Financial innovation comes from trial and error


By D. Pontoppidan*, Summer Fellow at the Mackinac Center

Here’s a letter I sent to the WSJ a couple of weeks ago:

We’ve recently heard of a new federal financial consumer agency which will have the power to scrutinize complex financial products, fit them with warning labels much like cigarettes or toys digestible by small children, and even ban them if they are deemed overly risky. Have we completely abandoned the belief in responsible consumers participating in the financial markets?

My primary concern is how financial innovation will come about in a situation like this, especially if the consumer agency becomes too strong. We all know innovation will not come from those monitoring the market, nor are innovative and bold new products likely to be viewed as safe or conventional when they emerge. I am reminded of the Japanese samurai who were paid in rice, and because of a series of bad harvests needed a stable method of converting their goods into coins. This in 1730 led to the establishment of the Dojima Rice Exchange, the world’s first futures exchange market. As it turned out, the system worked fairly well, and has since been implemented around the world. Other systems were flawed and failed. This process is known as creative destruction, and is how financial innovation is brought forth. Through trial and error. A market that includes everyone at all times and in all places, is better at testing and deciding on the value of financial products than a board of bureaucrats.

Robert Shiller, the Yale economist who predicted the financial meltdown, also suggested the expansion of a growing futures market based on the Case-Schiller indices that would measure house prices in large American cities. Such a market would be able to guide the direction of house prices much better than other systems, because it involves those who look for a rise as well as those who expect a fall. Similarly, we can imagine hedging against other macroeconomic factors such as inflation, interest rates and unemployment – the limits are endless. The question is, will financial innovation make it past the consumer protection agency?

*The author took a class on behavioral and institutional economics with Robert Shiller.

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