What has all this financial innovation done for us anyway?

In another of his great book reviews — of which the book is secondary to the commentary — Bob Solow looks at market failures and the Great Crash of 2008. He asks: “Is all this financial activity socially useful, even in the absence of breakdown?” A great question.

Cassidy quotes Alan Greenspan:

“Recent regulatory reform coupled with innovative technologies has spawned rapidly growing markets for, among other products, asset-backed securities, collateral loan obligations, and credit derivative default swaps. These increasingly complex financial instruments have contributed, especially over the recent stressful period, to the development of a far more flexible, efficient, and hence resilient financial system than existed just a quarter-century ago.”

Flexible maybe, resilient apparently not, but how about efficient? How much do all those exotic securities, and the institutions that create them, buy them, and sell them, actually contribute to the “real” economy that provides us with goods and services, now and for the future? The main social purpose of the financial system–banks, securities markets, lending institutions, and the rest–is to allocate society’s pool of accumulated savings, its capital, to the most productive available uses. It does a lot of this, beyond doubt.

To get at this you have to, of course, separate out the question of these innovations from generic financial activity:

We would be much poorer without a functioning financial system, and the flow of credit and equity purchases that it permits. If anyone who wanted to start a business–a software company, a biotechnology laboratory, a retail store–had to do so with his or her already saved-up wealth and the help of relatives, many good ideas would go unrealized, and some wealth would lie idle or be wasted. If every time you chose to invest in an existing company it was forever, because there was no way to sell your share and invest somewhere else, it would be much harder for promising enterprises to attract capital and grow.

But those needs were being taken care of a quarter-century ago, and well before that.

It is the other stuff that is the issue:

The real question, to which Greenspan gave such a confident and grandiose answer, is whether anything much was added to the system’s ability to allocate capital efficiently by the advent of naked CDSs and CDOs and the rest of the alphabet. No blanket answer is possible. The securitization of mortgages and college loans is not intrinsically a foolish or useless idea–it enlarges the pool of capital available to finance home purchases and college educations; but the opportunity for you and me to bet a large sum of money on the outcome of somebody else’s bond issue is not nearly the same sort of thing.

And he goes on. Well worth the read. There is no answer, of course, but the point is whether we should really fear a stifling of financial innovation that might accompany more stringent financial regulation. And if the rate of innovation was slowed down by a review process like we have for new drugs would that really be that costly? That said, it is also not a given that regulation can stifle innovation.

3 thoughts on “What has all this financial innovation done for us anyway?”

  1. We’ve just come though a period of increased financial innovation.  This period was strongly effected by new paradigms for statistical analysis whose robustness was over estimated, the growth of computer, software and communications power.  Like so many innovations it finally became overdone; now we have learned the limits of the new innovations and they are unlikely to repeat the mistakes.  Thus, I’m optimistic that we’ve seen the worst of the new innovations consequences and we will now have the more sober and mundane but useful benefits from the most recent period of innovation.

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  2. The BBC’s Robert Preston referred to a UK study which showed that all (underline) of the returns on capital above the historical average for UK banks made in the last 15 years or so were due to increased risk, not greater efficency. So maybe the answer is zero – the “innovations” just transferred wealth from other sectors to the finance sector.

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