the race to innovate

Finance: Before the Next Meltdown

Simon Johnson and James Kwak

I
f innovation must be good, then financial innovation should be good, too. If
finance is the lifeblood of our economy, then figuring out new ways to pump
blood through the economy should foster investment, entrepreneurialism,
and progress. Right? This, in any case, has been the mantra throughout three
decades of deregulation and expansion of the financial sector.
And yet today, financial innovation stands accused of being complicit in the
financial crisis that has created the first global recession in decades. The very
innovations that were celebrated by former Federal Reserve Chairman Alan
Greenspan—negative-amortization mortgages, collateralized debt obligations
(CDOs) and synthetic CDOs, and credit default swaps, among countless oth-
ers—either amplified or caused the crisis, depending on your viewpoint. The
journalist Michael Lewis recently argued that the credit default swaps sold by
A.I.G. brought down the entire global financial system—and found that the A.I.G.
traders he talked to completely agreed.
Recent financial innovation is not without its defenders, of course. As cur-
rent Fed Chairman Ben Bernanke said in a speech in May:

We should also always keep in view the enormous economic benefits that flow
from a healthy and innovative financial sector. The increasing sophistication
and depth of financial markets promote economic growth by allocating capital
where it can be most productive. And the dispersion of risk more broadly across
the financial system has, thus far, increased the resilience of the system and the
economy to shocks.

Intellectual conservatives and bankers have mounted an even more fervent

defense of financial innovation. Niall Ferguson has claimed, “We need to remem-
ber that much financial innovation over the past 30 years was economically
beneficial, and not just to the fat cats of Wall Street.”
Bernanke and Ferguson are being too generous. For the past 30 years, financial
innovation has increased costs and risks for both individual consumers and the

simon johnson and james kwak are co-authors of the economics

blog BaselineScenario.com. Johnson is the Ronald Kurtz Professor of
Entrepreneurship at the MIT Sloan School of Management, a senior fellow
at the Peterson Institute for International Economics, and a former chief
economist of the International Monetary Fund. Kwak is a co-founder of
Guidewire Software and a student at the Yale Law School.

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global economy. To take the most obvious example, consumers bought houses
they could not otherwise have bought using new mortgages they had no hope of
repaying, creating a housing bubble, while new derivatives helped hide the risk
of those mortgages, creating a securities bubble. The collapse of those bubbles
has shaken the world for the last year. Today’s challenge is to rethink financial
innovation and learn how to separate the good from the bad.

F
inancial innovation is different from what we traditionally think of as
innovation, which, in recent years, has occurred most visibly in the field
of information technology. Certainly, the financial services industry has
taken advantage of technological innovation; you can now access your financial
statements and pay your bills online, for example. However, these innovations
do not affect the core function of the financial sector, which is financial inter-
mediation—moving money from one place where it is not needed to another
place where it is worth more.
The classic example of financial intermediation is the community savings
bank. Ordinary people put their excess cash into savings accounts; the bank
accumulates that money by paying interest and loans it out at a slightly higher
rate as mortgages or commercial loans. Savers earn interest, households can
buy homes without having to save for decades, and entrepreneurs can start or
expand businesses.
The main purpose of financial innovation is to make financial intermediation
happen where it would not have happened before. And that is what we have got-
ten over the last 30 years. As Ferguson said, “New vehicles like hedge funds gave
investors like pension funds and endowments vastly more to choose from than
the time-honored choice among cash, bonds, and stocks. Likewise, innovations
like securitization lowered borrowing costs for most consumers.” But financial
innovation is good only if it enables an economically productive use of money
that would not otherwise occur. If a family is willing to pay $300,000 for a new
house that costs $250,000 to build (including land), and they could pay off a
loan comfortably over 30 years, then that is an economically productive use of
money that would not occur if mortgages did not exist. But the mortgage does
not make the world better in and of itself; that depends on someone else having
found a useful way to employ money.
In addition, financial innovation can go too far much more easily than inno-
vation in other sectors. Financial intermediation creates value by making credit
more available to people who can use it effectively. But it is possible for the
economy to be in a state where people have too much access to credit. With
the benefit of hindsight, it is easy to see how the U.S. housing sector passed this

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point earlier this decade. With negative-amortization mortgages (where the

monthly payment was less than the interest, causing the principal to go up) and
stated-income loans (where the loan originator did not verify the borrower’s
income), virtually anyone could buy a new house, leading developers to build
tens of thousands of houses that are now rotting empty, their current value far
less than their cost of construction. In short, excess financial intermediation, the
result of hyperactive financial innovation, destroys value by causing people to
make investments with negative returns. Put another way, we cannot say that
innovation is necessarily good simply because there is a market for it. The fact
that there was a market for new houses does not change the fact that building
those houses was a spectacularly destructive waste of money. Therefore, when
it comes to financial innovation, we must distinguish beneficial financial inter-
mediation from excessive, destructive financial intermediation.

I
n the early 1970s, Mohammed Yunus lent $27 to 42 female basket weavers in
a village in Bangladesh; they repaid the loan, with interest, from the proceeds
of their sales. In 1976, he founded Grameen Bank to make small loans to poor
villagers, often to fund startup costs for small ventures. Grameen Bank was the
first modern provider of microcredit. Yunus’s innovation was to recognize that
poor people could be good borrowers but had been ignored by a traditional
banking sector that refused to or was unable to serve them. In other words, he
found an economically productive use of money that was not otherwise occur-
ring. How does recent financial innovation in the developed world compare?
Defenders of unfettered financial innovation depict the alternative as a stale,
constricted market. As Bernanke said in April, “I don’t think anyone wants to go
back to the 1970s. Financial innovation has improved access to credit, reduced
costs, and increased choice. We should not attempt to impose restrictions on
credit providers so onerous that they prevent the development of new products
and services in the future.” However, as finance blogger Ryan Avent pointed out
on Portfolio.com, Bernanke’s examples of beneficial innovation–credit cards, the
Community Reinvestment Act, and securitization—all date back to the 1970s
or earlier. True, securitization—the transformation of large, chunky loans into
small pieces that can be easily distributed among many investors—was a ben-
eficial innovation, because it expanded the pool of money available for lending.
And securitization on its own, before the new products of the late 1990s and
2000s, did not produce the colossal boom and bust we have just lived through.
But more recent innovations in securitization led to a new generation of
increasingly arcane, increasingly risky products that Bernanke, Ferguson, and
others like to overlook. One of the paradigmatic products of the last ten years

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was the collateralized debt obligation (CDO), in which a structurer combined

a pool of assets and sold off the cash flows from those assets to investors. CDOs
did promote financial intermediation; those initial assets represent loans to real
people and companies, and without the CDO market to absorb them, those loans
might never have been made in the first place. But, as with negative-amortization
mortgages, the key question is whether those loans should have been made at all.
The magic of a CDO, as explained in the research paper “The Economics of
Structured Finance” by Joshua Coval, Jakub Jurek, and Erik Stafford, lies in
how CDOs can be used to manufacture “safe” bonds (according to credit rat-
ing agencies) out of risky ones. Investors as a group were willing to buy CDOs
when they would not have been willing to buy all the assets that went into those
CDOs. We don’t have to decide who is to blame for this situation—structur-
ers, credit rating agencies, or investors.
The fact remains that at least some
Financial innovation is good
CDOs boosted financial intermedia-
only if it results in financial tion by tricking investors into making
intermediation: moving money investments they would not otherwise
have made–because they destroyed
to places where it is needed. value. Another paradigmatic product
was the credit default swap, which
insured a security (like a CDO) against the risk of default. But by underpric-
ing that risk, it essentially tricked investors into buying securities that they
would not otherwise have bought. The losses were borne by the companies
that underpriced the credit default swaps, such as A.I.G., and by the govern-
ment, which had to bail out A.I.G.—leading to the misallocation of capital to
value-destroying investments. In other words, while securitization on its own
provided real economic benefits, it is harder to defend the very popular, very
destructive specific innovations it engendered. Contrary to Bernanke, maybe
the regulatory world of the 1970s doesn’t look so bad after all.

T
he role of financial regulation should be to discourage innovation that pro-
duces excessive intermediation and promote innovation that delivers finan-
cial services that people need. The key to any successful regulatory regime
is therefore discerning the difference between good and bad financial innovation.
Right now, ours doesn’t. Unfortunately, the Obama Administration’s financial
regulatory reform proposal, despite its improvements over the status quo, follows
the old conventional wisdom—that innovation is inherently good, and regulators
need only watch out for abnormal excesses or “bad apples.” Instead, the pre-
sumption should be that innovation in financial products is costly—it increases

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transaction costs, the cost of effective oversight, and the risk of unanticipated
consequences—and should have to justify itself against those costs.
Instead of a regime where any product is allowed so long as it is sufficiently
disclosed, we should consider a regime where only certain types of products
are allowed to exist, and they are allowed to vary only along specific dimensions.
Georgetown law professor Adam Levitin has argued that all of the “innovation” in
the credit card industry has simply been the invention of new, more complicated,
and less transparent fee structures, while the underlying product has remained
the same for decades. He proposes that regulation should standardize the terms
of credit cards, so that charges cannot be hidden in fine print, and issuers should
be allowed to compete on the interest rate, the annual fee, and the transaction
fee. This would ensure price competition while making it harder for consumers
to end up with dangerous products that encourage excessive borrowing.
This model could be applied to a wider range of financial products, even
to commercial products such as interest rate swaps and credit default swaps,
which baffled a fair number of supposedly sophisticated players during the
boom. For example, credit default swaps could be limited to a set of standard-
ized terms—the security being insured, the premium, the length of time, the
definition of a default event, the settlement date and mechanism—eliminating
the complexity that makes customized CDS difficult to price, difficult to trade,
and difficult for regulators to assess. While this could reduce the ability of firms
to “perfectly” hedge their risks, it would also reduce transaction costs and, most
importantly, reduce the systemic risk created by large, unknown derivatives
positions. Customized credit default swaps could still be allowed but should be
deterred (through taxation or other means) to ensure that they are only used
when “vanilla” swaps are truly inappropriate.
At the same time, regulators should look to promote those forms of finan-
cial innovation that the economy sorely needs. One is better ways of providing
financial services to the “unbanked” poor and minorities. Today, many inner-
city neighborhoods are forced to rely on payday lenders and other high-cost
intermediaries for basic banking services. Manuel Pastor of University of South-
ern California’s Program for Environmental and Regional Equity has shown
that traditional banks can succeed in opening ordinary branches and offering
ordinary services—savings accounts and accounts, mortgages, among others—in
these neighborhoods. In addition to benefiting these communities, this would
increase net savings and promote economic development.
Though it is not often thought about in these terms, reforming health insur-
ance—to make it universally accessible and stable in its premiums—would
be another financial innovation that would accrue both social and economic

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benefits. Because individual households’ economic fortunes are volatile, insur-

ance is one of their core financial needs. It is generally possible to buy adequate
auto, home, and life insurance, but for most people true long-term health insur-
ance is simply not available. While a majority of Americans get health insur-
ance through their jobs, many would be unable to remain insured should they
become unemployed. What they have is subsidized health care during their
term of employment; they don’t have true insurance. While there are several
ways to do it, making individual health care policies available to everyone (and
not subject to an accident of fate like a layoff or divorce) would allow consum-
ers to better plan their economic lives. There could be no better embodiment
of positive financial innovation.
Just as importantly, we need innovation in financial education. A large
part of our regulatory system relies on consumers being able to make intel-
ligent choices when faced by an ever increasing and ever more complex set of
financial choices. The recent crisis has shown that even large and supposedly
sophisticated investors, such as municipalities and pension funds, did not
fully understand the products they were buying. Economist Robert Shiller has
proposed government-subsidized financial advice; this may not be a sufficient
solution, but it is a start. Obama’s proposed Consumer Financial Protection
Agency (first proposed by Elizabeth Warren in Democracy, Issue #5, “Unsafe
At Any Rate”) could also go far in improving consumers’ understanding of their
financial options.
Simplifying the landscape of financial products, particularly those sold to
consumers, will reduce the opportunities for service providers to generate non-
interest fees from customers and will reduce the risk that households will make
catastrophic financial decisions. Slowing the tendency toward excess financial
intermediation will make it harder for the next credit bubble to form and reduce
the severity of the next crisis. In these ways, a more critical eye toward financial
innovation will help restore the balance that the American economy needs to
produce long-term, sustainable growth. d

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