When Ben Bernanke, chairman of the Federal Reserve, returned to Princeton last month, he defended the field of economics against the claim that it had failed to predict the current crisis by separating the discipline into “economic science” and “economic engineering.” While economic scientists study individual behavior and economies, economic engineers design tools, ranging from stocks to credit default swaps, for achieving economic objectives. As Bernanke put it, “Underpinning any practical scientific or engineering endeavor, such as a moon shot, a heart transplant or the construction of a skyscraper are: first, fundamental scientific knowledge; second, principles of design and engineering.”
But in reality, engineering comes first. Wall Street creates new financial instruments with no regard for systemic safety and tests them on unsuspecting people. Only then do economists study the effects. The dismal science seems to be the only one permitted to perform human subject research without consent, often with catastrophic effects.
And financial innovations often coincide with catastrophe. When banks realized they could sell consumers stocks on margin, the resulting stock market collapse and bank runs contributed to the Great Depression. The government fixed the mistake by creating the Federal Deposit Insurance Corporation and requiring banks to insure their deposits. Consumer banking is now safe and helps millions of people, but no one can deny the effort and turmoil that it took to get here. As Wilson School professor Elizabeth Bogan told me, “The cycle of regulation is often not efficient. It blocks a previous mistake and does nothing to stop the next mistake.”
Modern credit default swaps and other financial innovations “contributed to the current economic crises,” Nobel Prize-winning economist Joseph Stiglitz said in a recent debate in The Economist. Most of the instruments involved in the recession had nothing to do with economic efficiency, he said, but rather were used to hide information from investors, dodge taxes and commit fraud. “And those benefiting from such deception have been willing to pay amply for it, with large profits to the innovators, even if society as a whole loses,” Stiglitz concluded.
So what can we say of an industry that progresses through trial and error, and therefore will always be a source of risk and turmoil to the larger economy? No other sector of the economy is allowed to work this way. From pharmaceuticals to construction, innovative engineers must get permission to test their inventions on unwitting civilians. Why should finance be different?
Yet if you think we can rely on regulation and regulators to allow the good innovation and prevent fraud and abuse, ask yourself how many of your classmates are studying finance to go to Wall Street? How many become regulators?
Exactly, says Bogan. Even though the finance industry harbors a constant risk of catastrophe, over-strenuous regulation is a bad way to minimize that risk. “I don’t believe in prior approval of anything, unless it could cause physical harm,” she said. She supports increasing the amount of cash a bank must keep on hand to ensure it can cover its bets. This type of regulation makes all bets more expensive for banks, rather than just dictating which types of bets are good or bad.
Still, the bad types of innovations identified by Stiglitz will always occur as long as bankers are motivated by profit, tax dodging and fraud are profitable, and new financial maneuvers are hard for regulators to understand.
In the end, there are two options: We can err on the side of caution or on the side of economic efficiency.
If you believe that financial innovations have caused more harm than good, the answer is clear: Impose strong and exacting regulation to pour ice water on the overheated financial sector. Although we may miss out on the benefits of innovation, at least catastrophe will be less likely. Even increasing capital requirements as Bogan suggests would be a step in the right direction: Any cash used to gamble on derivatives is cash not being invested in the real economy.
However, even if you choose to err on the side of economic efficiency, it is still impossible to ignore that the cycle of financial innovation must necessarily be a regular source of catastrophe and pain for millions of Americans. Those who oppose strong regulation to prevent infection at least have a responsibility to help treat those with symptoms.
As Bogan put it, “If you’re some guy that never understood economics, diligently did your job every day and suddenly you’re fired ... it’s not much solace to say, ‘Well, nice guy, glad you contributed to long-term economic growth, the rest of your life sucks.’ You’re 55, and you may never get a job again.” Many of the downsides to allowing a less-regulated financial sector can be mitigated by a stronger social safety net. Free markets are beneficial, but they aren’t free. We can lessen their societal costs with unemployment insurance and government assistance for necessities like food and health care.
Whatever the benefits of financial innovation are, they come at a very real price to millions of Americans. If we choose to reap those benefits, we must acknowledge our responsibility to the regular people who pay that price.
Allen Paltrow-Krulwich is a freshman from New York, N.Y. He can be reached at apaltrow@princeton.edu.
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