Financial regulation vs. financial innovation

Thomas Masterson | May 6, 2010

The Washington Post reports that, testifying before a panel investigating the financial crisis, Henry Paulson “cautioned against overreaching on financial overhaul legislation now before Congress that he said could stifle innovation in the markets.” Well, we certainly wouldn’t want to do that! After all, financial innovation has been great for the economy right? Maybe not, but as Yves Smith notes, it has certainly been good for the finance sector and for financial innovators, as both empirical and theoretical studies argue. This suggests to me that Paulson, former head of Goldman Sachs, may not be thinking of the good of the society as a whole when he worries about the impact of financial regulation.

That being said, I don’t think any financial regulation coming out of Congress is likely to have much bite. Indeed, the Federal Reserve may have already had the regulatory power to avert the crisis but failed to exercise it, according to Bill Black (this post lays out his argument with links to video of his testimony on Lehman Brothers). This should come as no surprise, since the regional Federal Reserve boards are elected by bankers. Tom Ferguson points out that Obama was the candidate of finance, getting more of his early donations from them than any other candidate. If finance owns Congress (as Dick Durbin memorably¬†said), the Federal Reserve and the White House, where is effective financial regulation realistically going to come from?

It would be good if public outrage were transformed into the political will to reign in the over-sized influence of finance in our economy and politics. Outrage is (fortunately for bankers) being channeled against health care and energy policy instead. If that outrage were to find the appropriate target, we might get some actual financial reforms. Breaking up the big banks and reinstating the divide between commercial and investment banking would be a good start.

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