SKOPJE, Macedonia, June 24 (UPI) -- Financial innovation is methodical and product-centric. The resulting trade in pioneering products, such as all manner of derivatives, expanded 20-fold between 1986 and 1999, when annual trading volume exceeded $13 trillion.
Swiss Re Economic Research and Consulting had this to say in its study, Sigma 3/2001: "Three types of factors drive financial innovation: demand, supply, and taxes and regulation. Demand driven innovation occurs in response to the desire of companies to protect themselves from market risks ... Supply side factors ... include improvements in technology and heightened competition among financial service firms. Other financial innovation occurs as a rational response to taxes and regulation, as firms seek to minimize the cost that these impose."
Financial innovation is closely related to breakthroughs in information technology. Both markets are founded on the manipulation of symbols and coded concepts. The dynamic of these markets is self-reinforcing. Faster computers with more massive storage, speedier data transfer ("pipeline"), and networking capabilities, give rise to all forms of advances, from math-rich derivatives contracts to distributed computing. These, in turn, drive software companies, creators of content, financial engineers, scientists, and inventors to a heightened complexity of thinking. It is a virtuous cycle in which innovation generates the very tools that facilitate further innovation.
The eminent American economist Robert Merton -- quoted in Sigma 3/2001 -- described in the Winter 1992 issue of the "Journal of Applied Corporate Finance" the various phases of the market-buttressed spiral of financial innovation thus:
"1. In the first stage ... there is a proliferation of standardized securities such as futures. These securities make possible the creation of custom-designed financial products ...
2. In the second stage, volume in the new market expands as financial intermediaries trade to hedge their market exposures.
3. The increased trading volume in turn reduces financial transaction costs and thereby makes further implementation of new products and trading strategies possible, which leads to still more volume.
4. The success of these trading markets then encourages investments in creating additional markets, and the financial system spirals towards the theoretical limit of zero transaction costs and dynamically complete markets."
Financial innovation is not adjuvant. Innovation is useless without finance -- whether in the form of equity or debt. Schumpeter himself gave equal weight to new forms of "credit creation" which invariably accompanied each technological "paradigm shift". In the absence of stock options and venture capital, there might have been no Microsoft or Intel.
It would seem that both management gurus and ivory tower academics agree that innovation, technological and financial, is an inseparable part of competition. Tom Peters put it succinctly in "The Circle of Innovation" when he wrote: "Innovate or die." James Morse, a management consultant, rendered, in the same tome, the same lesson more verbosely: "The only sustainable competitive advantage comes from out-innovating the competition."
The OECD has just published a study titled "Productivity and Innovation". It summarizes the orthodoxy, first formulated by Nobel prizewinner Robert Solow from MIT almost five decades ago: "A substantial part of economic growth cannot be explained by increased utilization of capital and labor. This part of growth, commonly labeled "multi-factor productivity, represents improvements in the efficiency of production. It is usually seen as the result of innovation by best-practice firms, technological catch-up by other firms, and reallocation of resources across firms and industries."
The study analyzed the entire OECD area. It concluded, unsurprisingly, that easing regulatory restrictions enhances productivity and that policies that favor competition spur innovation. They do so by making it easier to adjust the factors of production and by facilitating the entrance of new firms -- mainly in rapidly evolving industries.
Pro-competition policies stimulate increases in efficiency and product diversification. They help shift output to innovative industries. More unconventionally, as the report diplomatically put it: "The effects on innovation of easing job protection are complex" and "Excessive intellectual property rights protection may hinder the development of new processes and products."
As expected, the study found that productivity performance varies across countries reflecting their ability to reach and then shift the technological frontier -- a direct outcome of aggregate innovative effort.
Yet, innovation may be curbed by even more all-pervasive and pernicious problems. "The Economist" posed a question to its readers in the December 2001'issue of its Technology Quarterly: Was "technology losing its knack of being able to invent a host of solutions for any given problem ... (and) as a corollary, (was) innovation ... running out of new ideas to exploit."
These worrying trends were attributed to "the soaring cost of developing high-tech products ... as only one of the reasons why technological choice is on the wane, as one or two firms emerge as the sole suppliers. The trend towards globalization-of markets as much as manufacturing-was seen as another cause of this loss of engineering diversity ... (as was the) the widespread use of safety standards that emphasize detailed design specifications instead of setting minimum performance requirements for designers to achieve any way they wish.
"Then there was the commoditization of technology brought on largely by the cross-licensing and patent-trading between rival firms, which more or less guarantees that many of their products are essentially the same ... (Another innovation-inhibiting problem is that) increasing knowledge was leading to increasing specialization -- with little or no cross-communication between experts in different fields ...
"... Maturing technology can quickly become de-skilled as automated tools get developed so designers can harness the technology's power without having to understand its inner workings. The more that happens, the more engineers closest to the technology become incapable of contributing improvements to it. And without such user input, a technology can quickly ossify."
The readers overwhelmingly rejected these contentions. The rate of innovation, they asserted, has actually accelerated with wider spread education and more efficient weeding-out of unfit solutions by the marketplace. "... Technology in the 21st century is going to be less about discovering new phenomena and more about putting known things together with greater imagination and efficiency."
Many cited the S-curve to illuminate the current respite. Innovation is followed by selection, improvement of the surviving models, shake-out among competing suppliers, and convergence on a single solution. Information technology has matured - but new S-curves are nascent: nano-technology, quantum computing, proteomics, neuro-silicates, and machine intelligence.
Recent innovations have spawned two crucial ethical debates, though with accentuated pragmatic aspects. The first is "open source-free access" versus proprietary technology and the second revolves around the role of technological progress in re-defining relationships between stakeholders.
Both issues are related to the inadvertent re-engineering of the corporation. Modern technology helped streamline firms by removing layers of paper-shuffling management. It placed great power in the hands of the end-user, be it an executive, a household, or an individual. It reversed the trends of centralization and hierarchical stratification wrought by the Industrial Revolution. From microprocessor to micropower -- an enormous centrifugal shift is underway. Power percolates back to the people.
Thus, the relationships between user and supplier, customer and company, shareholder and manager, medium and consumer -- are being radically reshaped. In an intriguing spin on this theme, Michael Cox and Richard Alm argue in their book "Myths of Rich and Poor -- Why We are Better off than We Think" that income inequality actually engenders innovation. The rich and corporate clients pay exorbitant prices for prototypes and new products, thus cross-subsidizing development costs for the poorer majority.
Yet the poor are malcontented. They want equal access to new products. One way of securing it is by having the poor develop the products and then disseminate them free of charge. The development effort is done collectively, by volunteers. The Linux operating system is an example as is the Open Directory Project which competes with the commercial Yahoo!
The UNDP's Human Development Report 2001 titled "Making new technologies work for human development" is unequivocal. Innovation and access to technologies are the keys to poverty-reduction through sustained growth. Technology helps reduce mortality rates, disease, and hunger among the destitute.
"The Economist" carried last December the story of the agricultural technologist Richard Jefferson who helps "local plant breeders and growers develop the foods they think best ... CAMBIA (the institute he founded) has resisted the lure of exclusive licenses and shareholder investment, because it wants its work to be freely available and widely used." This may well foretell the shape of things to come.
Part 1 of this survey ran Friday.
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