Financial innovation

By Felix Salmon
July 20, 2009

In my blog entry this morning about Robert Shiller and his bonkers defense of subprime mortgages, I made an en passant reference to financial innovation being, net-net, a bad thing. I didn’t go into too much detail, because it wasn’t all that relevant to the point at hand, and because, as Sean Matthews pointed out, this question has been debated in the blogosphere in some depth in the recent past.

But Tyler Cowen picked up on the line, and wrote:

I can understand that particular financial innovations might be bad, but financial innovation overall? Surely this claim was false in years 1200, 1900, and also 1950. (Of course you’ll find very harmful financial explosions between those years and the current day but still on net you’ll take the progress.) If the U.S. economy resumes growing at an average rate of about two percent a year, eventually our economy will look very, very different than it does today. It’s hard for me to see running the economy of 2100 with the banking system of…what is the nostalgic year? 1992? 1957?

We’ll need more than better ATMs, which is not to say we need approve of every step along the way.

I think that the case for the positive effects of financial innovation is yes pretty strong if you roll back the clock to 1200 or 1900 or 1950. But over the past 25 years or so, the claim is much harder to make stick.

As for banking systems, Tyler I think concedes that there’s an important distinction which needs to be made here. On the one hand, there’s what you might generally lump into back-office functions — the distribution, clearing, and settlement of exchange. ATMs, charge cards, debit cards, PayPal, online banking, m-banking, etc all fall into this bucket, and advances here are often (although not always) a good thing.

Then there’s the more purely financial innovation. There are good things here too — fractional reserve banking, factoring, common-stock limited-liability companies, tradable fungible bonds, stock-market index funds, that sort of thing. But on this front I think the low-hanging fruit was plucked decades if not centuries ago, and that we’ve long since entered a world of diminishing returns when it comes to the positive developments. Meanwhile, the negative developments, from portfolio insurance to CDO-squareds, have been arriving at an ever-accelerating pace.

I agree with Justin Fox:

I’m with Tyler in that I’d rather have today’s financial system, however flawed it is, than the financial system of 1200. But at the same time, an estimated 97.3% of all financial innovations (I just made that up, but it seems about right) are just new ways to fleece customers or hide risk, and all major financial crises have been associated with some financial innovation or another.

The point is that we’re not in 1200, or 1900, or even 1950. And if you look at how fast the US economy managed to grow in the 50s and 60s without the benefit of Black-Scholes or the Gaussian copula function — or, for that matter, how fast the Chinese economy has grown of late with very strict fetters on financial activities — it looks very much as though most of the financial innovation in recent decades constitutes a history of increasingly-desperate attempts to eke out returns in the context of a naturally-slowing economy. And that history, I think, is doomed to failure.

So yes, in 2100 I’m sure that checks and credit cards — hell, maybe even cash, too — are going to be a thing of the past. But all that falls under the general rubric of “better ATMs”. Are we going to need more than that to run the 22nd-Century economy? I’m not convinced. And even if we do, there’s no reason why we can’t get there from here slowly, and with circumspection.

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