Paul Krugman's column today called my attention to a paper that anyone interested in financial reform should check out.
The paper completely contradicts the conventional wisdom that innovation in finance is a good thing.
Indeed, the authors, including a behavioral finance theorist who has long challenged the "rational expectations" school (whose assumptions produced that so-called wisdom), say innovation inevitably leads to financial crisis built on what amounts to fraud, and that its only benefit ultimately is to the bankers that do the innovation, though even they end up suffering for it (unless of course they get a few-strings bailout like the TARP).
And the authors point out that the most recent crisis is by no means the only recent example of the phenomenon, citing the junk bond meltdown in the late 1980s as well as earlier problems in the mortgage market that led to the S&L crisis.
Don't ask me to summarize how their math demonstrates all this, but believe me when I say these guys, Nicola Gennaioli, Andrei Shleifer and Robert Vishny, are no slouches. Their money quote: "Innovation benefits the intermediary by allowing it to sell more claims while it hurts investors by enabling them to buy a claim that is more risky than they think."
I would only add that they might have included Enron and WorldCom in their list of examples of financial innovation that went systemically awry, though I suppose the dotcom meltdown didn't qualify as a financial crisis. Still, it did inspire the Fed to create a fresh asset bubble, via low mortgage rates and a see-no-evil approach to fraud.
Anyway, it seems to me the only basis for claiming that financial innovation has wider benefits is the claim that bank profits ultimately accrue to the public ("God's work," in Lloyd Blankfein's immortal phrase, or see his latest bon mot about the case against Goldman hurting "America.")
Indeed, the bottom line here is that latest research contends that even if those bank profits do trickle down to a significant degree, they are temporary at best and completely illusory at worst.