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Is Financial Innovation Good For The Economy?

In: Innovation Policy and the Economy, Volume 12

  • Simon Johnson
  • James Kwak

Executive SummaryThere has been a great deal of financial innovation in recent decades but its social value is unclear. In the run-up to 2008, banks took large amounts of risk relative to the size of the economy. This approach was made possible by and sometimes justified in terms of "innovation." But it also created a great deal of downside risk for the economy--including widespread job losses and a big increase in the fiscal deficit.Innovation is among the most powerful forces that shape human society. The improvements in the material standard of living enjoyed by most (though not all) Americans are largely due to innovation. One of the principal arguments for free-market capitalism is that it is the economic system that most encourages innovation, because it allows innovators to capture a significant part of the benefits of their work.Today, financial innovation stands accused of being complicit in the financial crisis that has created the first global recession in decades. (See, e.g., Johnson and Kwak 2010, 105-9). The very innovations that were celebrated by former Federal Reserve chairman Alan Greenspan earlier this decade--negative-amortization mortgages, collateralized debt obligations (CDOs) and synthetic CDOs, credit default swaps, and so forth--either amplified or caused the crisis, depending on your viewpoint.However, the conventional wisdom is coalescing around the idea that financial innovation is basically good, but just needs to be watched a little more carefully. As Ben Bernanke said in a speech in May 2007: "We should also always keep in view the enormous economic benefits that flow from a healthy and innovative financial sector. The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it can be most productive. The dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks. When proposing or impleme

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This chapter was published in:
  • Josh Lerner & Scott Stern, 2012. "Innovation Policy and the Economy, Volume 12," NBER Books, National Bureau of Economic Research, Inc, number lern11-2.
  • This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 12450.
    Handle: RePEc:nbr:nberch:12450
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    1. Josh Lerner & Antoinette Schoar, 2010. "International Differences in Entrepreneurship," NBER Books, National Bureau of Economic Research, Inc, number lern08-2.
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