As work continues on financial reform legislation (see for example today's New York Times story), one of the elements that is still a hotly discussed issue is some form of review of financial innovations. Proposals for a Financial Product Safety Commission or a Consumer Financial Protection Agency seem to be gaining ground after stalling (see a recent Washington Post story).
Behind this debate is the question of whether financial innovation is positive or negative. Bob Litan at Brookings recently posted a essay In Defense of Much, But Not All, Financial Innovation. He is responding to the critique of many -- including Paul Volcker -- that innovation in the financial sector has been damaging. Litan scores a number of innovations, such as home equity credit lines, money market funds, and adjustable rate mortgages as positives. He also scores asset-backed securities as a positive, but he recognizes the dangers especially with the "originate-to-distribute" (OTD) model. As he notes:
I think there is merit in both approaches. There are financial innovations we wish to promote as socially beneficial -- microloans as an example. Such innovations can be designed in a way as to keep them from going bad. And mechanisms put in place to catch them if they do.
As I've noted before the point is to understand when an innovation goes beyond its useful sphere. We generally thing of a rose as a desirable plant. But a rose growing in the middle of a wheat field is probably better characterized as a weed.
Our trick in revamping the financial system is to build a mechanism that can tell the difference between a rose and a weed -- and know when a rose has become a weed.
Behind this debate is the question of whether financial innovation is positive or negative. Bob Litan at Brookings recently posted a essay In Defense of Much, But Not All, Financial Innovation. He is responding to the critique of many -- including Paul Volcker -- that innovation in the financial sector has been damaging. Litan scores a number of innovations, such as home equity credit lines, money market funds, and adjustable rate mortgages as positives. He also scores asset-backed securities as a positive, but he recognizes the dangers especially with the "originate-to-distribute" (OTD) model. As he notes:
The challenge is how to fix securitization so that it continues to provide the consumer benefits of the added funds it brings to lending without having the workout disadvantages just described, and especially without becoming so complex and opaque that it distorts asset markets. . .This is an example of his general approach toward financial innovation:
If we want more useful innovations in the future - as I believe we should - we should not generally apply the precautionary principle to finance. But we should stand readier to correct abuses when they appear and not let destructive financial innovations wreak the kind of economic havoc we have unfortunately just witnessed.In a piece last year in the Financial Times Robert Shiller makes different point:
New products must have an interface with consumers that is simple enough to make them comprehensible, so that they will want these products and use them correctly. But the products themselves do not have to be simple.So Shiller is arguing for careful up front design of the products, whereas Litan is advocating a quick response to problems as they emerge.
I think there is merit in both approaches. There are financial innovations we wish to promote as socially beneficial -- microloans as an example. Such innovations can be designed in a way as to keep them from going bad. And mechanisms put in place to catch them if they do.
As I've noted before the point is to understand when an innovation goes beyond its useful sphere. We generally thing of a rose as a desirable plant. But a rose growing in the middle of a wheat field is probably better characterized as a weed.
Our trick in revamping the financial system is to build a mechanism that can tell the difference between a rose and a weed -- and know when a rose has become a weed.
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