Has Financial Innovation Been Discredited?

MOSCOW – Skeptics of financial liberalization and innovation have been emboldened by the crisis in the world’s credit markets that erupted in mid-2007, when the problems with sub-prime mortgages first appeared in the United States. Are these skeptics right? Should we halt financial liberalization and innovation in order to prevent crises like the sub-prime disaster from recurring?

The entire sub-prime market is largely a decade-old innovation – the word “sub-prime” did not exist in any language before 1994 – built on such things as option adjustable-rate mortgages (option-ARM’s), new kinds of collateralized debt obligations, and structured investment vehicles. Previously, private investors in the US simply did not lend to mortgage seekers whose credit history was below prime.

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But, while it does sometimes appear that the current crisis is due, at least in part, to financial innovation, financial-market liberalization has been shown to be a good thing overall.

A study published in 2005 by economists Geert Bekaert, Campbell Harvey, and Christian Lundblad found that when countries liberalize their stock markets, allowing them to operate freely without government intervention, economic growth rises by an average of one percentage point annually. The higher growth tends to be associated with an investment boom, which in turn seems to be propelled by the lower cost of capital for firms.

Of course, while complicated financial arrangements allow us to move forward economically, they also can create hazards. Think of the scaffolding and equipment around construction sites. Sometimes people trip over the equipment, or a piece of scaffolding falls, with disastrous consequences.

Any time you build something, there is always a chance of a setback. But, with every setback, we learn. Governments and insurance companies implement better safety requirements in response to construction accidents. The same is true, over time, with financial disasters.

The US is one of the world’s most financially liberal countries. Its financial markets’ high quality must be an important reason for America’s relatively strong economic growth. Indeed, given a very low savings rate and high fiscal deficit over the past few decades, the US might otherwise have faced economic disaster.

The reason is simple. Individual firms might have splendid investment opportunities – to enlarge plant and equipment, capitalize on new software, or exploit new research and new training of key personnel – but might be deterred by cash shortages or perceived macroeconomic risks. Effective financial markets enable them to pursue such opportunities despite these constraints by enlisting investors to provide the capital. These investors can, in turn, be encouraged when financial hedging devices and financial diversification protect them.

There has been a longstanding discussion about whether new derivative markets, which provide such financial hedging, tend to increase preexisting financial markets’ volatility. The consensus is that they do not.

In 2000, Stewart Mayhew, Assistant Chief Economist at the US Securities and Exchange Commission’s Office of Economic Analysis, surveyed the extensive literature on this topic. Mayhew concluded that it is rather difficult to tell whether derivative markets worsen financial-market volatility, because their creation tends to come when existing financial markets already are more volatile, or can be predicted to become so. Moreover, he found that there is no evidence that derivative markets create volatility in underlying cash markets; in fact, they may even reduce it.

The effect on underlying financial markets’ volatility may not even be the right question to consider in deciding whether to permit new derivative products. The right question is whether these products are conducive to economic success and growth.

Here, Mayhew concludes that new derivative markets clearly increase the liquidity and quality of information in existing financial markets. And it is this liquidity and quality of information that ultimately propels economic growth.

The sub-prime crisis has exposed serious problems that we must address. For example, we need stronger consumer protection for retail financial products, stricter disclosure requirements for new securities, and better-designed vehicles for hedging risks.

Some of the innovations associated with the sub-prime crisis – notably option-ARM’s, when extended to borrowers who couldn’t handle them – seem to have little redeeming value. But others – those involved with the securitization of mortgages – were clearly important long-run innovations, because they can help spread risks better around the world.

So, we should not slow down financial innovation in general. On the contrary, some of the fixes that result from the sub-prime crisis will probably take the form of still more innovation, further increasing the sophistication of our financial markets.