03/18/2010 05:12 am ET | Updated May 25, 2011

Drinking the Financial Innovation Kool-Aid: Day 2 at the Financial Crisis Inquiry Hearings

You can smell it on their breath -- the tell-tale fumes of "financial innovation."

Drink it and you start to believe that financial innovation actually exists. The commissioners and their witnesses are being ever so careful to insist that our economy will make room for it, not discourage it, not to over-regulate it , and to find market forces to enhance it.

But they seem incapable of the healthy skepticism expressed so well by Paul Volcker:

"I hear about these wonderful innovations in the financial markets and they sure as hell need a lot of innovation. I can tell you of two - Credit Default Swaps and CDOs - which took us right to the brink of disaster: were they wonderful innovations that we want to create more of? .... I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information.... The most important financial innovation that I have seen in the past 20 years is the automatic teller machine... How many other innovations can you tell me of that have been as important to the individual?" ("What Has Financial Innovation Done for You?")

Here's a line of questioning they might want to consider:

  • Which of the financial innovations that have taken place over the past twenty years have been good for the American people? Can you name any at all?

  • Why not set up a process by which new financial products must be approved (like drugs) before they can poison the economy?

  • How many of these "innovations" actually are nothing more than sophisticated casino games for those with excess wealth and for those who profit by creating them?

The commission must acknowledge that financial innovation is not like any other kind of innovation in our economy. If you create a new IPod and it goes sour, it hurts Apple, its investors and its suppliers. You create a synthetic collateralized debt obligation that goes south, you crash the world economy and kill millions of jobs.

Market forces will never solve the problem of innovation. It will take the heavy hand of regulation or we'll be bailing out the financial sector again and again when these "innovations" blow up.

Getting to the Root Causes
Shelia Bair, the head of the FDIC, was the first witness get near to addressing the major underlying causes of the crisis: our distended, finance-heavy economy. She discussed "economic distortions" and the "disproportional" size of financial profits in our economy. She said that during the 1950s and 1960s financial profits accounted for 15 percent of all corporate profits. By 2008 they had metastasized to 34 percent.

If someone had bothered to ask, she may have also addressed the underlying distribution of wealth and income that has created the demand for more and more speculative financial products. It once was the case that that productivity increases inevitably led to real wage increases. That's no longer true. Those two trends have split apart starting in the mid-1970s, and now the lion's share of the productivity increases go to the super rich.

In general there is a high correlation between the mal-distribution of income and economic crashes. The last time our wealth and income distribution was as skewed as it is today was 1929, and that's not an accident. When too much money is in the hands of the few it runs out of real world investment and gravitates towards speculative investments. This inevitably creates asset bubbles and crashes. Record pay and bonuses on Wall Street and high unemployment are connected. (See The Looting of America Chapter 2 and 11).

Ms. Bair opened the door to a line of questioning about how those imbalances were caused by decades of "tax reforms" that moved money to the very top of the income brackets. This was deliberate economic policy from Reagan on. This was the heart of trickle down. Combine the mal-distribution of wealth with financial deregulation and your get a crash, guaranteed.

Instead the commissioners are going after fraud, the rating agencies, the lack of regulation of subprime products, and derivatives. But, that won't get us there.

The commission would do well to review how we controlled finance and the distribution of wealth from the 1930s to the 1970s. Then, policy makers understood that a vibrant and stable capitalist system required a growing middle class, a tightly regulated financial sector, and a constrained distribution of income.

Since then we got this: In 1970 the ration of pay between the top 100 CEOs and the average worker was 45 to 1. By 2008 it was 1,081 to one.

Please Mr. Angelides, go there!

(You can find my live blog of the hearings at Campaign for America's Future)