Milken Institute
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Restoring financial innovation as a problem-solving tool
By: Milken Institute
May 03, 2012
If you want to quickly clear a room of people who got burned in the Great Recession, just say the words "derivatives" and "financial innovation." But a panel of experts who wrote the user manual for those terms insisted that these are exactly the tools needed to deflect a world of pain headed our way.

For starters, consider the baby boomer bulge approaching retirement. Elad Shraga of Deutsche Bank says the current model was built on faulty data. The money set aside is not enough for retirees who are living far longer than actuaries had ever anticipated.

"The practical implication is there has to be a restructuring of the social contract, but this is not being talked about," Shraga said. He sees three options: reduce the benefits; invest in high-risk, high-yield funds; or sell the risk to someone else. He says there are willing partners for door number three but it's not being publicly discussed.

The panel also included Nobel Prize winner and Stanford professor Myron Scholes as well as Richard Sandor, a fervent proponent of finding new financial instruments for dealing with incredibly complex problems.

There are plenty of examples where new financial tools worked. In 1970s and the 1980s, up-and-coming businesses were able to access capital markets rather than relying on banks. Southwest Airlines avoided fuel spikes by buying oil futures and passing its savings on to fliers. The Internet and the mobile phone have transformed financial transactions.

Institute Chairman Michael Milken said financial innovations can be used to improve the lives of others, but there can be nasty unintended consequences if those who use them doiaEUR(TM)t know their history. A case in point, he said, was the U.S. government's decision to make owning a home aEUR" large and in the suburbs aEUR" the quintessential American dream.

"The government, in my opinion, made a terrible mistake," he said. "They jeopardized the country."

By giving tax breaks for homeownership, he said, the government essentially shifted its funding priorities away from something could have generated long-term wealth like early education or college.

"The government is telling you that the price (of a home) is going to go up," said Milken, exuding frustration over congressional ignorance of U.S. economic history that should have foretold how the housing bubble would unfold. "If any country in the world should have known to get out of mortgages, it was this country."

Selling financial innovations is tough but doable. In 2003, Sandor launched the Chicago Climate Exchange where industries bought and sold greenhouse gas emission credits. The concept worked for eliminating acid rain in the American heartland and is now being applied in Kerala, India.

He described the qualities of a "good" derivative: It has to be transparent, regulated and traded on an exchange. But massive regulation, he said, can choke financial innovation. He noted that the Dodd-Frank amendment that regulates banks runs 2,000 pages - longer that the Old and New Testaments and the Koran, combined.

Scholes said that if used correctly, capital and exchange markets could be policy tools for the government. Like carbon, aspects of water and health issues could be also traded. "But we don't have a government that trusts derivatives and financial instruments."