The 5 Best Financial Innovations—Ever

No, crypto does not make the cut.

John Rekenthaler 18 October, 2022 | 4:28AM
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Never accuse cryptocurrency’s supporters of false modesty. A letter sent to the U.S. Environmental Protection Agency, signed by 55 crypto advocates (including a Fidelity official, Twitter co-founder Jack Dorsey, and that 11-day wonder, Anthony Scaramucci), concluded: “It is imperative that elected officials in the United States recognize that bitcoin, and the innovation of Proof of Work, is the most important financial, economic, and accounting innovation in the history of humanity.”

At least they left room for fire and the wheel.

Legacies are not immediately determined. Thus, although the claim that bitcoin is this planet’s greatest financial accomplishment strikes me as the grandest form of piffle, I cannot disprove the contention. I can, however, offer my own thoughts for the five most important financial creations and let you be the judge.

My candidates:

1) Hard currency

Whether the invention of hard currency improved upon the previous system of bartering—or in fact enabled the development of trading itself, as many historians now argue—is immaterial. Either way, business without the existence of currency is rudimentary. Nothing resembling modern trade is possible without using things that provide a neutral measure of value.

In addition to aiding transactions, currency fosters social cooperation. Agreeing on the worth of a currency requires a common understanding. This mutual belief does not necessarily prevent strife between the transacting parties, but it ensures that, at least to some degree, they speak the same commercial language.

2) Fiat currency


Fiat currency expands the notion of hard currency so dramatically that it earns separate acknowledgment. In hindsight, one wonders why people were so enamored with amassing piles of metal coins, ingots, or cowrie shells. But those goods nevertheless were regarded as possessing wealth in and of themselves. Nobody would have accepted a stone instead of a coin, with the assurance that the stone could later be swapped for an actual coin if the seller so desired.


Fiat currencies greatly extended the social contract. The first leap came from accepting the pledge that the stone may potentially be exchanged for hard currency. The second stretch, which arrived only recently, was to withdraw that guarantee, leaving the currency unsupported by an explicit promise.


Although fiat currencies are typically regarded as government creations, they can arise from anywhere. Whenever people share in the fiction that an objectively meaningless item provides value, they have created a fiat currency (at least as I use the term). Credit card transactions meet the description, as do cryptocurrencies.


3) Interest-bearing loans


Shariah law would disagree, as would most early Christians. But there is otherwise no question that interest-bearing loans were a splendid invention.


The practice has become widespread for the soundest of reasons: It serves both parties. Charging interest permits the wealthy to profit from their fortunes. Their risk will likely be less than if they had invested themselves (as they can either require the borrower to pledge assets to secure the loan or diversify by making multiple loans). As for the borrowers, the ability to access otherwise unavailable capital is a boon, even if the price is sometimes steep.


In addition to conferring a mutual advantage, interest-bearing loans convey a tremendous benefit to society by shifting assets from those who lack either the creativity or motivation to put those monies to work to those who seek change. As Adam Smith famously commented, entrepreneurs typically operate from self-interest. No worries. The faith-based perspective might disagree, but what matters economically is the outcome, not the mindset.


4) Pooled risk


The obvious application of pooled risk is insurance. If one house among 1,000 burns to the ground, 999 homeowners are unaffected, but the thousandth is ruined. If, on the other hand, the 1,000 owners share a common insurance plan, then the cost of rebuilding amounts to one part in 800 (assuming the insurance company’s overhead and profits consume 20% of the premiums). The burden has become affordable.


But the concept of pooled risk underlies many other financial services. Mutual funds pool risk, permitting retail shareholders to own many more securities. So do asset-based securities, by bundling disparate loans into a single package, thereby reducing the damage caused by individual defaults. Pensions are paid from pooled-risk accounts. The application is ubiquitous.


As with currencies, pooling risk is a social contract. Quite literally, it cannot be done at home.


5) The corporation


Researchers estimate that, after taking 3,000 years to double, from 1500 B.C. to 1500 A.D., then almost another four centuries to double again, global per capita production has ballooned sevenfold during the past century. Much of that increase, of course, owes to new technologies. But the adoption of the modern corporation also deserves recognition. The approach enhances economic growth in two ways.


First, it incorporates the previous principle of pooling risk. Corporations permit numerous owners to share the perils of owning a company. True, that arrangement could also be achieved through other structures but not so handily. Second, as Mitt Romney famously stated, corporations are people, too. Legally, they exist separately from their owners. If a company strikes a rock, its creditors cannot seize the personal assets of its shareholders.


That protection powerfully encourages enterprise. Not only does it permit entrepreneurs to pursue their dreams without facing personal bankruptcy should their efforts fail, but it also facilitates capital flows. Investors are far more willing to part with their monies if they know the limit of their potential losses.


Wrapping Up


Often, I write columns that rely on my highly specific knowledge of funds, accumulated over 30 years, and supplemented by proprietary Morningstar databases. Few are in position to challenge my conclusions. Today’s installment is different. Anybody who possesses a good sense of history matches my qualifications. So, feel free. Send me a note with your thoughts. If there is enough interest, I will use those thoughts to write a follow-up article.



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John Rekenthaler

John Rekenthaler  is Vice President of Research for Morningstar.

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