In defense of finanacial engineering

How new innovations in finance help both Wall Street brokers and regular investors

By , Guest blogger

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    Trader John Yaccarine, center, works on the floor of the New York Stock Exchange.
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Financial engineering has a bad name today. In the wake of the housing market decline, lots of people say that Wall Street tricked main street with lots of "fancy mortgage products" such ARMs, negative amortization loans and others. But, we love new products (at least the ones that Apple designs).

As I understand it, the point of new financial products is to convexify portfolio problems for consumers so that their set of feasible consumption paths over time and across states of the world increases. In English, if financial engineers can design a new product such as a mutual fund that offers you a higher rate of return for the same level of risk then you can afford a better consumption stream if you switch your $ into this new asset. Now, I agree that in a non-stationary economy past returns may not provide good estimates of future returns but if you are that cynical, you can still put your $ under your bed and earn a safe 0% interest rate.

This piece by John Bogle celebrates his role in designing the market index fund for Vanguard. Thanks to him, an investor could hold a diversified portfolio and face few transaction costs. Competition in this market means that Vanguard can't demand exorbitant fees from investors. If they tried to charge this, some competitor would offer access to a similar fund at a lower cost. Price gouging triggers entry. If such funds didn't exist, you would pay enormous broker fees trying to assemble such a portfolio on your own. Bogle in turn celebrates the role that Paul Samuelson played in nudging him to build this new product.

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As an economist, I like this synergistic relationship between the great economic theorist (Samuelson) and the Wall Street innovator. This is intellectual trickle down economics! Bogle knew that there was a demand for such a product and he figured out how to supply it.

While economists have helped Wall Street to design new products, are economists smart enough to help reinvigorate the labor market?
A long run solution is to invest more in young children but this will take resources to pay for.

A short run solution is to relax labor regulations and barriers limiting the hiring and firing of workers.

You can "create jobs" by making workers more productive or by lowering real wages. The first one is politically correct but hard to do in the short run. The opposite is true for the 2nd one.

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