For starters, these innovations have helped to create a cycle of financial booms and busts that have a tendency to spill over into the real economy, contributing to a heightened sense of insecurity.
They have shortened the time horizons of investors and corporate executives, who have responded by under-investing in research and the development of human capital.
They have contributed significantly to massive misallocation of capital to real estate, unproven technologies and unproductive financial manipulation.
They have made it easy and seemingly painless for businesses, households and even countries to take on dangerous levels of debt.
They have given traders a greater ability to secretly manipulate markets.
They have given corporations clever new tools to hide risks, liabilities and losses from investors.
And by giving banks the tools to circumvent reserve requirements and make more loans with less capital, they have enormously increased the leverage in the financial system and with it the risk of a financial meltdown.
But far and away the greatest damage from all this financial wizardry is the obscene levels of compensation it has generated for a select group of Wall Street executives and money managers.
For when you look over the long term, at the good periods and the bad, it is obvious that the pay collected by these masters of the universe has been grossly excessive -- out of line with the personal financial risk they have taken, out of line with their skills relative to the next-best performers and certainly out of line with the returns earned by investors...
It would be bad enough if the consequences of this excessive pay were confined to Wall Street. Unfortunately, it has not worked out that way. For the prospect of earning untold wealth also has attracted an enormous amount of young talent that could have been more productively used in science, engineering, medicine, teaching, public service and businesses that generate genuine long-term value.
Is it not fair to ask whether the United States can remain the world's most prosperous and innovative economy when half of the seniors at the most prestigious colleges and universities now aspire to become "i-bankers" at Goldman Sachs?
So I hope you'll forgive me, dear readers, when I say that the best thing that could happen to our economy is for a dozen high-profile hedge funds to collapse; for investment banking to enter a long, deep freeze; for a major bank to fail; and for the price of a typical Park Avenue duplex to fall by 30 percent. For only then might we finally stop genuflecting before the altar of unregulated financial markets and insist that Wall Street serve the interest of Main Street, rather than the other way around.
So, what is to be done? Some of the implications came up in Pearlstein's "chat" with readers. One is better regulation:
Boston, Mass.: Citigroup, State Street, and myriad other US banks hid billions in contigent SIV liabilities off-balance sheet, often using off-shore tax havens. What does this say about the FED's competence as a regulator? Or do you think it's a matter that the FED is corrupt and turned a willful blind eye to all of these off-balance sheet transactions? Is it time to combine regulators so that there is one sole financial markets regulator? Thanks Steve!
Steven Pearlstein: The Fed is not corrupt but they have been blinded by the mindless regulatory philosophy of the Greenspan era and they do look on the big bans and the holding companies as their charges -- institutions to be protected, part of a financial system that needs to be protected -- so they never utter a bad word about them and try to handle things quietly and without penalty. The result is that they give up the deterrant aspect of regulation, which is to have a ritual hanging every couple of years and scare the bejezzus out of people so they behave better in between the hangings. The Fed doesn't believe in that. They also don't believe they should substitute their judgment for the markets, which is crazy, because in financial regulation, that is exactly the purpose of regulation. Otherwise, you'd just leave things to markets. It is a form of modesty that they have taken to gross excess. And frankly it is not going to change until someone like Barney Frank finally makes such an example of a Fed chairman of the head of the Fed's banking regulation department that they get fired for being a bad regulator. Greenspan got out before he could be fired, but there are others who should be held accountable so that their unpleasant dismissal will be a lesson that will be remembered by their successors.
(N.B. Barney Frank is Chairman of the House Financial Services Committee). Pearlstein isn't the only one calling for more effective regulation - Martin Feldstein, one of Ronald Reagan's economic advisors (i.e., not a lefty), recently did so. The economic market failures that necessitate regulation are primarily of the "imperfect information" variety - i.e. that when people (or institutions) buy a financial asset they have a limited knowledge of the underlying risks. This problem seems to get worse as the financial assets become more complicated.
Another, more profound, issue that deserves more thought than it gets is the type of behavior that receives approbation in our society:
Potomac, Md.: Steven, thank you for your comment on the status of America's financial system today. As a 24 year-old finance professional looking to apply to business school in the coming years, I hope to shift into a line of work that generates "genuine long-term value." I remember at graduation the air of superiority surrounding my classmates who landed jobs as analysts on Wall Street. For many of us at "elite" Northeast schools, they seem to be the only jobs out there, because everyone is gunning for them. How can the other industries appeal to the talented kids who are so easily swayed by the glamour of I-banking salaries and bonuses?
Steven Pearlstein: That's a simple question that probably doesn't have a simple answer. But one thing we could do is not to glamorize Wall Street so much in the press or in movies, and begin to show more appreciation for real enterpreneurs and public servants and scientists and engineers. I think a lot of this is as much cultural as economic.
The "credit crunch" resulting from some of these "financial innovations" turning out badly is one of the reasons the US economy may be headed into a slump. That is, if there is a recession, we have partly to blame our excessive zeal for "de-regulation," "free markets," and greed (er, "rational self-interest"). The age of Milton Friedman, indeed.