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Fear and Looting in America: Innovation or Casino Capitalism?

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Every time someone calls for new financial regulations, Wall Street hoists the bloody flag of financial innovation: "If you regulate us, you will stifle innovation!" Every time I hear this, my blood pressure spikes because I know it's a lie but I can't really prove it. We now know for certainty that Wall Street's latest and greatest innovations, like synthetic collateralized debt obligations, have been a disaster. They increased systemic risk while piling up lavish profits for Wall Street traders. And they contributed absolutely nothing to the real economy. I'm now a card carrying Luddite.

"Not so," I'm told by financial pundits. Wall Street's fantasy finance does help the real economy by dispersing risk, reducing capital costs and by making more capital available for investment in tangible goods and services. Those innovations, insiders say, means there will be more plants, equipment, R&D, and infrastructure throughout the country. Even National Public Radio reporters who have boldly investigated Wall Street scams succumb to this mythology. Here's how NPR's Adam Davidson put it during an interview about toxic derivatives that milked five Wisconsin school districts for nearly $200 million:

"Over the last thirty years, there have been a series of financial innovations that have just been plain good. They have allowed city governments, local governments, to get money more cheaply, which means more hospitals, more schools, betters sewers, you know, just basic good public services, and that whole system may be permanently broken by this crisis."

I love his reporting, but I found myself screaming at the radio: "Prove it! Show me some evidence!" I keep hoping that someone will look at the facts instead of assuming fantasy finance is real.

Well, finally someone did. Hallelujah! Adam S. Posen and Marc Hinterschweiger reviewed the data and discovered that the dramatic rise in derivative financial products over the last several years did not lead to new capital formation. Furthermore, they found that the new products were traded among financial institutions and not within the real economy at all. As they put it: "There only seems to be a weak link, if any, between the growth of the newest complex -- and now proven dangerous if not toxic -- financial products and real corporate investment."

In short, these innovations had nothing to do with real economic growth. They were new casino games -- a series of financial bets that made Wall Street filthy rich... at our expense. For a while they helped local government get money more cheaply. But now they've cost those same governments tens of millions. That's gambling, not sound finance.

So how do we stop the proliferation of what Ben Bernanke called "exotic and opaque" financial instruments? Most government officials believe that careful regulations can tame the excesses without driving Wall Street overseas or stifling productive innovations. George Soros offers a more drastic solution. He wants to ban any derivative product that the average public official can't understand.

Now that's a financial innovation with promise.

Les Leopold is the author of The Looting of America: How Wall Street's Game of Fantasy Finance Destroyed Our Jobs, Pensions and Prosperity, and What We Can Do About It. (Chelsea Green Publishing, June 2009)