Adam Posen and Marc Hinterschweiger at the Peterson Institute for International Economics have a very interesting post up looking at some aspects of financial innovation during the boom. They examine derivatives use through two perspectives: sheer growth exploded in 2003 or so with the bulk of the activity by 2008 -- nearly 90% -- involving financial players. Posen and Hinterschweiger also note that while U.S. gross fixed capital grew 25% between 2003 and 2008, derivatives held by the 25 biggest U.S. banks grew 170%. Posen and Hinterschweiger's conclusion is that derivatives such as credit default swaps became a trading game between financial operators that produced very little in the way of "productive lending or a more resilient financial system."
There's no arguing about the resilient financial system. After all, we've seen the effect CDS had on undermining broad swaths of the system. And it's a clear lesson of this crisis that any number of innovations had a profound ambiguity, that is light and dark sides, which at the top of the boom were very hard to separate. And yet Posen and Hinterschweiger are trying to look at derivatives as discrete entities. What they're not seeing is how banks used derivatives to free up capital to produce abundant lending and liquidity. Much of that liquidity was then pumped out to nonfinancial borrowers, from corporations on buying sprees to the private equity firms assembling massive buyouts. A corporation did not have to be involved as a CDS counterparty to participate in the CDS-inflated credit bubble. And like consumers, few corporations did not participate in the boom in some way or the other -- and, given the mounting bankruptcy statistics, paying the price for it.
That's important because we now feel the effects of constrained credit and liquidity. The shadow banking system, which was another Janus-faced innovations, is currently moribund; and any number of derivatives markets are constrained by tight leverage. The result: Although the situation seems to be improving, there's still not the kind of free-flowing credit that's required to drive a recovery. In short, financial and nonfinancial operators have every reason to want to see some of these innovative mechanisms functioning again. The real question, of course, which Posen and Hinterschweiger do not tackle, is how we can regulate these innovations to emphasize the good, productive side and minimize the bad, speculative, nonproductive aspects. And so far, besides some movement on clearinghouses, there's been very little light thrown on that subject. - Robert Teitelman
Robert Teitelman is the editor in chief of The Deal.
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