Don’t Be Scared Of Financial Innovation

This article from the November 2014 edition of the IPA Review is by Adjunct Fellow at the IPA and Professor of Economics at RMIT, Jason Potts.

Close your eyes and think about innovation in medicine, or innovation in software design or clean energy, or even innovation in pizza delivery: your frontal lobes will flood with dopamine as you contemplate those new lower prices and improved performance, functionality and deliciousness. If you’re a politician, maybe you go to your happy polling place when you think about all the new jobs and new industries that innovation will bring.

So why do otherwise reasonable people go completely bonkers when it’s financial innovation we’re talking about? We get claims that financial innovation harms the poor, causes reckless speculation and frothy bubbles, collapses global economies, and probably eats babies too (it certainly doesn’t deny doing it!). Warren Buffett famously called credit default swaps (an innovative species of derivative) ‘financial weapons of mass destruction’. Here in Australia, heterodox economist Steve Keen was regularly calling ‘bubble’ on housing and stock markets, blaming financial deregulation. Calls to regulate the financial sector with ever more ‘Basels’ and prudential regulation authorities are sagely editorialised as the sort of thing that sensible grownups say.

Financial innovation is of course different to the more industrial species of innovation that tend to take place in corporate research laboratories staffed by white-coated elves, and which are awarded patents and earn tax credits—i.e. the sort of innovation that we work very hard to encourage.

First, financial innovation is much older. Various forms of debt and credit instruments trace back thousands of years. Financial innovation gave us the trade routes, money, the modern corporation, valuation, capital accumulation through investment, insurance: basically all of the ingredients of modern market capitalism.

To sharpen this point: the main beneficiaries of financial innovation are the same set of people who benefit from modern capitalism— namely the masses of poor who get lifted into the middle classes.

Yet, bizarrely, these are the very people that proponents of increased financial regulation to stop financial innovation claim to be protecting.

Second, because financial innovation is much older, any new idea probably already exists. The reason it’s not in play is usually because it’s illegal, or unprofitable in the milieu of current financial regulations. So unlike industrial innovation, which tends to lead with investment in research and development, and for the reward of market share, financial innovation usually requires targeted deregulation. It also tends to work through entire sectors (such as mortgage brokering) rather than a specific individual innovating firm. Financial innovation is thus far more tied up with industry lobbying and political gains and losses than is typical in industrial innovation.

Who gains and loses from that? It is important to understand that many financial firms—the ones that are already players in the market —want to be regulated, a point made by University of Chicago economist George Stigler many years ago. Now regulation is of course burdensome, in that it imposes costs and constrains entrepreneurial behaviour. But that cost falls more heavily on new entrants, thus in effect protecting rents inside the market. These incumbents will be the first to agree ‘for the benefit of the industry’ and ‘the protection of the consumer’ to all manner of supervision, regulatory restrictions, licensing, and so on. This doesn’t harm them at all. The real cost falls upon the consumer, who is now priced out of financial product offerings (such as on financial advice or risk management services) and thus chooses to go without; or it falls on the new firm that cannot make a business model work against these incumbent advantages.

The incumbent firms look like good corporate citizens, and the politicians and regulators look like they’re doing their jobs by protecting the innocent and vulnerable. Yet nothing could be further from the truth. Endeavours to stifle and control financial innovation are as harmful and damaging to consumer welfare as they would be in any other sector. And the benefits go to the usual suspects: insiders and cronies.

Earlier in the year, the Federal government initiated a Financial System Inquiry (the Murray inquiry) that has attracted over 280 first-round submissions, the general theme of which skews heavily toward the usual platitudes of calling for smarter, better regulation to meet diverse community needs, and weathering storms, and remembering the lessons of the financial crisis, and so on.

But where is the discussion about how some start-up in a garage in St Kilda might be developing a new platform for peer-to-peer lending that could destroy retail banking altogether as we know it. Or how financial advice might be bundled with other service products—say in nail salons. Or people trying to figure out ways that we can ‘short’ housing markets, or take equity stakes in people. Yet these disruptive things are precisely what our regulators are trying to avoid. In any other industry that would be considered traitorous cronyism. In financial services it is considered best practice.