Greg Ip

Articles by The Economist’s U.S. Economics Editor

Assessing financial innovation

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14:36 GMT +00:00

From Free Exchange. The original post is linked here.

 

AS A believer in free markets I’m inclined to believe that whatever innovation our kinetic and energetic innovators come up with is, until proven otherwise, welfare enhancing. Even if it becomes the subject of an investment mania that ends in tears. For all the money lost in its bursting, the internet bubble almost certainly accelerated by many years the development, diffusion, and adoption of many useful consumer technologies which are benefitting us today.

But the case for the welfare enhancing benefits of financial innovation is tougher to prove. At first blush, there should be no difference. If financial engineers come up with a more effective way for a company to hedge the risk of its operations or a homeowner of limited means to buy a home, why should we accord that less respect than an iPod or a broadband system that enables big city surgeons to view the MRIs of patients in remote locations?

I think the difference is that innovations create enormous spillovers, both positive and negative. Few inventors capture the majority of the social benefits their inventions create. Some capture none of them. Indeed, bubbles serve a very useful purpose—since no individual can rationally hope to capture all the returns involved in a risky investment, society will undertake too few of them. Bubbles alter that equation; inventors briefly think they can become fabulously rich inventing something that will be quickly copied and shared among millions of people, when in reality most will end up with a bunch of worthless stock options and unused Aeron chairs.

Financial innovation also has spillovers, but we are beginning to realise they can be net negative. A big net negative. Financial innovation can leverage up an entire economy to such an extent that when the bubble bursts, the entire financial system and the economic welfare of millions is put in danger. In that sense, it is a bit like someone experimenting with recombinant DNA. He may discover a cure for cancer, but he may also create a rogue bacteria that wipes out the human race.

I don’t know what the answer is. Most financial innovations are positive, and we don’t know ex ante which will be negative, so giving ourselves the power to block certain innovations because they might have negative spillovers is risky.

What I do know is that as researchers, we cannot decide if an innovation is positive until we’ve seen it through its entire life cycle. The benefits of subprime MBS and CDOs were obvious as long as the home-ownership rate among lower income Americans was going up, but we can’t make a final judgment until we see how many of them ultimately lose their homes. (I suspect the home-ownership rate will settle out lower than it began.) It’s like the chemicals and metals used in industrial processes; only by examining the life cycle from cradle to grave, can we decide if it makes us better off.

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Written by gregip

March 3, 2009 at 9:40 pm

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