Monday, 13 April 2009

Financial innovation and a free lunch

The following is a thread from some comments I made earlier in response to an interesting piece by Felix Salmon about potential for downsizing the financial services sector through increased regulation.
My first comment to this was as follows:

Ironically the pace of financial innovation is often driven by the need to circumvent regulations. There could be even more stacking of layers of financial intermediation and complex products rather than less.
They will probably not be as profitable to any individual firm as they were during the last several years (until the bubble burst), and to that extent I agree with your comment on Goldman Sachs. But it may be even more expensive to clean up the mess when they go wrong again.

One of the other commenters replied at length to my observation stressing that certain kinds of financial activity should be forbidden (he uses the word several times in block capitals)

My second comment in response was along the lines of what I have been writing extensively about recently for a new book.

You suggest in response to my comment that we should "make banking the utility it was until the 1970's and should be again"
If only it was so simple... the financial landscape is totally different today to the 1970's.

The biggest step towards the world of modern finance and all of its associated risks was the abandonment of the Bretton Woods stability framework and fixed exchange rates that took place in the 1970’s and Nixon's final nail in the coffin for gold convertibility with the US Dollar.
Increased risk was not for the reason that many believe i.e. the creation of fiat currencies but because of the creation of a new era of financial complexity. Suddenly the world had a plethora of new financial variables - exchange rates, floating rate instruments denominated in euro-currencies and I do not mean the Euro of today but the euro market that originated for dollar based deals that were outside the US jurisdiction and based in London, financial futures and swaps etc. etc.

Not only was there an explosion in the number of variables but innovative financiers began to exploit relationships within this new web of financial variables eventually creating layers of derivatives etc. This opened up the era of financial arbitrage – and allowed the smart money to think they were getting a free lunch....

Thirty years later we know that the lunch was rather expensive

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