Financial Innovation

| Tue Sep. 23, 2008 2:10 PM EDT

FINANCIAL INNOVATION....Via Ezra, Dani Rodrik asks a pointed question about the rapidly innovating financial markets of the past couple of decades. Would increased regulation really sap innovation and cost the world trillions of dollars in real wealth?

[Financial boffins] owe us a bit more detail about the demonstrable benefits of financial innovation. What I would love to hear are some examples such financial innovation — not of any kind, but of the kind that has left a large enough footprint over some kind of economic outcomes we really care about. What are some of the ways in which financial innovation has made our lives measurably and unambiguously better?

If I had asked this question a little over a year ago, I suppose I would have been hearing a lot about how collateralized debt obligations and structured finance have allowed millions of people to purchase homes that they would not have been able to afford otherwise. Sorry, but you will have to come up with some other examples now.

It's an interesting question. One of Rodrik's commenters offers this: "Interest rate, currency and credit swaps have been extremely beneficial to corporate risk management. OTC Derivatives on fuel futures have been very useful to manage fuel price risk faced by airlines (which is now over 40% of their operational cost)." And that's true enough.

But it's the scale of the growth that gets me. The size of the market for credit default swaps, for example, grew from about $1 trillion in 2001 to $62 trillion in 2007. Has anything in the real world grown enough to justify that kind of increase in the CDS market? Or has it mainly been a way for purveyors of mid-rated bonds to turn their dross into something that pension funds are legally allowed to buy? Is that really useful to the economy in any real kind of way?

I should say at the outset that I'm inclined to believe that recent financial innovations have, in fact, been highly useful, and that the root problems lie elsewhere (too much leverage, stupid mortgage practices, too little oversight, etc.). Still, it would be interesting to read an in-depth defense of how financial innovation has helped the global economy, wouldn't it?

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