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Is Financial Innovation Really So Bad?

Felix Salmon isn't keen on financial innovation:

Net-net, financial innovation is a bad thing: the downside, during times of crisis, is higher than the upside in more normal years.

What's Felix's evidence? He doesn't say, but presumably he's referring to the havoc caused by subprime mortgages, mortgage-backed securities and CDOs.

But Felix's claim is debatable at best. The impacts of financial innovation are almost impossible to measure. But if you take a look at GDP -- a number which oh so imperfectly captures our general progress -- it's still higher now than in 2006, when we were well into the housing boom. True, not all of that growth came from real estate, but a very sizable portion did.

Still, that's a minor quibble. The larger issue is that we need to reframe how we view financial innovation. And one of the first steps in doing so is to get a better handle on what types of things qualify as financial innovations. In the narrowest sense, a definition would include any new financial instrument designed by Wall Street. But more broadly, financial innovation should include the creation of any and all institutions and markets created to transfer money through time. (On the other hand, promising to negotiate a loan remodification does not qualify as an innovation.) Here's one of Robert Shiller's favorite examples of the latter which also highlights the interplay between technology and most any kind of innovation:

Consider the old age insurance of social security, which was first implemented by Germany in 1889. That plan, like most modern social security plans today, made payouts to retirees that depended on lifetime contributions, and hence required reliable records for millions of individuals for many decades. The German social security administrators needed to add to the records regularly, retrieve records reliably without losing them, and communicate with retirees around the country while managing a large payment system. The information technology available in the nineteenth century--the paper, the forms, the filing systems, the government bureaucracy--made this possible without prohibitive cost. It converted social dreamers into implementers. This particular risk management innovation has long since drastically reduced the problem of poverty among the elderly.

And if we look around us, financial innovation is plowing ahead despite the events of the past year -- except this time the primary enabler is the Democratic Party. For example, under consideration in the current health care reform debate is the creation of an insurance exchange intended to help pool risks and offer better access to health plan information for consumers. Similarly, a well-designed cap-and-trade system should help combat global warming. None of these institutions are guaranteed to work perfectly the first, second, or third time out (just take a look at Europe's carbon trading market), but that's little reason to limit their use.

--Zubin Jelveh