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After the financial crisis, in praise of Wall Street's wizards

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By Carlos Lozada
Sunday, February 21, 2010

Remember when we admired Wall Street's financial wizards, the math and computer geeks who dreamed up all those credit default swaps, mortgage derivatives, collateralized debt obligations and the like? They were wise. They won Nobel Prizes. They made the economy more efficient. And they earned tons of cash.

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Today, of course, they're the villains, the ones who ruined everything for everybody. The Obama administration wants to regulate their trading. Business reporters put out damning books about them, including Scott Patterson's "The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It." And former Fed chairman Paul Volcker says that their new products didn't really make the economy more productive and that the best financial innovation of the past few decades has been the ATM.

Into this fray steps Robert E. Litan, an economist at the Brookings Institution, with a spirited report titled "In Defense of Much, but Not All, Financial Innovation." In the 47-page study, released last week, Litan runs through the recent history of innovation in banking and finance, from ATMs to credit default swaps, with many stops in between.

He breaks down financial products according to their key roles -- allowing parties to pay one another, enabling savings, channeling savings to productive investment and allocating risk to those most willing and able to bear it -- and assesses whether they expanded access to finance, offered convenience and boosted economic growth. Litan concludes that most financial innovations accomplished all three goals, while acknowledging that some were poorly designed (such as collateralized debt obligations, which he decries as "financial alchemy") or misused (such as home-equity lines of credit).

Most compelling, though, is Litan's defense of the power of innovation in the economy -- a perspective that has virtually disappeared in the rage over bonuses and bailouts. Just because new financial products are often developed to bypass regulations, Litan writes, "this does not make them bad or good." (Money-market mutual funds, for instance, which he praises, came about because bank interest rates used to be capped.) Although Litan favors preemptive regulation for pharmaceuticals and nuclear power, he argues that financial products are best regulated after the fact, once the market has had a chance to test them. "If a skeptical view of financial innovation takes hold" among policymakers, he warns, the result could "chill the development of innovations that would benefit consumers, homeowners and investors."

-- Carlos Lozada

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