transfer wealth to a future period. The costs of buying and selling stocks have become negligible compared to 30 years ago, while the increasing prevalence of financial instruments, including futures, options, and other derivatives, enables trades that were previously impossible or too costly.

Mutual funds, hedge funds, and various retirement funds all provide investors with more choices, which result in greater participation and customization in the financial market. This customization enables investors to construct portfolios specializing in certain industries or styles, according to their distinct needs or beliefs. Consequently, the paper theorizes that financial innovation incentivizes savings by making a wider range of investment choices accessible. The ability to customize also drives assets up, as more money flows into the marketplace.

In addition, the researchers find that increases in aggregate demand for investments over time can lower the risk-free rate and the expected return on assets. In other words, individuals actually earned more on investments in the 1980s than they would in today’s climate, despite the sophisticated nature of modern financial instruments.

Low interest rates are also worrisome because they increase the likelihood of liquidity trap episodes, in which monetary policy is of little help. Liquidity traps occur when a government’s central banking system injects cash into private banks to stimulate the economy and provides more liquidity for the general population (an example would be to finance small business loans). However, instead of transferring excess funds to the public, banks may instead choose to hoard excess funds, since the opportunity cost of holding cash is nonexistent when interest rates are extremely low. This should sound familiar, as it parallels some critics’ observations of the Federal Reserve’s quantitative easing tactics, in that corporate investment remained low despite aggressive stimulus actions.

While financial innovation affects investors’ consumption and savings decisions, and also increases aggregate demand in the financial market, those who introduce or adopt these innovations often do not internalize the effects that might create inefficiencies. Perhaps the biggest takeaway is that, from a policy perspective, restricting portfolio customization might actually be beneficial to the economy by reducing the incidence of liquidity traps in the long run.

Article Source: Iachan, Felipe S., Plamen T. Nenov, and Alp Simsek.  “The Choice Channel of Financial Innovation.” National Bureau of Economic Research 2015.

Featured Photo: cc/(Tracy O)