But while listening to a panel on financial innovation that included famed financial economist Myron Scholes—also a legendary financial innovator—speak yesterday, I came to the conclusion that it's very likely that we are over-producing financial innovation.
The argument for this proposition is rather straight forward. For several decades, government policies and bailouts have protected financial companies from realizing the full cost of innovation. When financial innovations fail, the government has almost always stepped in to assure that the firms responsible for the innovation do not. The FDIC protects commercial banks, SIPA protects the brokerages, implied too-big-to-fail guarantees protect the money center banks, and on and on.
When government programs remove the downside risk of taking an action, you almost always get more of it than the market would support. By protecting financial firms from realizing the full cost of financial innovation, the government is practically guaranteeing we get too much of it.
Advocates of financial innovation can respond that this is a worthy subsidy. Perhaps the natural level of financial innovation is too low.
But they should not get away with the notion that recent financial innovations are a product of pure market forces.
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