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In Defense of Financial Engineering

These days it's fashionable to beat up on financial engineers and financial innovation in general, and understandably so - this discipline has been at the epicenter of the crisis we are currently facing.  The creation of "financial weapons of mass destruction" is, perhaps, not the most noble of pursuits, much as, say, the design and development of nuclear weapons.  There are surely people who would argue that better, more efficient nuclear weapons are necessary for the safety and security of our nation (or the world), whereas others will argue what's the difference: they're just going to kill people regardless, and why can't we devote the resources to the design and development of things that promote peace.  Interestingly, this argument appears to have been taken to an extreme when debating the need for financial innovation and Wall Street as a whole.  It seems that the horrific effects (and very real threat, as we see on the Korean peninsula) of a nuclear war, while highly undesirable, are no match for the clear and present danger of lost incomes and lost homes.

Whether we need nuclear weapons or not is not the subject of this post, however it is somewhat relevant as we ask ourselves whether we need financial innovation, or whether financial innovation adds value to everyday life.  If we believe such notable economists as Paul Volcker, the answer is no.  Mr. Volcker, you'll recall, was the one who asserted that the only useful financial innovation of the last 20 years was the ATM.  Google "financial innovation" and you'll see a slew of articles, papers, and reports skewering the industry and calling into question financial engineering as a discipline.

But to condemn the discipline of financial engineering as a whole is like condemning mechanical engineering for its contribution to the development of nuclear weapons.  It's just not fair.  Believe it or not, financial engineering isn't (and doesn't have to be) limited to the development of highly complex structures with little apparent regard for social good.  Securitization, for example, is regularly employed in the microfinance space as a means to distribute credit risk and ensure liquidity and funding availability.  Financial engineers are helping to wage the war against global climate change through the development of financial instruments used in the trading of carbon credits.  And financial engineers regularly contribute to the successful operation of institutional investors such as pension funds and charitable trusts which, last we checked, contribute significantly to the social good.

In fairness, Volcker's attack on financial engineering was from an economic growth perspective, not the betterment of society.  But are these goals mutually exclusive?  Maybe there isn't a "shred of evidence" that financial innovation has made a meaningful contribution in this regard, but some perspective is desperately needed to inform the public debate.

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