Credit default swaps aren't the enemy. Neither are collateralized debt obligations, straddles, asset-backed commercial paper or any of the other tricked-out derivatives cooked up on Wall Street and beyond in recent years. But ever since the markets for those instruments imploded in 2008 and took stock exchanges, national banking systems and entire economies down with them, their names are almost always preceded by adjectives like "toxic."
Ignore all that for a moment. And do your best to ignore Warren Buffett, who declared that derivatives are "financial weapons of mass destruction." (He, of all people, should know better. His most important holding is General Re, a business based on a derivative product: reinsurance.) Despite a shady past, derivative instruments have a very bright future.
Economic historians have long noted that periods of strong economic growth and technological advance have often been accompanied by major financial innovations. New York University professor Richard Sylla takes the case even further when he calls these commercial inventions an "active, instigating cause of economic growth and modernization." In other words, if it weren't for the bankers and brokers doing their thing first, and even the more dubious speculators who follow, the rest of us would not prosper.
In looking forward, it always helps to look back-in this instance, to the early 1600s, when the Dutch were emerging as the most sophisticated investors in the world. How? Financial innovation. They formed the first modern joint-stock company (a merger of the Dutch East India and West India companies), created a central bank of sorts (the Bank of Amsterdam) and began trading commodities futures and options. Britain moved into the top spot in the early 19th century, largely due to its shipping supremacy (for which it owed thanks to the marine insurance sold by underwriters who had begun congregating in Edward Lloyd's London coffee house near the end of the 17th century). Likewise, the rapid spread of railroads and factories in both Britain and the United States wouldn't have been possible without stock and bond markets, which raised vast amounts of capital. Japan's financial revolution began in the 1870s, much of it due to Masayoshi Matsukata, the visionary finance minister who encouraged the formation of new banks, insurance firms, and the Tokyo and Osaka stock exchanges. Sylla and others have argued that, in each case, financial innovations fuelled surges in output and income.
Just about every major household purchase is based on one financial innovation or another. The growth of consumer credit in the early 20th century propelled the sale of furniture, appliances and automobiles. By pooling those loans and selling securities based on the amounts receivable, lenders were able to collect their money up front and minimize their risk. Mortgage-backed securities owe thanks to the Roosevelt administration, which, in the interests of promoting home ownership, established the Federal National Mortgage Association (Fannie Mae) to buy up individual mortgages from lenders. In the 1970s, Washington began bundling them into liquid, government-backed securities. And while other financial instruments have become increasingly more Byzantine, credit default swaps are relatively straightforward: A buyer purchases a contract from an issuer who promises to pay off a specific debt if the buyer cannot, and for this protection, the buyer pays a premium.
Why did the swaps blow up so spectacularly in 2008? For the same reasons that innovative new instruments often do: The trade in them is poorly regulated, speculators are going after quick profits, and many investors take on excessive debt to make huge, unhedged bets. Case in point: insurer AIG's financial products unit. By the middle of 2007, it had used default swaps to guarantee more than $500 billion (U.S.) of debt. AIG was collecting more than $3 billion (U.S.) a year in premiums on those swaps, while assuming that the risk of all the major equity and derivative markets in the world plunging at once was so statistically remote as to be negligible. Oops.
Do the benefits of financial innovation outweigh the carnage that often follows in its wake? In a 2006 paper titled "Decomposing the effects of financial liberalization: Crises vs. growth," economists from the International Monetary Fund, the University of California and the University of Osnabrück in Germany crunched data from 60 countries for the period 1980 to 2002. The conclusion: On average, the deregulation of domestic financial markets boosts real growth by 1% per person per year.
Of course, stretching the data out to include recent events would certainly reduce that average. Still, economic outcomes in individual countries gave the authors cause for optimism. When Thailand floated the baht in 1997, the value of its currency plummeted, triggering an economic collapse throughout Asia and a worldwide currency crisis. Yet, by 2002, Thailand's GDP per capita was 148% higher than it was in 1980. In contrast, India was slower to liberalize its financial markets (the International Monetary Fund had to bail out India in 1991, and only then did the country act to establish a national stock exchange and remove some restrictions on foreign investment). India's per capita GDP growth has lagged behind at 99%.
Leave it to an optimist like Sylla to point out that even the worst global crackup of all time, the Great Depression, wasn't fatal. Sure, the current crisis is a whopper-Sylla says he'd "certainly put it in the top five" of the 15 or so financial panics in U.S. history-but nowhere near as bad as the 1930s Depression or even the Panic of 1837. (The latter was caused, in part, by banks issuing far more paper money than their reserves of gold and silver could cover.)
As has happened in the past, inevitably there will be a retreat from risky dealing and regulations will be tightened. In March, The Wall Street Journal convened a forum of 100 experts to brainstorm global finance reforms. Proposals for fixing credit default swaps included: a centralized clearing house, regulations on capital, and explicit reserve and margin requirements. Billionaire George Soros addressed the same issue in his recent book, The Crash of 2008 and What It Means, arguing that writers of contracts should have a direct financial interest in the instruments they create. Sylla, for one, thinks the act of setting up centralized markets will help a lot. "These instruments were not traded on exchanges and priced every day," he says. "So when AIG gets into trouble, the market just freezes up."
Nevertheless, most agree that to completely stifle the often-avaricious impulses that give rise to financial and economic innovation-what John Maynard Keynes called "animal spirits" -would be a mistake. It seems greed isn't just good; it's essential.