Financial innovation has been less beneficial than advertised.

From the Peterson Institute for International Economics

Like most innovations, the theory behind the most-recent financial developments made sense. Innovative financial products such as credit default swaps and collateralized debt obligations were supposed to promote an efficient allocation of risk and hence allow those market participants to bear the risk of an asset who could do so best. Freed from the burden of such risk, nonfinancial companies would be able to engage in more-productive capital formation, generating growth for the entire economy. Furthermore, financial companies would be more stable because they would be able to get illiquid assets off balance sheets and not be tied to collateral. This mantra of Wall Street investors and financial economists alike implied that expansion in the use of newer derivatives and the like would lead to an expansion in the country’s capital stock, and that these financial products would be useful to nonfinancial companies, not just to banks.

The growth of derivatives and real-sector investment in the United States tell a different story (figure 1). Between 2003 and 2008, US gross fixed capital increased by about 25 percent, a reasonable number during an economic expansion, but hardly a boom. During the same five-year period, the global amount of over-the-counter (OTC) derivatives increased by 300 percent, while derivatives held by the 25 largest US commercial banks rose by 170 percent. Clearly, growth in new financial products has outpaced fixed capital formation both globally and in the United States by a large margin. This has been especially true since 2006, when investment stagnated, but derivatives continued to grow at a rapid rate. There only seems to be a weak link, if any, between the growth of the newest complex—and now proven dangerous if not toxic—financial products and real corporate investment. ...

Going forward, the US Congress and its international counterparts will have to decide how much to increase regulation and supervisory oversight of financial institutions. We are already hearing warnings from the financial industry that government should be careful not to overreach in its attempts at reform, for fear of harming financial innovation. While that is a worthy principle, our belief is that the record of recent financial innovations acts as a warning to be skeptical about excessive claims that all financial innovation is worthwhile. What was advertised as something to redistribute risk, and thereby increase productive investment, generated little capital formation; what was supposed to benefit nonfinancial businesses was mostly used in a speculative game between financial players.