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Financial Innovation and Financial Compensation

Paul Krugman writes about the dubious case for financial innovation:

So why did some bankers suddenly begin making vast fortunes? It was, we were told, a reward for their creativity — for financial innovation. At this point, however, it’s 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.

Consider a recent speech by Ben Bernanke, the Federal Reserve chairman, in which he tried to defend financial innovation. His examples of “good” financial innovations were (1) credit cards — not exactly a new idea; (2) overdraft protection; and (3) subprime mortgages. (I am not making this up.) These were the things for which bankers got paid the big bucks?

I think another way of looking at what’s dubious about the innovation = massive profits line is to ask what happened to the competition? After all, there’s all kinds of innovation happening in the economy all the time. But the fact that a given sector is producing some innovations doesn’t normally lead to a structural increase in the sector’s profitability. Cars made in 2007 were way better than cars made in 1967, but each company had to compete against other companies who were all making better cars. There wasn’t some general upward lift in the returns to the car industry.

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Take a look at Simon Johnson’s chart of the structural increase, since the late 1970s, in the share of American profits that go to the financial sector:

Since that time, we’ve obviously had enormous innovation in the manufacture and design of computers and computer components. We’ve had massive innovation in telecommunications. We’ve had tons of innovation in terms of how we design and print books and magazines. We’ve had all kinds of innovation. But obviously not all of our sectors can increase their relative share of profits. And it’s also obviously not the case that the financial industry has been the most innovative over the past thirty years.

What would explain the rise in profits pretty clearly is that finance operates with a lot of implicit and explicit subsidies from the government. In exchange for those guarantees, the financial sector is subject to a lot of regulations. But if you have “innovative” ways of executing regulatory arbitrage, then you can achieve windfalls profits by taking advantage of the guarantees without paying the price in regulation. Now clearly you can’t pass a law that says “firms aren’t allowed to seek regulatory arbitrage.” But when you see a firm seeking regulatory arbitrage and someone proses changing the regulations to prevent it, then I don’t think you should take anyone very seriously who responds by saying that we need to fear that financial innovation will be stymied. A certain amount of regulatory arbitrage is inevitable, but there’s no public interest in seeing it happen.