ECONOMISTS uniformly agree on very little when it comes to macroeconomics. Off hand I can think of two things in particular: bad monetary policy wreaks havoc and innovation, ultimately, is the engine of economic growth. I like to believe we have learned enough that the days of hopelessly misguided monetary policy are behind us and the future will be full a new innovation. But, so long as we have innovation we will also have business cycles. Innovation by definition creates uncertainty. The uncertainty reveals itself in a Schumpeterian sense, over investment which inevitably leads to contraction. But most recently it has caused problems because innovation out-paced the infrastructure it needs to work properly.

The new financial derivatives, what makes up the so called “shadow banking system”, have frequently been named the villain in the latest financial crisis. They rely on complex mathematical models, not accessible to the non-quantitative. The perception has become that this makes them opaque and difficult, if not impossible, to regulate. Whenever anything comes along that is unfamiliar, but not yet fully understood, there exists a temptation to label it as uncategorically dangerous. But limiting innovation because of uncertainty constrains growth. The market for derivatives has allowed investors to take positions they never could before. But that is not necessarily a bad thing.

Allowing investors to take the risky position they desire makes more than just Wall Street traders better off. For example, innovation in the market for derivatives of commodities has increased the flow of energy and commodity products around the world. In particular, emerging markets have gained better access to these resources. This has in turn resulted in the huge improvement in real estate, infrastructure, and the general quality of life for the people of China, India (these two alone represent over 1/3 of the world's population), and many other countries.



An eminent economist I spoke with recently made the following analogy: derivatives are like a car with four wheel drive. Four wheel drive makes driving safer, but it also means people will be more likely to drive in the snow. If someone has an accident in the snow does that mean we should get rid of cars with four wheel drive or restrict their use?

The market for financial derivatives grew exponentially in the last ten years because there was a demand for them. Risk is always rampant in finance; derivatives made it possible to better price and allocate it more efficiently. However, they did not eliminate risk entirely. The growth of the market out-paced the infrastructure to properly understand the implications and how to best regulate it. Things have recently gone badly, but that is not justification for excessive regulation. This will only make the problem worse. The market exists for these products. Regulation may only give people an incentive to come up with even more opaque products, which will lead to even greater uncertainty.

Uncertainty and risk is inherent in financial markets. This means they will always be prone to a crisis. But restricting the use of derivatives now would be as sensible as restricting investing in equity in 1929.