Being skeptical of financial innovation: The derivatives case study
Ryan Avent wants more skepticism of the merits of financial innovation, and I'm happy to oblige. Lately, when I think about this, I think about over-the-counter derivatives. They're the customizable, opaque suckers that juice bank profits and confuse regulators and created the situation where everyone owed tons of money to everyone else, but few knew who owed what to whom, or who could pay what they owed, and so the market panicked.
And yet with clockwork regularity, there are op-eds defending this state of affairs. In today's Wall Street Journal, for instance, Mark Brickrell argues that if companies have to set aside the money needed to pay off their derivative bets, then that will mean they "set aside billions of dollars that would no longer be available, as 3M testified last year, to build more factories or create new jobs." Similarly, if I have to set aside enough money to pay my rent each month, I will have less money to purchase consumer goods that will stimulate my local economy! But I still have to do it.
My real skepticism, however, comes from the graph above. These derivative products barely exist in the 1990s. They become bigger in the early-Aughts. Then they explode after the 2005 Bankruptcy Bill gives them favorable treatment in bankruptcy proceedings. So we've got a pretty good natural experiment here: Has the post-2005 economy been much better and more stable than the pre-2005 economy? Or has the Aughts economy vastly outpaced the '90s economy?
Of course not. And nor have there been massive technological or sectoral changes that make these economies so different that entirely new financial instruments are needed to survive them. Instead, it seems pretty clear that banks developed a new product that increased their profits, government was lobbied to give it favorable treatment, and then it took off like gangbusters.
Now people are trying to justify the product's importance to the economy. But there's little evidence of its importance to the economy, as opposed to its importance to bank profits and certain schemes to make balance sheets look better and certain efforts for corporations to hedge slightly more risk in a slightly more elegant way than they could've otherwise. And given the dangers of customizable derivatives, it's hard to say those marginal benefits outweigh the dangers of this opaque market. Innovation is great and all, but as entrepreneurs know, new ideas have a pretty high failure rate.
May 14, 2010; 10:32 AM ET
Categories: Financial Regulation
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