The 27th Annual Milken Institute Global Conference kicked off live in Beverly Hills on May 6 to 8th of 2024. This year, we present a RealClearMarkets exclusive interview with Dr. Glenn Yago.
Yago is a Senior Fellow at the Milken Institute. He is also the founder of the Financial Innovations Labs at the Milken Institute and is Senior Director of the Milken Innovation Center.
His research contributed to policy and program innovations fostering the democratization of capital to traditionally underserved markets to finance ideas for projects by business and social entrepreneurs globally. Yago is also a visiting professor and Dean’s Fellow at the Hebrew University of Jerusalem School of Business and the University of California-Berkeley.
I first met Dr. Glenn Yago over 25 years ago at the Milken Institute Global Conference, and always enjoyed listening to his thought-provoking presentations. I interviewed him on the sidelines of Global Conference. We discussed the history of financial innovations, market-based innovations for growth, recent developments such as blockchain technology, and developing markets.
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Altenbach: Can you tell my readers about the Milken Innovation Center and the Jerusalem Institute for Policy Research, and what is your role in these organizations?
Yago: I've always gone back and forth to Israel. Fourteen years ago, I moved there. The Milken Innovation Center in Israel grew out of the Institute.
We run a fellow's program through the Israel Civil Service Commission that trains young professionals after their MBAs, engineering degrees, or policy degrees to work on specific projects where innovative finance can drive economic development and new sectors of the Israeli economy. We have expanded from information technologies to biomedicine, AgriTech, and CleanTech.
Eight years ago, we started a very close working relationship with University of California, also training global fellows, in the U.S. and Israel who can then work in their home countries on sustainable economic development finance projects in all the areas of food, energy, water, and healthcare; things that are core to the Milken Institute's agenda in terms of democratizing of capital and financing.
My teaching continues at Hebrew University and at Berkeley between California and Israel.
Financial Innovations:
Altenbach: You used to moderate the “Financial Innovations” panel with Mike Milken, Lew Ranieri, Nobel laureate Myron Scholes, and Richard Sandor. These are among the greatest financial innovators in history. Could you explain to my readers what financial innovations are, and why do they enhance economic growth? Why are they important?
Yago: Financial innovations are critical to enhance economic growth. All the names you mentioned, Mike, Lew, Myron, Richard, and later other people created financing techniques and new markets. Whole companies have been spawned in innovative finance.
“What financial innovations address is a basic issue in macro national accounting: that issue is how savings are transformed into investments. There should be an identity in an ideal world. There are intermediaries and financial intermediaries that take savings at one point in time and transform it into investments that can create value in the future and increase returns.”
“And that's why for 100 years, most of finance has been based on the idea of looking at risk and return and what the asset values are that result as a process of the intermediary nature of finance, and its ability to reduce the cost of a major factor of productivity in a firm, a country, a farm, etc. This increases total factor productivity. That is finance's core function.”
Financial Innovation & Complete Markets:
Yago: Innovative finance means that “you produce securities, designs of financial products, institutions, trading platforms, insurance products, and savings instruments that become investment instruments that can create a more complete market.“
I've done a lot of writing with Franklin Allen, he used to run the finance department at Wharton and is now at Imperial College.
Altenbach: You wrote four textbooks with him.
Yago: Yes. He's one of the great financial theorists of our times. His theory on how to complete markets is solid. “Financiers complete markets by having financial innovations that can align the interests both of investors and entrepreneurs, and governments and consumers that are trying to finance both their savings and investment.” At the same time, this gives people the ability to finance their hopes and dreams. That's classic Mike Milken.
Simply put, a financial market is complete if there exist contracts to insure against all possible eventualities.
Complete markets are desirable because they enable producers, consumers, and investors to allocate scarce resources, invest capital, and share financial risks in the most efficient manner.
Financial Innovations such as call and put options, futures, derivatives, and junk bonds are socially beneficial because they enhance completeness.
Altenbach: Recently, people think of innovations in finance as being digital. However, some innovations involve changing and adopting new market conventions, but also there are often tax hurdles to overcome. Lew had to solicit and convince Congress to change the tax code so the mortgage-backed securities would be fully applicable.
Yago: Issues regarding taxation shape or misshape a market, as documented by Nobel Prize recipient Merton Miller’s work.
Greatest Financial Innovations:
Altenbach: Could you name the top financial innovations in the past one hundred years?
Yago: Thinking historically, we could go back in history to the period after the American Revolution. In response to the Whiskey Rebellion in 1791, Alexander Hamilton created the early sovereign bonds. The United States was a major credit risk at the time, but France and other buyers would purchase our paper.
Another innovation was the Homestead Act of 1862 that facilitated land and agricultural financing in the United States. After that, the grain storage units where farmers could store produce and get warehouse receipts for agriculture credit, would later become the Federal Reserve System.
But for the last one hundred years, what happened in the public equity markets after World War II, is new issuances exploded.
Later on, Richard Sandor worked in the creation of derivative markets in the 1960s and 1970s.
Yago: Move along into the corporate bond market (circa 1970 to mid-1980s), Michael was certainly a revolutionary thinker in that era in terms of the new issue market in high yield debt.
Until then, ninety five percent of the public debt market was taken by five percent of the firms that were investment grade, therefore completely monopolizing the debt market the same way the equity markets had been occupied by the top 30 companies in the country before World War II.
Mortgage securitization was Lew Ranieri’s innovation of the 1980s. What happened in the great financial crisis of 2008 was an example of regulatory pressure and the lack of transparency in the markets. Mispricing of assets occurred.
Yago: There was very little transparency regarding the underlying cash flows associated with many of those assets that had become overly complex.
Lew was on record early on, before the crisis, about what mistakes were made in securities design of some of the issues.
The main lesson is that complexity is NOT financial innovation. Rather, financial innovation is an attempt to be able to increase capital access and to have deployment that generates returns that investors are looking for.
Altenbach: And what about Myron Scholes' work?
Yago: That was like the discovery of DNA. This enabled us to be able to do asset pricing based on Black-Scholes, and to estimate asset pricing and risk.
Innovations have different buckets. You have the bucket of financial products, from high yield bonds or buckets of asset securitization. And asset securitization has just blossomed after the great financial crisis and now private debt markets are now larger than public debt markets.
Prosperity of a Society is enhanced by Financial Capital Access:
Altenbach: Regarding the total prosperity of a society, Mike Milken often displays his famous prosperity formula, stating: “access to financial capital serves as a multiplier effect on the world's largest asset - human capital.":
Altenbach: You have seen this formula many times. I have, too. Can you explain to my readers the significance and importance of this formula and how prosperity is influenced by the interaction of financial technology, human capital, social capital, and real assets?
Yago: Mike first wrote this formula in the Bancroft Library at UC Berkeley back when he was a student aspiring to go to business school. He wrote it after studying financial literature and reading reports about the mispricing of non-investment-grade bonds that were ‘busted’ railroads bonds and fallen angels.
New Growth Theory:
Yago: But to answer your question, why is this so important? There was a great dialogue between Paul Romer and Mike a couple of years ago. Romer won the Nobel Prize in 2018 for coming up with the idea of Endogenous Growth Theory or New Growth Theory (NGT). NGT explains how long-term economic growth is related to technological innovation.
Yago: New growth theory was Michael's ‘hand in the back of the envelope,’ -but with more formulas-, way of explaining why technology relates to human capital, social capital (being what human capital does as a group), and real assets.
These assets are not just land, labor, and capital, but also ideas. That is what technology is, the manifestation of intellectual and knowledge capital into techniques, just like tools. Instead of hand axes, we have computers now. In our evolution, these different technologies are key.
For example, Romer documented that most post World War II growth can be explained by the fact we had Veteran Laws that provided investment for people to go to college and get trained. This produced many accountants and engineers.
This in turn drove the aerospace industry, along with the hard and soft technology that came, and then later information and computer technology, then biological sciences, and every advance thereafter.
NGT codified why technology and human capital together explain the variation in macroeconomic growth. The little formula that Mike came up with was an early form of Romer’s extensive NGT that informs us how economics works.
Blockchain Technology:
Altenbach: Blockchain technology is a new digital technology that everyone knows. It has multiple applications, but it's most well-known for cryptocurrency. What do you think of cryptocurrency?
Yago: We have several very good panels at the global conference on that. There's no short answer but let me try to give a medium-term answer.
Altenbach: Okay.
Yago: What's common between information technology and financial technology is both are trying to overcome what in economics and in computer science is called information asymmetries: - The fact that I may know more about one thing than you, and you may know more about something else than I do. If we can get more knowledge about what each of us know, we can better value a transaction.
Altenbach: Ok
Yago: Using computer science and its ability to link things, Blockchain technology is probably the greatest invention since double entry bookkeeping that came out back in the Middle Ages.
We haven't had anything that important for accounting until now. We can now establish quantitative accounts of things and where they are in the value chain or the supply chain. It is not just the supply chain of a sector, whether agricultural or industrial or other, but rather the value of an overall economy, so we can better value and monitor the macro economy. That is where blockchain technology has enormous potential.
Tokenization of Assets:
Altenbach: I think blockchain technology's greatest application may not be in cryptocurrency, but in the tokenization of assets. Tokenization can be more cost effective and scalable than securitization, and thus it better supports ethical financial services based on inclusion, & equality of opportunity, as well as faith-based objectives including Islamic Finance seeking and other objectives.
Yago: Absolutely. You are spot on, Jim.
Altenbach: I want to share with you an example, and we could talk about this. I noted this in a publication I authored:
“In October 2019, Indonesia's BMT Bina Ummah, an Islamic microfinance institution, raised $50,000 U.S. dollars through the world's first sukuk issuance on a public blockchain, and that created the world's first micro-sukuk. The micro-sukuk structure uses sukuk issuance on the blockchain to fund micro-SMEs (Small Medium Size Enterprises) and entrepreneurs. The use of the blockchain is expected to reduce issuance costs and attract retail investors.” BMT Bina used the Smart Sukuk platform introduced by Blossom Finance.
“The platform standardizes and automates bond, legal, accounting and payment systems. The platform makes micro investments accessible, transparent, and tradable.”
Altenbach: I think this is a significant development in the democratization of capital. What are your thoughts on asset tokenization and of this example?
Yago: I couldn't agree with you more. I was so excited that you brought up this example. I was introduced to this example by one of my graduate students at Berkeley from Indonesia.
Yago: It's so exciting. The point you are making here relates to what we were talking about earlier. We are in the middle of trying to establish a more inclusive economy that can grow.
In terms of mainstreaming the developing economies that are now the majority of global GDP on a purchasing parity basis, these types of innovations are needed.
For example, we had one of our financial innovations laboratories back in December on smallholder farmers.
Roughly 80% of the farmers in the world generate over 60% of the food in the world.
Yet, a significant part of the world is suffering from food insecurity. Smart technology needs to get into the hands of these smallholder farmers to help them maximize both their incomes and their productivity in being able to meet the food security gap over the next 25 years.
Altenbach: So, this type of technology could make issuing the very small dollar issuance and finance facilities more available. And that's something we never were able to do. So, you could service these types of operators in an economic manner?
Yago: Right. And some of our fellows, and the MasterCard Foundation are sponsoring experiments in this area, along with the US Development Finance Corporation and USAID and other development finance institutions.
People are very excited about this convergence of financial technology with information technology. It is bringing everybody online and giving them access to these tools, both the financial tools and the technologies in soil science, seed science, cultivation, and post-harvest storage.
This brings us back to your question about what financial innovations are, and what Milken’s insights are and what Romer and his team of growth theorists and practitioners have done in macroeconomics; How do we bring those points together? They're converging at the points that you made with the wonderful example above with the tokenized BMT Bina Ummah micro-finance deal.
Yago: Summing up digital finance and the digitization of everything, whether it's a greenhouse or taking a product to market, or measuring water in water stressed areas, or seed yields, all of this will enable a greater level of participation and growth in the economy.
Opacity vs. Transparency:
Altenbach: Many years ago, you were part of a team of scholars that researched the role of Opacity in retarding economic growth by placing a cost (or shadow tax) on businesses and governments. You even quantified a measure called "O Factor Scores” which enabled you to index countries’ economies according to transparency. I thought it was remarkable that you even estimated the costs associated with Opacity in terms of ‘corporate tax equivalency’ as well as a ‘risk premium on capital.’
Can you elaborate on your work on Opacity, why it is important to promote more transparency, and how do we do that?
Yago: That was the book “Global Edge: Using the Opacity Index to Manage the Risks of Cross-border Business” I co-authored with Joel Kurtzman published by Harvard Business School Press.
Altenbach: I was in the room 20 years ago when you presented that in Santa Monica.
Yago: That was at an early point, and history has been very generous to that book. Many of the ideas have been adopted and internalized by finance ministries, central banks, the Bank for International Settlements, and other regulators. They have looked beyond just the political transparency that was the general notion of transparency and try to break it down into accounting, judicial, other factors that were in that multi-factor set.
The concepts have been extended to looking at elements of systemic risk that would be generated by low-frequency, high-impact events.
Altenbach: That is Nassim Taleb's Black Swan.
Yago: Right.
Yago: But you asked why is this important? Let’s remember the ultimate impact of financial innovation is to reduce the weighted average cost of capital. If you can reduce the discount rate from 11% to 8% or even to 4%, you can finance more things and that can generate economic growth.
Lower capital cost enhances the breadth of the capital markets, and how deeply and broadly those markets can grow. In turn, having broad and deep capital markets is an essential property of having ones that can function well in converting savings to investment.
Altenbach: And transparency decreases information asymmetry.
Yago: You do not have mispricing, you don't get perverse markets, you don't get distortions, you don't get cheating, etc. Your point about there being a tax equivalency of the lack of information is really true.
For example, the hurdle rate in Ghana and many African nations right now is enormous. It’s well over 15%. These are all countries that are much lower than investment grade.
Yago: In order to facilitate infrastructure projects for more energy, food, water, and health how do we pool those projects and design them in a way that they can be investment grade or have a higher rating, and then get foundations, get philanthropic investments, get concessionary capital into those capital structures in a more variegated and stratified capital structure that lowers the weighted average cost of capital, in order to enable more energy, food, water and health to be produced and consumed.
Altenbach: Even without lowering taxes, government regulators, especially in developing countries, can attract capital if they fix problems such as corruption, weak legal systems, inefficient enforcement policies, deliberately confusing or illegal accounting procedures, and dysfunctional regulations.
Yago: Right. That's the whole part.
Agri-Tech Solutions:
Altenbach: A few years ago, you were part of a team of researchers who published a report called: "ACCELERATING AGRITECH SOLUTIONS IN ISRAEL, CALIFORNIA, AND DEVELOPING ECONOMIES". The research regarded agricultural technology and meeting the challenge of water scarcity in regions including both Israel and California. What can California learn from Israel in meeting the challenges of water scarcity?
Yago: That report focuses on agriculture. Twenty-five percent of the countries in the world are water stressed right now, however in the next couple of decades 50 percent will be water stressed.
It’s important to have water for food production. Drinkable water is needed which is challenging. Fifty seven percent of the hospital beds in the developing world are filled with people that are suffering from water-based diseases because of drinking unclean water.
Altenbach: What's the Israeli way of addressing water scarcity?
Yago: They understood prosperity and inventions come with overcoming problems of scarcity. That's basic economics. They started to manufacture water.
Desalination has been a major aspect of it. The recharging of aquifers has been very key.
The other main factor is increased efficiency in the use of water. Israel was the first country to adopt drip irrigation rather than flooding. People have been flooding fields since the Mesopotamian era. California followed with drip irrigation.
More food can be grown with the same amount of water by using drip irrigation. Add computers with software predicting growth stages that adjust the drip accordingly based on the growth stage of the plant, and producers can reduce water usage even more.
Fertigation:
Yago: With fertigation, you take the cow manure and put it back into the corn fields, you get a circular effect on both the improvement of milk production and corn production.
It's been done in California a lot, and part of the outcome of that was having a dairy farm that grows corn.
The other part is recycling. Israel recycles 82% of its wastewater into usable treated water.
Yago: The next closest country is Spain, with 17% recycled water. California has been recycling more water but mostly for use in fruit and vegetables, but not in row crops. These processes are replicable.
Altenbach: Regarding desalinization In California, we are behind Israel.
Yago: California is moving ahead and has learned a lot from Israel.
Desalination uses a lot of energy:
Altenbach: Desalination is a tremendous application in California, however, to do desalinization, you need a lot of electrical energy to do it.
Yago: California has been a leader in energy with rooftop solar and other renewables here with a portfolio of energy sources.
Yago: Sixty percent of water production is energy. You must move it around. Just think about water flow every time you flush the toilet. There is a lot of energy involved in the process of generating water.
Altenbach: To use desalinization in the U.S. on a mass scale, wouldn't we need nuclear power? Not necessarily the huge dome style reactors. Westinghouse has their eVinci Micro-Reactor. I think one of those would be able to power desalinization plant.
Yago: Oh, yeah. You and Bill Gates agree on that one, in terms of the role of nuclear power in solving challenges of clean energy as the pathway to lift billions out of poverty.
Altenbach: I think the days of those big domes like San Onofre, are probably over. What do you think?
Yago: It’s a very interesting point you're making that decentralization is the way to produce and distribute not only electricity, but also democratic power. This requires having more people operating in local and community levels of participating and not the old command and control centralized economies that we were used to.
Altenbach: Well, we covered a lot. It's been a pleasure.
Yago: Same here, Jim.
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