Brookings’ Bob Litan has written a paper that takes a refreshingly cool and even-handed look at financial innovation, trying harder than anything else I’ve read to sort the good, the not-so-good, and the bad. His assessments are debatable, of course, but given the currently prevailing view, endorsed even by luminaries such as Paul Volcker, that most financial innovation is rent-seeking if not actually corrupt, Litan has performed a very valuable service.
In this essay, I take up Volcker’s challenge [to produce evidence that innovation has promoted growth]. I do so by highlighting many, perhaps most, of the key… innovations since the 1960s that have changed the way finance carries out its four economic functions: enabling parties to pay each other; mobilizing society’s savings; channeling those savings toward productive investments; and allocating financial risks to those most willing and able to bear them. Admittedly, my analysis is more qualitative than quantitative, reflecting the difficulty of putting numbers to the impacts (a follow-on project I hope to undertake). But I nonetheless assert that logic and reason can lead to lead to certain meaningful conclusions.
… I find that there is a mix between good and bad financial innovations, although on balance I find more good ones than bad ones. Individually and collectively, these innovations have improved access to credit, made life more convenient, and in some cases probably allowed the economy to grow faster. But some innovations (notably, CDOs and Structured Investment Vehicles, or SIVs) were poorly designed, while others were misused (CDS, adjustable rate mortgages or ARMs, and home equity lines of credit or HELOCs) and contributed to the financial crisis and/or amplified the downturn in the economy when it started.
Along the way, I also address two of the main critiques of financial innovation… The fact that many financial innovations have been and continue to be designed to “get around” financial regulation does not automatically make them bad. Indeed, the opposite is true if the regulations are impeding productive activity. Indeed, I argue that a number of financial innovations of this sort have been socially useful for this reason.
Volcker’s observation that because economic times were good in the 1950s and 1960s… does not prove, by itself, that those innovations, when they came, added no social value. Events or trends in the real world, notably the growth of productivity, typically have many causes. For that reason, one cannot simply compare the performance of productivity or total output in two different time periods – without, and later with, modern financial innovations – and conclude that any difference in those measures can be attributed to the presence (or absence) just of financial innovation. The appropriate question to ask is what productivity or total output, or as I will also argue, other measures of net welfare, would have been “but for” any particular financial innovation or group of innovations.