Are the problems posed by financial innovation due to the lack of a free market or due to the nature of the market?
In a purely free financial market with no regulation, a financial innovation could that takes hold and becomes ubiquitous (like the repo example) creates a systemic risk because if a significant number of banks fail, then you have a contagion that spills out to people who had nothing to do with it. Basically, a big, negative externality. The regulation seems like it should be about reducing that externality (but financial innovators find their way around it and keep recreating it).
“In the context of a free market, innovation is a positive-sum game. The innovations that survive—most don’t—are the ones that conserve resources and improve quality. In the case of financial innovation, improving quality could mean better risk management.”
I’d say
In the context of a free market, innovation is a positive-sum game. The innovations that survive—most don’t— are the ones that reduce both scarcity and uncertainty. Financial innovation succeeds when both resource allocation and risk management improve.
More importantly, I’d say that financial intermediation has always been regulated by governments. This regulation has been motivated mainly by the need to finance the spending of governments and special interests. Only recently it has been motivated by the prospect of fraud in the management of other people’s savings.
This is the best explanation of the repo market i've ever read or hear and i've been reading/listening on this topic for over a decade. Thanks Arnold.
Are the problems posed by financial innovation due to the lack of a free market or due to the nature of the market?
In a purely free financial market with no regulation, a financial innovation could that takes hold and becomes ubiquitous (like the repo example) creates a systemic risk because if a significant number of banks fail, then you have a contagion that spills out to people who had nothing to do with it. Basically, a big, negative externality. The regulation seems like it should be about reducing that externality (but financial innovators find their way around it and keep recreating it).
You say
“In the context of a free market, innovation is a positive-sum game. The innovations that survive—most don’t—are the ones that conserve resources and improve quality. In the case of financial innovation, improving quality could mean better risk management.”
I’d say
In the context of a free market, innovation is a positive-sum game. The innovations that survive—most don’t— are the ones that reduce both scarcity and uncertainty. Financial innovation succeeds when both resource allocation and risk management improve.
More importantly, I’d say that financial intermediation has always been regulated by governments. This regulation has been motivated mainly by the need to finance the spending of governments and special interests. Only recently it has been motivated by the prospect of fraud in the management of other people’s savings.