Two of the Scariest Words in the English Language: Financial Innovation

Posted on Sep 16, 2013 | 2 Comments

Just a few years ago, much of the world applauded when former U.S. Federal Reserve chairman Paul Volcker told financiers that the only useful financial innovation they’d created during the previous two decades was the ATM.

After a real estate bubble and bust that had been assisted by impossibly complex financial instruments, Volcker’s words were a refreshing response to Wall Street’s humbug.

But today, writes Simon Nixon in The Wall Street Journal, “financial innovation is not just back in favor but a public policy priority.” Governments, eager to accommodate everyone’s demands of “cheap credit for all, a risk-free financial system and perpetual growth,” want banks to start lending more and get more credit flowing.

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Image credit: Sean Ryan

The trouble, argues Nixon, is that governments are not encouraging innovation as much as a repeat of bad old tricks. “While the government talks about encouraging financial innovation, it has introduced a variety of new subsidies to reduce bank funding costs and encourage riskier mortgage lending that tilt the playing field against innovative new entrants,” Nixon writes. “Indeed, the biggest innovation arising from the crisis may be a shift from implicit guarantees for too-big-to-fail banks in favor of explicit guarantees and subsidies for politically favored groups.”

Certainly, as we’ve observed, none of this is the sort of innovation that Peter Drucker liked to see. In fact, Drucker shared a lot of Volcker’s skepticism about the financial industry. “The dominant financial services institutions have not made a single major innovation in 30 years,” Drucker wrote in a 1999 essay on financial services, published in Managing in the Next Society. “The only innovations have been any number of allegedly ‘scientific’ derivatives.”

Nonetheless, Drucker did believe that financial innovation was possible, potentially beneficial and even necessary. In his essay on the topic, he laid out a number of ways in which he felt large financial firms could benefit consumers. These included expanding the investment services offered to the middle class and offering outsourced financial management to midsize businesses.  And he saw plenty of merit in helping people to increase their purchasing power—provided it was done sensibly, as Cyrus McCormick did in the 19th century with installment purchases for farmers, and not just with reckless extensions of credit.

Was Drucker sanguine that such healthy innovation would happen? “It may not be too late for existing financial firms to become innovative again,” he wrote. “But it is surely very late.”

How can government policy encourage healthy financial innovation?

2 Comments

  1. Marion E. Houser III
    September 17, 2013

    spare me … “quantitative easing” is perfect evidence for “financial innovation” along with whatever word salad we were lemmingly ingesting leading up to qe

    “financial innovation”? … no thanks – debauched currency is enough for me

    Reply
  2. Maverick 18
    September 21, 2013

    Paul Volcker was simply wrong. The ATM was invented a long time ago (1930s), but was never implemented to any significant degree until after credit cards were in use. The origin of credit cards is after WW II, and the first credit card widely used was the Diners Club card circa 1950. ATMs were introduced later but were not widely implemented until the computer age got rolling. One could say that ATMs were a by-product of the computer age and not financial innovation at all.

    Great moments in financial innovation include such things as establishing a national bank, a national currency, various types of taxes, the Federal Reserve system, and doing away with debtors prisons and involuntary servitude. Perhaps it’s time to re-examine some of the biggees, e.g. the entire multi-layered taxation scheme, widely regarded as too complicated, too costly, and unfair. Government needs to innovate with respect to its financial role as the first step in encouraging healthy financial innovation.

    Reply

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