Analysis of the financial crisis — and financial innovation

MIT Sloan School professor Simon Johnson offers an unsettling interpretation of the financial crisis. Also: Federal Reserve Chairman Ben Bernanke spoke about the relationship between financial innovation and consumer protection.

Ready for an unsettling interpretation of the financial crisis? MIT Sloan School professor Simon Johnson’s new article in the The Atlantic is titled “The Quiet Coup.” His argument? As a former chief economist for the International Monetary Fund, Johnson observes striking similarities between the current financial crisis in the U.S. and earlier crises that affected emerging markets. One common factor, he indicates, is a too-cozy relationship between a country’s government and its business elites. Writes Johnson:

Elite business interests — financiers, in the case of the U.S. — played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive.

The Role of Financial Innovation

According to Johnson, one of a number of symptoms of the financial sector’s political influence over the last decade was “an intentional failure to update regulations so as to keep up with the tremendous pace of financial innovation.”  In a speech last week, Federal Reserve Chairman Ben  Bernanke  addressed the  relationship between financial innovation and consumer protection.

In his speech, Bernanke acknowledged that the last two years have shown that financial ”innovation that is inappropriately implemented can be positively harmful.” He later added that “the difficulty of managing financial innovation in the period leading up to the crisis was underestimated.”

Bernanke concluded that, rather than prevent innovation, regulators should allow “responsible innovation” that increases consumer welfare. How to do that? Bernanke suggested that regulators, in effect, weed out harmful financial innovation before it is implemented — by asking more questions upfront. (One example: ”How will the innovative product or practice perform under stressed financial conditions?” ) 

Reflecting on Bernanke’s speech, James Kwak, who blogs with Simon Johnson at The Baseline Scenario website, draws a distinction between two different types of financial innovations: those that make consumers’ lives easier — such as ATMs — and those that increase access to credit — which may or may not be beneficial, depending on the circumstances.

On the other hand, Kwak notes, many innovations — not just financial ones — have a “double-edged” quality – in that they offer both benefits and drawbacks. For example, he points out that the development of plastics has had great benefits — but has also led to problems such as “ an enormous amount of garbage that is now collecting in giant pools in the middle of our oceans.”  (For more on that topic, see MIT Sloan Management Reviews sustainability blog.)