Financial Innovation Is Dangerous But Necessary

Are Wall Street, Lombard Street, and other key financial capitals in the global marketplace nothing more than casinos? Sure, financiers, academics, and economic textbooks all say that the job of financiers is to gather savings and invest the money, and if done well, their efforts spur economic growth. What's more, although most people couldn't really understand the mechanics of financial innovation in recent decades, the net justification was that it enabled finance to do its fundamental job better.

Try telling that to Main Street. Many people outside finance are skeptical of that reassuring perspective, considering the volatility in the markets, the huge bets taken by gun-slinging money mavens, and the rise of exotic securities such as synthetic collateralized mortgage obligations. The sense that Wall Street is a gambling den and not an engine of economic growth was reinforced following the spectacular, speculative boom centered on the housing market and the subsequent dramatic, painful bust. All that so-called financial innovation boiled down to nothing more than making it easier to gamble with other people's money.

Even Paul Volcker, the widely respected former Federal Reserve board chairman and current chairman of President Obama's Economic Recovery Board, has dismissively asked a roomful of financiers how many innovations could they come up with that were "as important to the individual as the automatic teller machine." Ouch.

CDOs for Side Bets

The revelations surrounding Goldman Sachs' (GS) now-infamous Abacus deal only reinforce the sense that innovation on Wall Street is synonymous with gambling. The synthetic collateralized mortgage obligation was specifically designed to be sold as a bet that real estate prices would fall and mortgage defaults soar while the buyers were gambling that the market wouldn't crater. The derivative security wasn't designed to finance the process of building a factory, funding a shopping mall, backing an innovative product dreamed up in a garage, or making it easier for an aspiring homeowner to buy a house. It was a side bet, pure and simple (although nothing was simple about the underlying product), with all the economic utility of wagering on which team wins the coin toss at the Super Bowl.

"Speculators may do no harm as bubbles on a steady stream of enterprise," wrote John Maynard Keynes in 1936. "But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."

Clearly, speculators were in charge in the most recent bubble. The synthetic CDOs and similar opaque derivative securities were nothing but side bets. It's disturbing that institutional investors managing other people's money thought this a game to play. It's why no one really disputes that finance needs new restraints, especially when it comes to eliminating the "too big to fail" syndrome.

Outstripping Responsibility

But the charge that speculation had run amok is not the same as saying financial innovation that benefited society was nonexistent. "I think financial innovation is no different from industrial or technological innovation," says Andrew W. Lo, economist at MIT and chief investment strategist for the hedge fund AlphaSimplex Group. "The financial technologies we develop, just like computer technologies, often overstep our ability to use the innovation responsibly."

That's true of any powerful new utility: Think of e-mail, greasing the wheels of global communication while at the same time providing a fresh new field of opportunity for spammers and scammers. A similarly supercharged financial tool, the credit card, provides another example. U.S. credit-card volume was $100 billion in 1983 and approximately $2 trillion in 2008, according to Robert Litan, an economist at the Brookings Institution. Credit cards are controversial, with many people falling into debt peonage with their cards. But on balance, the cards have added to everyday welfare, Litan argues in a paper titled "In Defense of Much, But Not All, Financial Innovation."

Similarly, a combination of info tech advances, regulatory changes, and securitization made it cheaper and easier for homeowners to refinance their mortgages and extract some equity from their homes. Problem is, easy refinancings coincided with a period of rising real estate prices and falling interest rates, all but guaranteeing that when the market peaked, defaults would go up, according to a research paper by Lo, his colleague Amir E. Khandani, and Robert C. Merton of Harvard University. "Financial innovation is a story of two steps forward and one step back," says Lo.

Why Financial Innovation Matters

Fact is, securitization remains a powerful innovation that was abused. That's why putting new restraints on Wall Street, especially demanding greater transparency, more capital, and less leverage, will allow the financial industry to put innovations like securitization to better use. For the need for more financial innovation is there. The human population was about 1.5 billion in 1900, and it now numbers 7 billion. The world is an increasingly crowded and complex place. Simply put, the number of people who need financial products and services has grown exponentially, especially now that the wealth that was largely confined to a handful of advanced industrial nations is now spreading throughout emerging markets.

Speculators gained far too much power in recent years. The current swing toward regulatory restraint and reform is welcome. Done right, finance will once again become a necessary infrastructure for supporting economic growth. After all, the capital markets remain a remarkable social and economic institution for communicating through price changes all kinds of data, information, gossip, rumor, and knowledge.

The lesson of history is not that financial innovation is rare. It's that speculators will eventually game the system and abuse innovation at everyone else's expense. It's a dilemma that won't ever go away.

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