3. Technology and Invention in Finance

published on July 13, 2020

Good morning today I decided not to use PowerPoint and I'm using index cards this is traditional lecture style I want to talk today about this is our third lecture for financial markets I wanted to talk today about invention in finance and this is about I think of finance I

Don't know whether this will encourage you to be interested or not but I think of it as a form of engineering finance is all about inventions devices that solve problems and that help people do things and get on with their purposes in

Life and the inventions have many small details just like any invention like an airplane if you look at an airplane how many parts are in there how many different people worked on the different parts and it's so complicated that you

Might have disbelief that this whole thing is going to work but somehow it does work and another part that I want to emphasize in today's lecture is that engineering requires a human element Engineers know that their devices will

Be run by people and people are imperfect and so they have a course in engineering schools called human factors engineering and that's about designing machines so that human beings won't mess up when they try to use them and so that

Gets us into psychology so I think to me when we talk about behavioral finance which is going to be a theme of this course human psychology and finance it's fundamental to the inventive side of finance so that's what I want to talk

I'm going to give you some examples of invention and and talk how they solve the risk problem the fundamental problem of maintaining incentives in the face of risks but before I start this lecture I wanted to

Just briefly review the last lecture which was a very important lecture for this course because it talked about the underlying probability theory that well and applications of probability theory to finance let me just mention some of

The concepts that I talked about last time the first one was return we talked about the return on an investment which is the has two components the capital gain which is the increase in the price of the investment and the other is the

Dividend which is something that comes separately as in the form of a check made here a electronic entry but we then moved quickly to probability theory we talked about random variables a random variable is a quantity that's created by

Some kind of experiment or event that is uncertain in advance and becomes known later and then we talked about measures of probability distributions we talked about central tendency and we talked about the the average or mean and the

Geometric average and we talked about measures of risk we notably variance and but then there's also measures of co-movement between two random variables we talked about covariance and correlation and we talked about

Regression and then finally we talked about distributions of random variables and the normal distribution which is famous it's the famous bell-shaped curve which is thought by many people to represent a typical distribution and

Then finally we talked about failures of the something the idea of independent random variables that are normally distributed is a powerful idea that we have some idea that there's a bell-shaped curve

And we know something about what relates to someone and what doesn't relate to what these ideas are partly intuitive and they're partly wrong and so the concluding element of the last lecture was that the financial crisis that has

Enveloped the world in starting around 2007 seems to be related to people's failure to understand the limits of the independence assumption they were making and also to to the limits of the of the normal distribution namely failure to

Consider outliers so in this just think about independence briefly for a moment you it's in its inherent in the intuitive view we have of the world when you toss a coin every time you toss it you think each toss has to be

Independent of the previous toss they're not going to come up the same because it's there's nothing relating the two tosses so you have a strong intuitive sense that some events are independent you might also think that returns on the

Stock market from day to day are independent why is that well because they relate to news right what what changes the stock market on any day its news and by definition news has to be new so it can't just be yesterday's news

So it has to be something fresh and I showed you a plot of the stock market and of Apple stock and in this plot it came out that the stocks look roughly independent the returns from day to day but they not necessarily independent and

They can surprise you and that's when crises is occurred occurs we also talked about idiosyncratic risk and market risk remember we regressed Apple stocks returns the stock markets returns and then we

Got a fitted value which was beta times the market return and that's the market component of Apple risk and then we we saw that the extra component idiosyncratic is uncorrelated with the market risk but in this case it's

Uncorrelated by construction so it has to be uncorrelated oh by the way I don't know if you caught the news it's just coincidence that I mentioned Apple stock in my last lecture you must have heard the news

It was headline news in the Wall Street Journal we had a three-day weekend because of the Martin Luther King holiday in the US and over the weekend Apple announced that Steve Jobs is taking a long leave

Of absence from Apple because of his health and so we talked about the Steve Jobs is viewed by a lot of people as the genius beside behind Apple and the last time he left for a long time Apple didn't do well and so you

Wonder what would happen to the stock well since the UA announced it on a daily before just before the market was closed and so it was opened in Europe and there was a 7% drop in Germany of Apple shares it it opened down 5% on

Tuesday in the US but then it be covered and it wasn't really down that much probably because there was good earnings news at the same time that's just completing our little story about about Apple so what I want I don't know if I

Gave enough emphasis to the central limit theorem yesterday last lecture this is a fundamental theorem from probability theory which says that if you have independent automatically distributed random

Variables that is that all every every random variable is independent of the other and they're all they all of the same distribution and if it has a finite variance then the distribution of an average of these variables converges to

The normal distribution as the number of elements in the average is increased in other words averages are approximately normally distributed the bell-shaped curve works as well as it does because so many things we observe in nature are

Averages so many things that we observe are the sum of many effects this is what history is all about anytime big events occur it's probably because a number of things chance to happen at the same time and that's why that probability

Theorists think that we know we kind of know the probability distribution of and that's this bell-shaped curve which I had on a slide last period the critical thing about the bell-shaped curve is that the tails drop off really fast

After you get certain distance out and either end they essentially hit zero they never hit zero the probability is never zero that anything anything can happen with a normally distributed variable but but the normal distribution

Does not have fat tails after two or three or four standard deviations basically the probability is zero that that kind of thing will happen that that a return if it were if we're applying it to returns that that that would occur so

The the problem with the central limit theorem that it's only as good as its assumptions and it assumes that the underlying variables have a finite variance that they themselves are not so

Fat-tailed that the variance of them is in is infinite and in fact that assumption might be wrong because we see especially in finance we see big outliers coming from time to time and so I have to present a theory and say I

Like the theory the central limit theorem is an important theory but it's also Rohan and we that's the problem with a financial theory it's not quite as good as the theory that physicists are chemists to use it's it has its

Limitations nonetheless that's what we have to talk about and we have to make do with that as much as we can I wanted to just correct look also I'm almost done with my review of the last lecture I wanted to discourage

I said that fat-tailed distributions were discovered by Dan wah Mandelbrot but that's I have to be give credit properly it's actually his teacher so I've got this now there was here I'm say Paul from here Levy was a

Mathematician who lived from 1886 to 1971 who really first developed the theory of fat-tailed distribution and he was at the a called Polytechnique in France and his student was Benoit Mandelbrot who was one of the

Great mathematicians they were both among the great mathematicians of the 20th century so I think we are our knowledge of fat distribution comes down to us through word-of-mouth sir from levy who was

Mandelbrot's teacher to Mandelbrot to me and then to you I think so we don't require any printed word to to know this that's the way the history of thought goes so there's an old joke about the normal distribution it said that the

Joke goes as follows the mathematicians think that the normal distribution is ubiquitous in nature because applied workers have discovered that everything is normally distributed but applied workers think that the normal

Distribution is ubiquitous in nature because mathematicians have proved that it's ubiquitous in nature in fact it's sort of ubiquitous but it sort of surprises you and that's one of the fundamental lessons in finance the the

Fundamental essence in finance is that you might go through years observing some random return or some random variable in finance and you kind of think you know how it behaves and you learn some confidence there will come a

Day when it defies all of your expectations and that's what fat tails are about so ok I want to move on now to today's lecture which is about invention and particularly financial invention and a lot of how should I start here then

Let me let me start by recalling how much finance has changed since 1970 that's 40 years ago in 1970 there were no options exchanges well there were options but they were not traded on any exchange there were no financial futures

There were no swaps I don't say that I haven't defined what these things are for you what else did they not have they didn't have electronic trading they would do trading by word-of-mouth they would meet together on the floor of an

Exchange and and shout at each other and talk I guess they had telephones but it was all words and people and writing on paper so that's the proliferation of financial instruments in 40 years is stunning and so I wanted to use that as

A springboard to think about what is the next 40 years going to be like and if any of you go into finance this will be your career I think that the it's reasonable to suppose that the transformation that we see in the next

40 years is going to be just as dramatic as the last 40 or more so because the technical progress doesn't doesn't slow down I don't see any reason to think that it's slowing down so I like to think about the future but it's hard to

Talk about the future because we're not there yet I've written a couple of books one of them is about really about the future of finance one of them called macro markets which I wrote in 1993 about the big market macro means big

Markets that we'll be seeing in the future and the other one was called new financial order which I wrote in 2003 and we have the introductory they're on the reading list for this for this lecture but the basic what what I

See is happening with all of these incidentally we have a lot of questioning of these inventions now because they kind of blew up on us in this financial crisis so it's a little bit like after an airplane crash people

Are kind of critical of the aeronautical engineers for a while or when they invented steam engines some of them blew up and it was bad you know when a boiler blows up it scalds all the people around it awful

So people were mad at them for a while I think that's what we're going through now and people are angry about some of these inventions but that's that's just part of progress well it doesn't mean that we don't want to regulate them we

Regulate boilers right in airplanes right now to prevent crashes and we need to regulate our financial markets just as well but so the financial markets that that we have are they're based on mathematical model this is a

Mathematical discipline but the mathematical models depend only on certain intuition maybe a core part of the intuition that underlies financial inventions is the idea of Independence and that if risks are going to try and

Talk in really basic terms if risks are independent of each other then we can pull them and they go away that's the core idea it but but how to make that happen requires some thought and some devices

The intuitive idea that we can exploit independence to improve our lives goes back to ancient times actually a lot of things that people do are done in recognition of what is independent and what is not I think you know even in big

Causes that people get emotional about over the ages our causes that III can think of them as examples of the application of probability theory in modern finance so you might not agree with me but this is my view of it think

Of socialism what is socialism well you know it was invented by the philosopher or entrepreneur Robert Owen and the word was invented by him in the early 19th century but what is it it is that society gets together and pools all of

Its activities and I think well why would you want to do that well one reason you do that is that it in crews improves human welfare because it shares risks and we're all in it together and we you know we won't have rich in poor I

Think that's part of Robert Owens idea it he was worried about inequality that some people are much better off than others and that's bad and so let's be this create a socialist society so he had an invention of sorts but it didn't

Seem to be a very in his form was not a very successful invention because it was didn't work somehow he set up a town called New Harmony in the United States which was supposed to be harmonious by the name of the town and everything was

Shared and unfortunately they ended up arguing and fighting amongst each other and they were not happy he didn't get it figured out right he was trying to pool risk but he didn't do it there are other idealistic societies that try to do it

Like a kibbutz seem in Israel but that's one of many where people get together and form a community and they pool everything and kind of works for some people but only a tiny fraction of the population in Israel lives on a kibbutz

Now why not I think most people just don't fit in that well you know we share everything after a few months living there you might think I'm out of here and I want to share everything with

Everybody so people do thing in the Old West of the pioneers in America they had a kind of a social compact that if one farmer's house burned down everyone will come by and help and erect a new house for that person so that's again risk

Management that's it and it works well it sounds almost like a moral thing but it's it works only because they don't all burn down at the same time it would be totally worthless if they all did and so there are primitive ideas of

Insurance that underlie that but the ideas aren't worked out well and it doesn't perhaps work well to do it on such an informal basis so our society has particular inventions that we call them financial or insurance inventions

That make these things work better and so yes so we need it what we're talking about is motivated by theory and the mathematical theory of finance but that's not the subject of this course I want to in this course talk more about

The inventions themselves and in particular we'll be talking about risk management now this brings up but a basic issue about finance is finance good is it helpful to people you know a huge issue in the history of humankind

Is inequality and that people have get upset when it seems like other people have an unfair advantage over us but inequality is something that you'd think finance works against modern finance is about risk management so you can get rid

Of the purely random element in people's lives that should make people more equal and it should be a good thing that is the way I view it but the other side of Finance is that it also creates opportunity an opportunity

Is very important also we can all be equal and living in poverty and we don't particularly like that so that's why it's its financial inventions eventually inspire and get people excited so I always remembered um shell pings famous

Statement in the late 1970s and and when China was adopting modern financial methods and some people were getting rich and someone asked dong isn't this inconsistent with our ideology and then he said well I'm

Quoting him approximately we're all going to get rich but somebody has to get rich first and that's the way it is financial markets do they do manage risk but they also create opportunities and that can actually increase inequality so

You have to consider both sides of this so so maybe the most important concept in finance really is risk and risk is all about limiting inequality or at least the random gratuitous inequality right but what people are troubled by it

Troubled by inequality if it's arbitrary but if you know most people won't begrudge someone who works very hard and shows real genius and insight and makes a lot of money most people say that's all right but we have troubled in now

Part of the way we deal with risk is is our taxes tax and welfare system so our tax and well I'm going to come back to that mostly in our last second of the last lecture but we have a progressive income tax that taxes rich people more

And we have welfare and we also should add it's not counted as well for the free public education which is a form of I wouldn't call it welfare but it's equalizing expenditure these are actually our most important risk

Management devices that's what makes life tolerable in modern society that we do have progressive taxes and welfare but we don't rely on those exclusively and so finance is getting into the other dimensions and we kind of want to let

Insurance private insurance rather than social insurance flourish because it when the government handles everything it doesn't seem to work as effectively or creatively as it can if we look private entrepreneurs handle things so

What we're talking about here is to always put it in perspective what we're talking about in this course is about something that is an add-on to an existing welfare and tax system but an add-on that is we hope particularly

Effective and it's added on by people in their own self-interest or maybe maybe their own in their for their own purposes but something that ultimately contributes to a I think a better world

And that's what I want to so I have several themes in this life first is a risk theme which I'm just discussing another theme I want to talk about here is a framing theme and that is that psychologists use the term framing to

Refer to the context and associations that we have with something so the way people use things depends on what they see them associated with because people can't think through – the can't think through – the

Fundamental theory all the time so we have to frame things in a way that's convenient to people and this is part of financial engineering I'll come back to that in a minute but then but framing has to do with language and names that

We give the things we have to design inventions so that so that they are framed and in good ways what will explain that in a minute and I have a device theme that finance is really about about devices like steam

Engines we call them financial contracts devices are complicated complicated structures that we set up to for a certain purpose and like airplanes or automobiles and we we learn through time how to make them

Better and better and they tend to get they tend to come out in the world with a flourish a surprise there's some new invention you know when the Wright brothers first exhibited the airplane in the Paris Air

Show in 1904 I think and people were stunned they were actually flying and it immediately set up around the world aircraft engine industry if you look around the world these devices look very similar in automobiles airplanes they

Look almost the same in every country but but that's because they have an internal logic to them that makes them work well and the logic may not be apparent to you you might not understand why a device works as well as it does

Well I have an example of a simple invention and I was curious I haven't and use this example before how many of you use this invention you know what a gimlet is never sure how many of you own a gimlet nobody nobody owns a gimlet can

Someone tell me what a gimlet is it's amazing no one I shouldn't be a gimlet is a simple tool that everyone used to have a hundred years ago and what does it look like it's made out of wire okay this is a handoff okay you don't do you

Have a gimlet not not I've drawn a picture of it yeah so what you did with those they were really cheap you could buy one in 1820 go to a hardware store in downtown New Haven they'd have a whole set of them and you use it to make

Holes and it works really well I find you can buy them on the internet I bought one out of curiosity and now I use it the point is that inventions inventions come and go the nice thing about a gimlet is it's come it's really

Nice it comes to a pinpoint and if you want to make a hole in wood you just push it in and it gets it goes exactly where you want it and then you just turn a little bit and it goes right in well we have electric drills now right and

We're kind of used to the problem you know once you start using a gimlet you love it because you can control it so well that drill when you start drilling it kind of bounces around and it doesn't make the hole where you want it so

There's something good about this invention but you can go out and buy one now for very little money on the Internet it'll be mailed to you and now that I have it I'm thinking about it all the time for using it but somehow it

Comes and goes inventions are part of our culture that appear and disappear through time so I wanted to talk about another invention this is by way of inspiration um but I'm getting to Finance in a minute but I have to do

These simple maybe someone will reintroduce the gimlet I don't know it seems like probably gone forever it illustrates the fact that modern electronic technology has given us something maybe better but if you were

Used to using this you'd want it you know I just don't want to use that electric drill because I I know how to use this and I can control it and I'll give you another example of an important invention which I saw a common

Lifetimes and that's real suitcases okay now you bet you have one of these right a suitcase with wheels on it when I was a boy there were absolutely none nowhere no one had a wheeled suitcase and that strange he'd be carrying these

Suitcases around with you he'd put it on wheels and so I looked up the inventors of this it's not that long ago I thought I all right yeah okay it was in the wheeled suitcase was invented by Bernard Sadow

In 1972 and with his was the first one he had a suitcase with little wheels four little wheels and he had a strap and you'd pull it and it would trail behind you but then the other the really important invention was by Robert laughs

This isn't find him but I kind of think of it as finance in it was 1991 and he called it the roller board this is what you own right you want to roll aboard right it has it has a rigid handle that collapses into the suitcase and it has

Two wheels that are horizontal the problem with Bernard Saito's invention is that it tended to flop over you're pulling it with a strap behind you and then you look back and it's flopped over you can't go around corners very well so

We live with say dolls for 19 years and it took 19 years to invent the modern roll-aboard so I actually heard from Bernard SATA I wrote about him in new financial order and I got a letter from him it's about two weeks ago or email

From him and he said I heard about your book can you thought you talk about me in your book and he said he'd like to get me to autograph it for him so I I said fine I'll send you the book and I sent him an

Autograph with appreciation of it but that's a show that's not long ago so I guess you I could ask you to reflect why didn't people have wheeled suitcases well but you weren't born yet right so I can't reflect on that I'm thinking back

To myself you know it's almost something that I would do myself I'd put wheels on it but I guess you were embarrassed to do it back then because maybe it seemed sissy too but was everybody worried

About being a sissy not everybody why doesn't it anybody do it well Bernard said oh I had my student interview him and he listened to objections and people told him in 1972 no one's going to buy that because if you if the suitcase is

Too heavy you just get a red cap you know the red cap is if you don't open a red cap is someone poorly paid person who stands around at train stations was wearing a red cap and helps you with your luggage right that's not a good

Answer right there isn't always a red cap to help you and so obviously you need wheels on suitcases but this illustrates how technology moves it moves sometimes slowly I'll give you another example other examples from my

Book about the slowness of inventions one is just the invention of wheels did you know that in the Americas before Columbus there were no wheels no wheeled vehicles the American Indians had no wheeled vehicles at all not even

Suitcases nothing–no wagons nothing and then to complicate it they've discovered from the in the late Classical period in Mexico they've discovered wheeled toys and if you go to museum in Mexico you can see them they made toys for their

Kids they're not cars there are little Jaguars and animals with and you could roll them along the floor so they made the toys why didn't they think of making a wagon it just never occurred to them oh and another example I give in my book

That I really like was this the movie subtitle this is an amazing thing when they invented MOOC I gave you a Thomas Edison sound movie but didn't work he couldn't make a sound movie they

Didn't find out how to make sound movies until the 1920s so they did what they ought to give a dialogue to a movie they give what they called intertitles they would show the movie you know what I'm saying then they'd stop the movie

And there'd be a title with some phrase that someone said and then it would go back to the movie but it's obviously better just to put subtitles on the bottom of the screen right lit that the movie proceeded you've seen movies with

Subtitles right it works fine well it turns out that someone tried it in 1920 there was a movie called the chamber of mystery and someone made us a subtitled silent movie but the response was bad it seemed like nobody liked it and so it

Wasn't for another subtitles didn't come in until after sound movies were invented after sound movies were invented they wanted to make movies in one language and show them in another country so they had to put subtitles in

So that people in another country could see the movie and then that's how it came in it's there's a slowness to understand or appreciate invention anyway I want to move to invention in finance and that's the analogies that

I've just talked about are are important so let me start with an important invention in finance that goes way back well I was going to start I think I think I mentioned last time the very simple idea of setting up a company and

Dividing up shares in the company that's a really old invention that's thousands of years old all right you're going to you and your friends are going to do a business how do we divide up the profits well let's give shares to each of us and

The guy who's contributing more gets more shares right and someone who's contributing less gets less shares but then we all have a incentive to make the company go and that's the idea of a corporation

Corporation comes from the Latin word corpus which is a body it becomes and it becomes like a slave owned mutually by all the people in the company and your share in the company is determined by the number of shares that you own but I

Wanted to focus here that's an old idea it's an invention but I wanted to really focus on a particular nuance that developed was its limited liability what limited a limited liability corporation is a corporation that

Guarantees that you as a shareholder will not be liable for the debts of the company in England they sometimes will put limited the name of the name of the company and after it will say limited but in the us we just say incorporated

So that tells you that it's limited liability what it's talking about limited liability means that somebody sues the company and the company can't pay they can't go after the stockholders so limited liability has kind of a

Complicated history but according to a history by David Moss who is a Yale history graduate student when he wrote this but is now at the Harvard Business School it started limited liability really took hold in 1811 with a

Corporate law in the state of New York which represented a significant invention the corporate law of New York in 1811 actually had two important components the first component was anybody can start a corporation just

Filed the papers with the government of New York and you've got a corporation it there may have been some regulatory requirements but the point was you didn't need an act of Congress or an act of Parliament to start a corporation it

Used to be very hard to start a company because people would say well what's your purpose and you know we don't just do this automatically that was the first part of the New York law in 1811 but the second part is particularly interesting

They said under no circumstances can the shareholders be sued you put in your money to the company that's it you are protected by the law no worries about that now this was the first corporate law in the world according to Maus that

Imposed limited liability as a clear right of the shareholder there were limited liability clauses before but it was never so crystal clear at the same time around 1811 other states in the United States were looking at New York

And saying you're crazy what are you doing you can't sue the shareholders they could do something irresponsible and so the state of Massachusetts at around the same year I made a completely opposite law and they said they made it

Clear that the shareholders are responsible you invest in a company you're responsible and that's the only way it's fair they thought well guess what happened New York became the financial center of

America nobody wanted to set up a company in in Massachusetts anymore because you know they couldn't raise money the capitalists were at risk if you bought one share in a company in Massachusetts

And the company did something criminal let's say or bad I don't know something bad then they come they might sue the company and then come looking for anybody who is among the shareholder owned one share in the company so we can

Take everything from you and take your house your car we didn't have a car you take whatever you have so the rule was be really careful before you invest in any company and you got to watch them all the time

But you know what that did that kept Massachusetts down because nobody wanted to do that and you'd only invest with trusted friends you'd never invest in just some random company but what happened in New York was that companies

Started appearing rapidly because of this and they're never as many critics said a lot of these companies are fly-by-night they're going to go under we're going to find out that they weren't doing a good business they were

Just show-offs and they go bankrupt but some of those companies did extremely well and they it created a they created a powerful New York economy and so then people learned well yeah you could invest in a hundred companies and 99 of

Them will go under they're all wild not all of them how there's one that will be the Walmart and make you make you rich so the example set by New York was eventually copied by Massachusetts by every state in the United States by

Every country in Europe and now every country in the world it C it was an experiment that that might not have gone well you know what David Moss thought and this has to do with framing again Moss thought that what is it that New

York became such a capital of finance because of this law and because it made investing fun and this is a matter of framing and Moss emphasized that when you buy a share in a company and it's limited liability you know that you

You've already put out all the money that you'll ever put out but you could get an infinitive well there's no limit to the amount of money on the upside and he thought that it's just framed better as a

Psychologically appealing gamble it's like a lottery ticket people like lottery tickets right then they just enjoy the thought I don't know I don't do this but apparently a lot of people do that you go and you spend a

Dollar for a lot or $2 for a lottery ticket and then you think tonight I could be a millionaire all right and so that's just so much fun that you want to do it again but if the lottery ticket said well you have a small probability

Of being a millionaire but you also have a small probability of going bankrupt we're going to come after you and take everything you wouldn't like that it wouldn't be so much fun right you like to savor the possibility

Of getting rich and so people flocked to these stocks it's it's like a sport it's an invention of something fun to do for a lot of people but it has this productive side to it that it funnels capital to where it's needed

So that was an important invention that I want to give you another example that is variation on this I'm going to move forward in time my next invention is the guard I'm breaking chalk here this goes now to China Township and village

Enterprise or PvE and I'll try to say in Chinese Chang Jiang Shia I say that right close anyway so what was this when China emerged from a communist strictly communist state in the in the early

Period in the nineteen in the late 70s but more in the 1980s the Chinese economy increasingly became built on a certain kind of organization called a Township or tve and the tve was like a company a corporation except that it it

Always involved the town so in other words if you want to start a business built making something making toys for export to the world you wouldn't just start a toy company you would go to the mayor of your town and you talk to the

Mayor and say I want to start a toy company as this town's enterprise and I want to share the profits with you with the whole town now this is kind of unique I don't know if it's unique but we don't see this in the United States

But it proliferated it was actually the invention that led the initial successes of the Chinese economy by 1985 I believe I have the statistics here there were 12 million TVs in China by the mid 1990s most of the industrial production of

China was done by TVs so then you have to ask why this is an invention but we don't see it in other countries why in China well people who look back on it think that it was inventing around certain constraints at the time in China

And that the invention got around a legal constraint that China having been a communist country did not have all these financial lawyers and they did not have courts that imposed enforced legal contracts

The way we do in the US and that entrepreneurs in China were inhibited from from starting an enterprise because they thought it would just be usurped by the village you live in a village you start a toy company as soon as you start

Making money they'll just put a tax on you or look they'll take it you that was your worry so you had to involve them it was a it was a fact of life very important fact of life you had to involve the whole community you could

Not start a business you have we could not start a business without involving the community but it was a very successful invention because it actually led it actually led the the Chinese economy on its first huge successes okay

I'm going to move to another example now of of an innovation in finance and I want to talk about about Index inflation indexation and I could pick many these are examples that I like personally that there's an infinite number of examples

It doesn't matter exactly which example we pick but there's a fundamental financial problem and that is that the value of money changes through time we have inflation measured by a Consumer Price Index and when inflation proceeds

Price the VAT the prices go up and so the buying power of money goes down and it's uncertain there's inflation risk that we face because of because of the uncertainty about prices this is an inflation risk

It's under concern right now after the quantitative easing that the Fed will come back to that the Federal Reserve is expanding the money supply dramatically in an effort to deal with this crisis and some people are worried about

Inflation risk but it's a long-standing worry it goes way back in time most debts are most debts are done in nominal terms and that means they're written in the written in the currency units and if the currency becomes worthless you

You're wiped out why do people write contracts in currency units well it's because it's familiar with them and so it's framing we're used to thinking in terms of money and so we write contracts in terms of money all the time so the

Idea is maybe we should start a something else let's not write contracts in terms of money let's write in terms of something else and that's an invention but it's another invention it seems obvious

Let's index our debts to some measure of inflation so the invention I want to talk about first goes back to 1780 that the first indexed bond was issued in the state of Massachusetts in 1780 by the Massachusetts government

And that was an indexed bond they defined a consumer price index they didn't call it that and they said that the bond would pay you so many pounds they weren't using dollars yet they're using pounds British pounds the amount

Of pounds you would get would be increased if inflation were to start so they defined an index of of commodities that you might purchase and that index was was used to input a formula that created inflation correction to to the

Bonds so these bonds were issued in 1780 and it had has served an important purpose because the US was fighting a war with the United Kingdom at the time and there was tremendous inflation so they were very important but after the

War after the Revolutionary War ended they stopped issuing these bonds and they forgot about them in the United States until 1997 it's amazing why did the invention disappear it's like gimlets I think maybe gimlets will

Make every appearance maybe some of you will buy a gimlet they're very cheap privately and they're very useful so maybe it seems like there's a psychological barrier toward adopting something that's a little bit

Complicated and people have trouble understanding index bonds and they have trouble understanding the have trouble understanding how to how the formula works and they think you know I just want money this is not my but but then

You ask well why didn't people learn that if you look through history we've had bouts of inflation so many times in so many different countries and you know if you buy a nominal bond it's risky if you especially buy a

30-year bond people are doing that even today all over the world they buy these 30-year bonds denominated in dollars or Euros or some other currency and but what's going to happen to those currencies so why don't you do nominate

Your bond in something more realistic well after 1997 at the introduction in the United States of index bonds the reintroduction in 1997 it seems to have the seem to be started by one person Larry Summers who is assistant Treasury

Secretary just believed in this and he did it and so we still have them it got up to over 10% of the US debt now under Bush and Obama the they're kind of letting them sag now and they're down to 6% of the US debt but it really should

Be a hundred percent of the us that should be indexed so this is a kind of example of progress that is made gradually through time and maybe you'll see that in the next 40 years I'm trying to think of how we can make these things

Happen that's an agenda for people younger people who can start innovating and changing our financial system so I wanted to talk about it invention that it particularly intrigues me that comes

From the country of Chile and it has to do with it's a financial invention that overcomes framing problems psychologically sailing is an important invention and it illustrates some of the basic concepts so let me talk about

Chile we're jumping around the world here shellay had a problem with like many Latin American countries especially at that time with inflation so they had a currency called the peso which inflated enormous ly it went up I

Don't have the numbers on it but it went up you know like if prices went up a thousandfold or and people were saying we can't trust anything in written I wouldn't take a contract paying pesos it the peso is gradually becoming worthless

So Chile switched to another currency called the Escudo in 1960 they said okay we're starting fresh we're not going to have inflation and this is brand new now we're an Escudo country no inflation then in 1975 they switched back to the

Face so the exchange rate pay said it was sciutto was one in scooter was a thousand pesos okay because they'd had something like a thousandfold price increase and then in 1975 the exchange rate was one new peso is a thousand

Escudos so they went up a new page there was a million old pesos okay this is getting embarrassing I mean like can we trust anything or anybody in Chile so the invention started in 1967 people in Chile were

Saying we just want stability you know this is crazy our prices if I owned one pace I have a nice thousand peso note from 1955 and I pull it out in 1975 and it's worth nothing it's not even worth the paper it's printed on so we got to

Get stability somehow so somebody in Chile had the idea all right maybe we can't protect we don't know how to protect the currency but we can create a unit of account that that is stable in value and let's write contracts in this

Unit of account rather than in pesos so in 1967 in Chile they created something called me Luna Dodd the momento that's Spanish for a unit of development but what it was was a unit of account that is indexed to inflation and they

Said write your contracts in terms of and they call them UF's okay so everything could be written in UF's forget pesos because you don't trust pesos any mejor let's let's write contracts in terms of something else and

That's stuck in let me see it started out as a hundred escudos let me see what was it I think it was one UF was 100 you escudos in 1970 67 but by 1977 a UF was 450 new pesos now if you want to know what a UF is worth now you just go on

The internet and it gives it for every day and the website is I had it written here what is it I think it's I think the website is Val are you f dot C L but it's from my memory and so I looked up what a UF is worth today and it's I'll

Use the dollar sign for pay so twenty one thousand four hundred and sixty-eight pesos so that means that since 1977 prices have gone up about 50 fold in Chile okay but if you signed a contract written in UF's you're

Completely protected from that and so it's a very important invention it eliminated why is it an important invention it's important because it without it Chileans wouldn't index we don't index much in the United

States nothing almost nothing is indexed to inflation why not I don't know there's it's like resistance two-wheeled suitcases you almost can't figure it out it's so obvious when when you rent an apartment they should index it to

Inflation they should tell you our end our apartment rent goes up every month or down depending on the price level when you advertise a house for sale it should be indexed to inflation otherwise you're just making it crazy you're just

Making a Yale tuition should be indexed inflation should go up and down with the level that keeps its real value constant but we don't seem to do it because we can't something is blocking our thinking about it so we have to do something like

This I believe and so that's what Chile has done so this is the way things are done today in Chile it became an invention that took hold and never left that country if you rent an apartment in Chile good chance that your rent will be

Quoted in UF's okay and if you're paying a monthly rent check this is what you do so your your your rent is I don't know how many UF's you go to val-d'or you f dot CL you find out how many pesos it is you write out a check for that number of

Pesos okay and they do this out of half and the amazing thing I discovered is that in the United States and in just about every country of the world except Chile alimony payments are defined in currency

Alright you get a divorce the mother let's say has to support children the father is required to pay alimony for the next until the children grow up or indefinitely all right that's a long-term contract

What if there's inflation what does it do to the value of the alimony well of course the real value goes down so shouldn't courts just index it to inflation well they do in Chile because they've got a habit of doing things in

Terms of UF's so this is an important financial innovation by the way guess how much home consumer prices have gone up in the United States since we created the Consumer Price Index in 1913 it's 22

Fold and we've had a lot of inflation in this country 22 fold that means well 1 dot what $1 in something that cost 1 dollar in 1913 will cost $22 today that means that if you held cash between 1913 and today basically you're completely

Wiped out but the inflation rate is only 3% a year that's 3 percent a year for almost a hundred years is a 22 fold increase so we're living with this kind of uncertainty in the United States today we have not adopted the Chilean

Invention of us it's interesting that this invention spread somewhat throughout Latin America and it stopped at the Rio Grande Mexico has something called UD which is the Mexican version it's UDI which is the Mexican version of

Unidad de Fomento but the rest of the world doesn't want to copy this idea why is that I think it's partly because this idea emerged out of embarrassment Chile had had a massive inflation which is embarrassing and nobody wants to copy

Anything from someone having that bad experience it's also cultural that we're not used to Latin American thing just like we're not used to using gimlets so we don't we don't have them so let me just give one more invention

It's important and then I'll stop this is another financial invention more recently it's the invention of the swap I'd like to give this example because it relates to a couple of our speakers what is a swap well the the swap is a

Financial contract that was invented by none other than David Swensen who will be speaking soon he is the chief investment officer for Yale University he invented this before he came to Yale when he was working for

Salomon Brothers which was a major Wall Street investment bank that no longer exists but back then in the early 80s he apparently it's I've got a couple of sources I don't think I think he is the real inventor of it what is a swap it's

A contract between two parties usually a fairly long term contract to exchange cash flows so the simplest swap would be a currency swap where one country one there's two parties of two different companies let's say one of them are

Promises to exchange euros for dollars every however every month for the next five years and the other one promises to exchange dollars for euros every month for the next five years it's a swap but we decide in advance on what the

Conversion is what the swap rate is between euros and dollars and so that's useful for risk management purposes because somebody someone in Europe may be getting dollars revenue in their business they know they're going to get

This revenue over the next five years it's kind of a long term contract a long term business there and they want to go 20 years but they know that they don't know at what rate they can convert it back into

And on the other side we have the Americans who may be doing business in Europe and they get euro income and they want to convert it to dollars so they can they can make a contract that that swaps these cash flows and that was the

Invention and it didn't come until the 1980s it's amazing that these simple ideas weren't out there and why weren't they out there well it may have something to do with legal uncertainty regulatory uncertainty there was a

There's something called ESDA which was founded since the 1980s that's the International Swaps and Derivatives Association and what it does is it lobbies lawmakers for laws that permit swaps to work efficiently and

Effectively and so you need a industrial and organization like is des that will make these contracts work as effectively as the art now swaps are an excuse hugely important contract my last example which is a sub example from this

Is the credit default swap which is something that I won't quit david Swensons name and credit default swap is a base again a contract between two parties that has to do with the risk of a credit event so there's a protection

Buyer there's two parties one will call the protection buyer and the other is a protection seller and it would it would have to deal with basically the buyer promises to pay this the seller regularly at

Regular intervals for some period of time for the and just pay the money just flows regularly from the buyer to the seller until a event occurred we just say a bankruptcy of some company its defined

In the contract in which case then the protection seller has to pay the protection buyer now you might ask isn't this like an insurance contract isn't wouldn't you call this insurance if I'm paying regular payments to somebody else

Too and then if an event occur I'm getting insurance against default by some company and I may be doing business with a company or I may be investing in the company's bond so I may want this

Protection but it looks like insurance right well actually there's something else called credit insurance which goes back to the nineteenth century there were companies in like 1880 that would allow you to buy insurance against

Default or some failure of a company so this was an institution and an invention of the 19th century but credit default swaps or what's the difference well the difference is that their whole culture and regulatory environment developed

Around credit insurance that limited it they didn't have is de they had state insurance regulators okay and they just didn't have the same conceptual framework it's complicated the credit default swap was was boosted by is de

And other thinkers who thought of how to make this into a huge huge business credit insurance turned out and it ended up being kind of limited in its application and often the credit insurers were more we're more like

Consultants they would say will insure your credit again it will insure you against the default by your someone you learn money too but we want also to be involved in helping you avoid making bad contracts like that so the credit

Default swap became huge now I'm saying is let me just conclude with it this brings us back to our uh one of our outside speakers Hank Greenberg is going to talk about his company AIG which failed because of errors didn't fail it

Got bailed out by the government it got bailed out because of errors made in credit default swaps I don't think that these errors were his fault because this happened after he left the company but I just want to mention this because it's

All part of a big picture we had a financial invention the swap then we had the credit default swap and these are important inventions they called a leap forward in our ability to do risk management they created attendant risks

They were new and they weren't understood well enough and so a big part of what happened in this crisis was a failure of the credit default swap market but that's not to me a indictment of financial innovation I think the

Credit default swap was an important innovation and we will see more like it and it will help make for a better world

Related Videos

Yamana gold has recently launched a new standard in tailings management and here to talk to us about this initiative is senior vice president of health safety a...
He's peter hogg director of precious metals here at kikko peter welcome back it's good to be here michael uh everybody was predicting this uh precious m...
Gold traders took profits this week as the bullion saw the largest single day drop in years on tuesday but how are hedge funds an institutional investor's p...
Gold prices have taken a hit tuesday but can this downward trajectory continue uh here to talk about this correction and his long-term forecast for gold is joe ...
He's will ryan ceo of granite chairs will welcome to kitko thank you michael good to be back let's talk precious metals versus treasuries in a note toda...
Gold took its largest single day drop in years on tuesday what happened here to talk about this and answer this question is gary wagner editor of the goldforeca...
Gold is seeing a lot more volatility this week as bond yields have finally started to rise joining me today to talk about his macro views and what to look out f...
Welcome to kitco news i'm niels christensen the gold market continues to see surging momentum but can this momentum last in an environment where we're s...
Okay let's shift gears now to the base metals uh elon musk in his second quarter earnings call uh has made this statement i'm just going to read it tesl...
As gold hit the much anticipated two thousand dollars announced this week our next guest warns that more volatility is coming up joining me today is george giro...
Our next guest is frank holmes a guest everyone's familiar with on our show he's been calling for gold prices to hit all-time highs for basically ever a...
All right we have a few minutes left so i have one last question for the both of you what are the major risks that you're looking out for today we're al...
gold futures hit new record highs speeding 2011 year highs of 1920. anna's remained very bullish on gold stating that the two thousand dollar price tag is ...
On the same day police have made - at first unrelated of arrest they arrests a gentleman named Al and they caught him red-handed selling drugs so it's an op...
What I want to do in this video is get a better understanding of oligopolies and we'll be talking about it I'll they got pulleys we'll be talking ab...
What I want to do in this video is think about why it's so hard for a monopolistic monopolistic competitor to make money in the long run and just as a remin...
We've spoken a lot about monopolies monopolies monopolies and we've spoken a lot about perfect competition perfect competition and we kind of view them ...
What I want to do in this video is review the revenue and cost graphs for a monopoly for a monopoly so let's up here let's draw the demand curve for the...
For those of you who are curious and have a little bit of a background in calculus I thought I would do a very optional and when I say it's optional you don...
Based on what we've done in the last two videos we've been able to figure out what the marginal revenue curve looks like for the monopolist here for the...