On Financial Innovation

A recent Felix Salmon blog post relaunched the debate over the value of “financial innovation” and launched interesting comments from Tyler Cowen and Justin Fox as well as a good followup from Salmon himself. I’ve been doing some recent reading that’s sharpened my thinking on this.

One thing you can say is that over the long run, socially valuable innovations definitely arise. The center of the US population mass has drifted steadily westward over time, which means that on average the center of gravity of the existing capital is further east than the center of gravity of ongoing construction. Back in the 19th century it was genuinely difficult to shift capital from east to west, and interest rates were systematically higher in California than in Boston or New York. The move to the more current paradigm is genuinely useful. Similarly, securitization of mortgages allows for risk to be geographically diversified in a genuinely useful way—it helps a lender separate out the risk that some individual borrower will be unable to repay from the risk that a specific area will undergo a systematic negative shock.

But at the same time, an awful lot of “financial innovation” during the years 1988 to 2008 was dedicated to a particular and very narrow purpose—locating and exploiting loopholes in the existing regulatory regime. When you look at the origins of the Credit Default Swap, for example, it’s extremely clear that the motivation was to use CDS to skate out of Basel capital requirements.

And it doesn’t require any esoteric or “left-wing” economic theories to predict that regulatory evasion will be the purpose of much financial innovation. Finance is regulated precisely because finance is substantially backstopped by implicit government guarantees. If you can manage to take advantage of those guarantees while slipping free of the prophylactic regulation, there are windfall profits to be made. And firms seek to innovate precisely in order to generate windfall profits. The moral of the story, pretty clearly, is that this—innovation as regulatory evasion—is something regulators should expect to happen, and should be extremely vigilant about. What we had instead during the Rubin/Greenspan/Bush years was precisely the reverse, regulators who didn’t believe in regulation, but who didn’t necessarily want the hassle of explicitly scrapping all the rules on the books and therefore encouraged their wards to find and exploit loopholes.

That, in turn, is both a hard problem to solve and an easy problem to solve. It’s hard because you can’t pass a rule saying “don’t be idiots, important political appointees!” But it’s easy because you don’t really need a rule. What you need are regulators who are smart, alert, and who actually believe in regulation and therefore take a dim view of “innovators” who are spending all their time trying to evade regulations.