Shiller: Has Financial Innovation Been Discredited?

Robert Shiller says we shouldn't try to limit financial market innovation, we might need it to prevent another crisis:

Has Financial Innovation Been Discredited?, by Robert J. Shiller, Project Syndicate: Skeptics of financial liberalization and innovation have been emboldened by the crisis in the world’s credit markets... Are these skeptics right? Should we halt financial liberalization and innovation in order to prevent crises like the sub-prime disaster from recurring? ...

[W]hile 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. ...

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. ...

The reason is simple. Individual firms might have splendid investment opportunities ... but might be deterred by cash shortages or perceived macroeconomic risks. Effective financial markets enable them to pursue such opportunities despite these constraints...

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. ...

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, ... 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.

Update: I probably should have noted Dani Rodik's "Why Did Financial Globalization not Deliver the Goods?.