Adam Posen and Marc Hinterschweiger of Peterson Institute say:
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.
An interesting way to analyse benefit of financial innovation. As I had said in my previous report- time to reassess financial innovation. Further:
Another way to assess the presumptive benefits for the real economy of these products is to analyze who made use of derivative instruments. Figure 2 shows the share of OTC derivatives by counterparty as of June 2008 (78 percent of all global derivatives for which such a level of detail is available are included). Reporting dealers, mainly banks and investment banks, accounted for 41 percent of all counterparties (double-counting is eliminated). Other financial institutions acted as counterparties in almost half of all cases. Only 11 percent of all counterparties were nonfinancial costumers.
Hence, almost 90 percent of all derivative contracts took place between financial institutions. Had their usage by financial institutions generated either a boom in productive lending or a more resilient financial system, then, even if unused by nonfinancial companies directly, these new products could still have been productive. Since we have clearly seen the opposite over this time period, it is a revealing indicator that the nonfinancial companies for whom these products were prescribed did not themselves use them.
This is precisely what I also found in my report on CDS (written too early in may 2008). Needless to say the report was not much appreciated.
In fact, given the gap between these products’ claims and their actual usage and impact, one has to wonder whether recent financial products are like the recalled weight-loss supplement Hydroxycut, the repeatedly crashing DC-10 aircraft, or the Chernobyl nuclear reactor design. If so, even if many financial innovations are beneficial, all of them need to be monitored over the long term, as well as scrutinized before issuance, by regulators for their safety and effectiveness.
That deserves an ouch. Modern finance people surely need to hunt for answers.