Eight Financial Innovations to Believe In

What does the financial industry have against the regulatory reform? Well, there's money, naturally. The bill that passed the House last week would create a Consumer Financial Protection Agency, a big new watchdog bureaucracy that will inevitably raise compliance headaches and interfere with the industry's unfettered ability to dream up ever more complicated financial products. The way the industry has chosen to phrase this latter concern is to say that reform will hurt consumers by stifling financial innovation.

In this issue of Democracy, economists Simon Johnson and James Kwak skewer the idea that financial innovation is an unqualified blessing for you and me. Former Fed chairman Paul Volcker's rant to bankers in London last week makes the same point.

I hear about these wonderful innovations in the financial markets and they sure as hell need a lot of innovation. I can tell you of two - Credit Default Swaps and CDOs - which took us right to the brink of disaster: were they wonderful innovations that we want to create more of?

.... I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information.

A few years ago I happened to be at a conference of business people, not financial people, and I was making a presentation. The conference was being addressed by a very vigorous young investment banker from London who was explaining to all these older executives how their companies would be dust if they did not realize the joys of financial innovation and financial engineering, and that they had better get with it.

I was listening to this and I found myself sitting next to one of the inventors of financial engineering who I did not know, but I knew who he was and that he had won a Nobel Prize, and I nudged him and asked what all the financial engineering does for the economy and what it does for productivity. Much to my surprise he leaned over and whispered in my ear that it does nothing. I asked him what it did do and he said that it moves around the rents in the financial system and besides that it was a lot of intellectual fun.

The most important financial innovation that I have seen in the past 20 years is the automatic teller machine... How many other innovations can you tell me of that have been as important to the individual?

To give financial innovators, their due, I can think of a couple other innovations of the past three decades, besides the ATM, that could fairly be said to have made financial life better:

• Credit and debit cards: They're a little like fire: Risky in the wrong hands, but overall a great advance for civilization.
• Mortgage-backed securities: They put more money for home loans into circulation and lowered rates for homeowners. It wasn't until Wall Street further bundled them into CDOs and bankers abandoned all lending standards that they became the enablers of the housing crisis.
• The money market fund: Okay, maybe the money market fund has been over-engineered to seem safer than it really is. But by unlocking market interest rates to ordinary savers, money funds freed us from being monopolized by banks.
• The index mutual fund: The index fund brought low cost investing and the best academic thinking about markets to the ordinary person. Here on CBS MoneyWatch.com, Nathan Hale eloquently explains why index funds are something to be thankful for.
• The 401(k): Until employers pushed it to replace traditional pensions as the foundation of the U.S. retirement system--a role it was never designed to play--the 401(k) was a clever and elegant way to democratize benefits that had been limited to top executives.
• The ETF: I like the ETF, when used as a low-cost alternative to index mutual funds, but like most financial innovations, Wall Street has done its best to turn it toxic. The latest variations are no more than invitations to gamble on narrow market sectors, and can trade at wide discounts and spreads, totally negating the benefits of low cost.
• The target-date retirement fund: Yes, they lost money in the crash, but what didn't? Their basic idea is sound. Over the course of most people's career, they'll do far more good than harm.

That's about it, though. Eight useful innovations. Not much to show for 30 years of financial creativity.

Most financial innovations for consumers tend to be ways to fatten profits for financial service providers by rendering simple products more complicated. (I'd join my colleague Allan Roth in putting many life insurance investments in that category.) Too often financial innovations arise not to help people, but to cater to their worst excesses of greed or fear: Technology funds introduced at the height of the tech stock bubble, or the emerging markets funds that inevitably come out of the woodwork at market peaks. In the current risk-averse climate, I'd say that equity-indexed annuities that prey on people's worries about the stock market are another innovation we could live without.

But maybe I'm being too harsh on our financial engineers. Are there others I'm not thinking of that actually have made your financial life better? Are there others you'd single out as especially dangerous?

More on MoneyWatch:

Why We Need a New Agency to Protect Consumers
Why the CFPA Won't Save You

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