When Someone Says "Financial Innovation," Put Your Hand on Your Wallet

Our society needs financial innovation, and still seems vulnerable to changing animal spirits and speculative bubbles that create truly big problems. Even if they can be mitigated, periodic crises may not be preventable, at least not by banning abusive credit cards or even by throwing the bad guys in jail.

--Robert J. Shiller, July 18, 2009, NYT

The financial flack who came up with the phrase "financial innovation" deserves the Bernie Madoff Financial Engineering Prize of 2009, which I propose be awarded to the most outrageous fantasy finance concept of the year. That felicitous phrase builds on an analogy that equates financial hustles with tangible inventions in the real economy. But if you push on that analogy just a little bit, it collapses.

Yale economist Robert J. Shiller uses the analogy to compare financial engineering to the problems associated with the first steam engines:

James Watt, who invented the first practical steam engine in 1765, worried that high-pressure steam could lead to major explosions. So he avoided high pressure and ended up with an inefficient engine.

It wasn't until 1799 that Richard Trevithick, who apprenticed with an associate of Watt, created a high-pressure engine that opened a new age of steam-powered factories, railways and ships.

Shiller's point is that we need to be more patient with the financial crap that crashed the economy, since it was just the first pass through the invention cycle. Don't worry, he counsels, we'll get there.

I hope not.

He unintentionally misleads us and himself with his analogy. Unfortunately, the differences between inventions like the steam engine and the creation of a synthetic collateralized debt obligation are so great as to make the comparison totally meaningless.

For example, when the first stab at the high pressure steam engine failed, nothing much happened to the real economy. Okay, at most maybe Mr. Watt had to lay off a couple of craftsmen. However, when the first pass at our synthetic collateralized debt obligations exploded spectacularly, it took down the entire world economy and killed more jobs than any time since the Great Depression. The crash was so great that our government felt compelled to dump more than $13 trillion in TARP funds and asset guarantees into our collapsing financial system. I don't think it is possible to find an example of a failed invention that had such a negative impact in such a short period of time.

We need to get rid of this misleading analogy. The "financial innovations" that brought down the system are not really inventions (consider the fact that none are patentable, and that's true even under our current patent regime that is far too generous toward "inventors"). Nearly all of them are financial casino games designed to produce fat fees for the banks that create, package and market them. They won't be able to get rid of the risk of gambling any more than alchemists could turn lead into gold. (For the full version, see The Looting of America.)

Though generally a perceptive analyst of modern economic absurdities -- he was one of the shamefully few voices pointing out that the housing bubble was in fact a bubble, before it had burst -- Professor Shiller firmly believes that if we keep working at it, we'll come up with derivatives that will protect us all from bubbles and busts, as well as all the other gyrations of our modern capitalist economy. By doing so, he joins the chorus of bank lobbyists and mortgage hustlers who warn Congress not to be too tough on the financial industry for fear a crack down might stifle "financial innovation."

But that lobbying game has nothing to do with financial innovations that will better society. It has everything to do with avoiding constraints that might interfere with what Wall Street is all about: making as much money as possible in the shortest period of time.

Hang onto to your wallet because right now, some financial "engineer" on Wall Street is working on news ways to separate you from it, while the bank lobbyists are making sure no government regulation gets in the way of the heist.