Monday, July 20, 2009

Financial Innovation

Felix Salmon has a silly post arguing that financial innovation is a net waste to society. One problem with his argument is that his view of financial innovation is too narrow.
if you look at how fast the US economy managed to grow in the 50s and 60s without the benefit of Black-Scholes or the Gaussian copula function — or, for that matter, how fast the Chinese economy has grown of late with very strict fetters on financial activities — it looks very much as though most of the financial innovation in recent decades constitutes a history of increasingly-desperate attempts to eke out returns in the context of a naturally-slowing economy. And that history, I think, is doomed to failure.

There are two problems here. First, he simply ignores many innovations that are of recent vintage. In the period he castigates as net loser, we had such innovations as:

*money market investment funds
*NOW accounts
*municipal bond mutual funds
*IRA accounts
*Universal Life insurance policies
*financial transactions by personal computer
*electronic funds transfer

and many others. For more see Van Horne's Presidential Address to the AFA in 1985. He discusses many financial innovations and possible excesses. At least the issue is taken seriously there.

The second problem, which is perhaps more significant, is that he only thinks about the impact of financial innovation on growth. But many financial innovations are ways to share risks. They may increase welfare without increasing growth. Think of any insurance. Without fire insurance I have to save more to cope with the state where my house burns down. My consumption is lower but my savings is higher. Growth might even be higher without the insurance because of higher savings. But welfare is lower because the goal of an economy is to allow people to consume.

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