Some financial ‘innovations’ are merely new names for ways of lowering credit standards, running up leverage, and increasing risk. How do we know what’s real and what’s not?

Financial Innovation — Illusory and Real

By Alex J. Pollock

In the 1990s, James Grant, that incisive and acerbic chronicler of the adventures and foibles of financial markets, wrote about the 1980s that science and engineering were progressive, but finance cyclical. He went on to say:

"In technology, therefore, banking has almost never looked back. On the other hand, this progress has paid scant dividends in judgment. Surrounded by computer terminals, bankers in the 1980s committed some of the greatest howlers in American financial history."

And what about the bankers and other financial actors of the twenty-first century? Surrounded by exponentially more computer power, supplied with reams of data, and informed by Nobel Prize–winning financial theories, they made even more egregious mistakes, creating, as we all know so well, an amazing bubble, an international panic, and a massively costly bust.

A while ago, the Financial Times had a contest to come up with the best word to describe the opposite of a “bubble.” My entry was a “shrivel,” which did not win. The winning entry was a “bunge.” This was drawn from “bungee cord,” the idea being that you experience a terrifying free-fall, but do in the end reach bottom and bounce back up. But we are speaking here of eternal financial patterns, not innovations.

The Kauffman Foundation’s Bob Litan has presented a highly interesting list of “good” and “bad” financial innovations. But as skeptical Greek sophists pointed out long ago, the same thing can be both good and bad. (Fire can warm you and cook your dinner, but it can also burn down your house or your neighbor’s barn.) So I propose a different distinction: that between illusory and real financial innovations.

In every boom, we hear about “creative” new financial products. For example, the Clinton administration’s home-ownership strategy in the 1990s called for “creative mortgages.” An extreme example of this sort of “creativity” was the “Option ARM” mortgage, where borrowers did not even pay all the interest due, thus in effect borrowing more each month — with this additional borrowing being booked as income by the lender.
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