Innovation = skimming off the top

I’m sure I’m preaching to the choir here, but I just want to say again that the banks need to be heavily regulated. Especially if they are operating on de facto government guarantees, which shield them from the financial consequences of their foolish risk taking. You know, privatizing the profits and socializing the losses…

One argument against regulation is that it will stifle financial innovation, the source of the exploding profits on Wall Street. Fed chairman Bernanke came up with a few examples of the type of innovation he didn’t want to see stymied:

(1) credit cards — not exactly a new idea; (2) overdraft protection; and (3) subprime mortgages

Amazing eh? Just for score keeping, the credit card was invented in the 1950s (although there are earlier examples of similar ideas; overdraft protection is “meh” worthy; and subprime mortgages were a complete disaster.

What financial “innovation” has really meant is that banks have found ways around regulations to take more and more of a share of real business profits. Just let this graph soak in:
GRAPH of Financial Industry profits taking more and more of the % of business profits

Yglesias explains this phenomenon thusly:

I think another way of looking at what’s dubious about the innovation = massive profits line is to ask what happened to the competition? After all, there’s all kinds of innovation happening in the economy all the time. But the fact that a given sector is producing some innovations doesn’t normally lead to a structural increase in the sector’s profitability. Cars made in 2007 were way better than cars made in 1967, but each company had to compete against other companies who were all making better cars. …

Since that time, we’ve obviously had enormous innovation in the manufacture and design of computers and computer components. … We’ve had all kinds of innovation. But obviously not all of our sectors can increase their relative share of profits. And it’s also obviously not the case that the financial industry has been the most innovative over the past thirty years.

What would explain the rise in profits pretty clearly is that finance operates with a lot of implicit and explicit subsidies from the government. In exchange for those guarantees, the financial sector is subject to a lot of regulations. But if you have “innovative” ways of executing regulatory arbitrage, then you can achieve windfalls profits by taking advantage of the guarantees without paying the price in regulation. …  A certain amount of regulatory arbitrage is inevitable, but there’s no public interest in seeing it happen.

2 Comments

  1. Ian

    The regulation stifling innovation argument is weak. I don’t even see how the two are connected. It just seems like a handwaving argument meant to scare you off of regulation.

    I see it like this: regulation might stifle the big booms in profits, but it also prevents major drops as well. The major issue with the banking industry is that it is so essential to every other industry. The whole economy is so interconnected that everyone else isn’t insulated from its ups and downs. Thus these people arguing against regulation are essentially asking us to let them make massive profits, and we might benefit a little too, but deal with it when they start losing money and then bail them out. That’s crap.

    Regulation should inspire innovation. Since basically you will have to innovate to make massive profits under the new rules.

  2. Chris

    The idea presented by Yglesias and Krugman is that financial innovation (apart from genuinely good stuff like credit cards and other technological upgrades) is primarily tied to finding ways around regulation, rather than actually improving services. So while it’s likely impossible to stop “innovation” as such, it makes no sense to heed the calls of those who say regulation will stifle it.