In Defense of Much, But Not All, Financial Innovation

Robert E. Litan

After decades of being celebrated as one of the hallmarks and virtues of American-style capitalism, “financial innovation” has come onto hard times. Soon after the financial crisis began in 2007 and 2008, certain instruments of recent high finance – the collateralized debt obligation (CDO) and the credit default swap (CDS), as leading examples – were blamed by the media, the public, many policymakers, and even by some top economists for nearly bringing the U.S. and global financial systems and their economies to their knees. It didn’t take long for financial innovation more broadly to be condemned.

New York Times columnist and Princeton professor Paul Krugman, for example, has asserted that it was “hard to think of any major recent financial innovations that actually aided society, as opposed to being new, improved ways to blow bubbles, evade regulations and implement de facto Ponzi schemes.”

Former IMF chief economist and now MIT Professor Simon Johnson, writing with his fellow blogger James Kwak, are less withering, dividing financial innovations into “good” and “bad” ones.  Examples of the former, in their view, are the credit card, early forms of securitization, and the Community Reinvestment Act (though the last entry was a piece of legislation “invented” by Congress, rather than by the private sector itself). The CDO, the more complicated and less transparent successor to the plain vanilla mortgage-backed security which I discuss in more detail later, is cited as a “bad” innovation.

Perhaps the most devastating critique of financial innovation comes from one of finance’s greatest living giants (both figuratively and literally): Paul Volcker, the widely and deservedly acclaimed former Federal Reserve Board Chairman, who is now Chairman of President Obama’s Economic Recovery Board. Volcker has provocatively asked: “How many other [recent] innovations can you tell me that have been as important to the individual as the automatic teller machine, which in fact is more of a mechanical than a financial one?”  Volcker’s implicit response is that there are none.

Volcker went on to lay out a major challenge to finance practitioners, economists and other analysts when he stated that he has “found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy. Maybe you can show that I am wrong. All I know is that the economy was rising very nicely in the 1950s and 1960s without all of these innovations. Indeed, it was quite good in the 1980s without credit default swaps and without securitization and without CDOs.”

In this essay, I take up Volcker’s challenge. I do so by highlighting many, perhaps most, of the key truly “financial” (not mechanical) 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.

My ultimate verdict is that like Johnson and Kwak, 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 just cited. 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 when none of the modern financial innovations that I will review shortly had even been invented 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. To answer that question requires taking into account, explicitly or implicitly, other causal factors affecting these measures in order to isolate the impact of financial innovations, individually or collectively.