The current financial crisis has been caused by a 'credit crunch' in inter-bank lending that has been brought about because financial institutions no longer trust traditional ways of rating the risks and value of loans and assets. This has been caused by concerns that highly leveraged derivatives, such as credit default swaps and collateralized debt obligations, are not properly valued which has made the financial obligations of lending parties increasingly opaque and difficult to understand. When banks are not sure of the stability of the other institutions they are lending to and borrowing from because of concerns about their financial exposures to complex derivative positions, they lend less which has produced the current crisis.
The financial innovations that have generated this crisis have evolved along a cumulative trajectory related to a series of improvements in how the risk of lenders defaulting on their loans is framed, standardised, analysed, and re-engineered. This has produced a huge increase in the use of technology (to measure and hedge exposures), the use of derivatives (that are now approximately 700 times the value of their underlying assets), and the use of leveraged business models (i.e. hedge funds and private equity). The current crisis reflects how a technological trajectory based on using financial engineering techniques to analyse and repackage credit risk has complicated the financial system and increased the importance of liquidity risk. By better understanding these changes FINNOV should be able to contribute toward better informed public policy and the regulation of both types of risk to address sustainable social cohesion within Europe. WP 8 will focus specifically on the development of the current credit-risk based 'technological trajectory' of financial innovation.
The current crisis therefore relates directly to the main research agendas of FINNOV in financial innovation, the role of the financial system within the economy, and the social distribution of risks and rewards. The relationships between social inequality and financial systems are complex but under-researched. They have been central to the current financial crisis – for example, an important proportion of the outstanding derivative contracts were derived from real assets in the subprime mortgage market. The value of these assets (and therefore derivatives) was supported by rising home prices that enabled subprime households to manage, and if necessary, restructure their mortgage payments. When US housing prices began to decline from September 2006, higher income volatility in the US compared to Europe increased the risks of default, this changed the value and volatility of the underlying assets and made the actual value of the complex financial derivatives they were based on much more opaque.
The roots of the financial crisis therefore go much deeper than changes in financial technology or banking regulation and reflect important shifts in the social distribution of risk within the US, and therefore global, economy. The social institutions that socialised risks in the post-war period have been gradually replaced by institutional structures that individualised risks (Hacker, 2006) and remove the slack in the system that provides a buffer against large scale losses. Institutional changes in the role of the innovative enterprise in the US economy and an increase in income inequality have removed institutional protection in a highly interdependent way that remains under-researched. Prime tasks for FINNOV will therefore be to determine how Europe can ensure that the financial system supports investment in innovation in ways that generate stable employment and equitable incomes.
For example, the innovative enterprise – defined as a social process that generates higher quality, lower cost products, given prevailing factor prices – has been foundational for growth in per capita incomes. The development and utilization of productive resources that result in innovation entail a collective and cumulative process that employs large numbers of people over a sustained period of time. As a result, the innovative enterprise can provide stable, remunerative, and often creative employment to both its workforce and the network of firms and institutions to which it is connected. The widespread growth of the innovative enterprise in both the US and Europe in the 20th century was directly related to the rise of abundant "middle-class" employment and relatively more equal distributions of income. The result in the three decades after World War II was "sustainable prosperity" with stable and equitable economic growth.
Over the past three decades, US GDP per capita has grown at an average annual rate of almost 2 percent, but that growth has been neither stable nor equitable, as the distribution of income has polarized. This has been characterized in the United States by a decline in the stability of middle-class employment, measured by income volatility, since the early 1980s. The 1970s and 1980s saw widespread plant closings and a decline of well-paid, typically unionized, manufacturing jobs. This was partly a structural change in economy reflecting a long term shift towards service employment, but while this influenced the rate of change, the direction of change was influenced by government policy, politics and financial regulations. The American, Japanese and European economies all shifted toward services, but differed fundamentally in how those changes were undertaken. In the US, much more so than in Germany or Japan, profitable companies were restructured to maximize shareholder value by cutting well-paid “middle managers” who had traditionally finished their careers with their current employers. Similarly, in the 2000s middle-class employment has been off-shored to developing nations such as India and China. Different institutional structures therefore influence whether organisational changes are innovative, in the sense of increasing resources, or simply re-allocate existing resources, which typically has involved concentrating them in particular social groups.
For example, high level corporate managers have seen very substantial increases in their incomes, particularly through the use of stock options. Corporate executives have benefited by repurchasing their own companies' stock to drive up earnings per share, which in turn typically result in higher stock prices. The combined repurchases of the S&P500 companies rose from $120 billion in 2003 to $597 billion in 2007. In 2007 repurchases alone represented 90 percent of the net income of these companies, while dividends were another 39 percent (Lazonick 2008). Similar changes have happened with Aggressive Tax Planning in which firms seek to push the boundaries of legal tax avoidance through complex and entirely unproductive financial structures (NESTA, 2006). This aspect will be a core focus of Work Package 5.
Changes in the relationships between firms and their employee, firms and their senior managers, and firms and the financial markets have a major influence on the supply of stable and remunerative 'middle-class' employment opportunities that provide good housing, health care, education, savings and pensions. The current financial crisis has been made worse by increases in economic insecurity: the large-scale subprime mortgage market emerged in the world's richest economy largely because many people did not have access to stable and remunerative middle-class jobs, and was particularly unstable in the US because when markets changed, subprime mortgage holders did not have sufficient protection to maintain their mortgage payments if they lost their jobs. The current crises therefore reflects systemic risks, that require effective institutional management (Moss, 2002)
Currently, the European economy, and its corporate governance and institutional networks are very different from the United States. However, how to maintain stable and equitable economic growth within a European setting is neither obvious nor inevitable. By investigating the current financial crisis within a novel Schumpeterian framework that pays explicit attention to wider concerns about sustainable, social inclusion and the role of innovative enterprises, we aim to inform a new and emerging agenda of academic research, public policy and corporate strategy related to finance and innovation in a world where the links between systemic liquidity and credit risks play important roles in both the financial sector, and in society more generally.
