Sonia Gandhi has finally placed the regulation of finance squarely on the political agenda.
Till very recently, financial innovation appeared to be a growth engine for the US and UK. It drove the explosive growth of derivatives till they came to exceed three times the size of global financial assets (broadly defined). Many well-trained minds rushed to the city for the lucrative task of designing and selling new and finely differentiated credit risk products. This century seemed well on course to be the Schumpeterian century, defined by innovation, led by finance.
Presciently, Schumpeter?who brilliantly analysed the way economies were propelled by the mechanism of innovation and who coined the memorable phrase ?creative destruction? to capture the manner in which innovation created not only winners but also substantial losers?feared for capitalism in the long run. His concern was that governments would be unable to provide the social insurance necessary for people threatened by the destructive counterpart of innovation. What we now see is an entirely different animal: notable innovators in a notably innovative industry are on the brink of ruin.
In her speech, Sonia Gandhi stressed the need to balance prosperity and social justice, and the need for ?liberalisation within the framework of sensible, but not heavy-handed, regulation?. This is a hard problem. How are regulators to tread the narrow line between rules that are too loose and those that are too tight? Are there any general principles?
First, as in other industries, competition drove financial products to become more complex. As Schumpeter pointed out, any new product tends to have a niche with high profit margins for a while. But as the product becomes standard, market gets competitive, profit margins drop and providers begin to differentiate. Complexity makes direct comparisons of price and product difficult and is a source of profitability. Hence, for example, the bread and butter financial innovation of mortgages led to the innovation of bundling mortgages into pools against which securities of different risk levels could be sold to buyers with different risk appetites. But then these securities were themselves pooled, and claims sold against such pools, and further, then securities of this provenance were again pooled and further securities issued against them, and so on. The instruments were so convoluted that they could not be priced even by their creators. Innovation engenders much complexity.
Second, enlargement of market size via entry of new classes of buyers is an important innovation?providing easier access to financial markets and information to ordinary people. This may be described as democratisation. In finance, this was not limited to more day-traders buying and selling vanilla financial products. Marketing of complex instruments reached out to corporate mandarins who did not have the capability or the time to analyse these things. Innovative marketing and sales pitches, aided by ratings, democratised the market for complex financial products.
So what we have learnt is that when opaque financial products are bought by a wide range of people who do not understand them, at hit or miss prices, the consequence is the build up of tight and critical interdependencies in the financial system. Then, small triggers can set off unintended but fatal consequences. The lesson is that while it is simplicity that combines well with democratisation, the compelling logic of the innovative process is to harness both complexity and market reach.
Just like untested drugs, complex unproven financial products can have fatal side effects. A loose analogy that regulators of financial innovation might work towards is that of clinical trials. Designing and setting up a workable laboratory for this will take a lot of effort and capability, and international regulatory co-operation. But then, many experienced, able and eager individuals are available for the purpose at this time. As Paul Romer said, a crisis is a terrible thing to waste!
The author is reader in economics at Judge Business School, University of Cambridge