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.

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.