Great Depression 2.0 – Now, That Is An Innovation!

Financial innovations have been at the heart of the current economic mess. For any economist who is educated and specialized in the domain of economic renewal and innovativeness, it must have been a distinctively uncomfortable experience to hear the word innovation so many times in the context of financial products.

All these bankers and their financial liaisons who commonly use this word, only do so because it seems to sound about right. Too many times this simple word is used in an elaborate story in which it is falsely claimed they were unaware of the substantial risks they took creating these so-called financial innovations.

Did they really think that risks could be innovated non-existent? In this age of financial wizardry, such an explanation must be considered a harbinger of blatant ignorance and intellectual incompetence.

If (any)one is to review the economic literature on the subject of economic renewal, creative destruction, or the whole of the innovation literature, one will find a strong basis before one is able to use the word “innovation”. Generally, definitions concentrate on two elements after an invention has been made. In the academic domain it is only considered an innovation when there is (1) an element of novelty to either the developer, the industrial sector, the nation or the world and (2) an element of proved success in the marketplacei. Yes, they were new, but the element of success cannot be found in any way.

Now, I can be wrong, but what has been successful about credit default swaps (CDSs)? What has been successful about collateralized mortgage and debt obligations (CMOs and CDOs)? Can any of these financial wizards who created these novelties explain how these have been successful? Can any of the representatives who bought these monster products explain how they thought these products would provide successful returns?

Until now, these products have proved only successful in shifting off risks to third parties and harvesting its short-term profits. In the end, these products turned out to be a cause for financial disaster. If anything successful at all, it is that their current success is a result of bail-out money provided by tax-payers…

What is even worse is that most of these financial innovations use complex mathematical formulas, such as a Gaussian Copula functionii. The fact is, these mathematical functions only allow inductive hypotheses.

An inductive hypothesis is a scientific and methodological reference that points out the hypothesis cannot be proved or disproved on its merits or validity. In other words, even if the formula is sound, its use is open to interpretation. It only allows an exercise in arguing the depths of one’s fantasy, without having to prove this empirically. Though such a fantasy may sound plausible, it cannot be considered a solid ground for proof.

The really scary part is that this misuse of science was not only highly rewarded by Wall Street firms, it led to the creation of some 64,000 financial products that were awarded an AAA-status. To put this number into perspective, there are only 12 companies in the world that enjoy this top quality-standard. These products are a hell of an innovation, aren’t they?

In this regard, Willem Buiter’s call for a shift in paradigmiii meets all necessary conditions to implement right away. He argues only to allow new financial products if they are tested upfront such that they meet preconditioned characteristics before they are allowed in the marketplace. And if allowed, these products must be monitored through an exchange to produce transparency for anyone who wants to get involved.

Regrettably, at this very moment, an untransparent market amounting to trillions of dollars of credit derivatives still goes without any form of oversight or regulation. The odd thing is that credit default swaps (and alikes) are not really a problem, these merely are insurance deals. The bigger issue is that one can insure oneself for defaults of corporate or governmental bonds without having financed these bonds in the first place. Secondly, counterparties – such as AIG – are not legally obliged to keep reserves as insurers have to.

As a consequence, we find ourselves in a situation where the nominal insured bonds exceed the nominal amount of bonds outstanding, with no transparency in counterparty deals and risks, in a deadly deflationary economic environment which is still rapidly deleveraging. This spells disaster.

As more defaults are on their way, these financial weapons of mass destruction – as Warren Buffet nick-named them – will wipe out much of what has been left of a real economy. The question is not if they’ll strike, it is a question of when. It is killing businesses, it is killing Main Street! Instead of talking prevention, we are talking silly on a couple of million in bonuses.

If anything innovative at all can be found with these financial products, it is that these behold a bold innovation in the scope and scale of the economic catastrophe that still is on its way. We might as well call it the Great Depression 2.0.

We’ll have Wall Street, including the Fed for providing excessive liquidity, the SEC and the  CFTC for not doing their jobs, and US Congress for making these legal practices, to thank for. How wonderful, they all displayed some innovative capabilities.

To all economists I make this humble request: either disqualify anyone who misuses the word innovation or let us come up with another word. I consider the latter a serious option because its meaning has been lost. Let us come up with another word, instead of having all these dimwits using our terminology that we have theorized upon with scientific rigour, integrity and honesty.

Otherwise, we might as well start to use this term to refer to our own being, as we are pretty great innovated primates. But then again, let us not overestimate ourselves, we have not been that successful in the global marketplace. We are primates after all.

iSee: Galanakis, K. (2006), “Innovation Process: Make sense using systems thinking”, in: Technovation 26, pp. 1222-1232. It is a very extensive summary on the variety of views and scientific perspectives on innovations.


iiiQuoting him “….(2e) Financial innovation (that is, the introduction of new instruments, services, products and institutions) should be regulated the way the FDA regulates pharmaceuticals.  The required testing, evaluations, trials and pilot schemes should be regulated at the global level, to avoid innovation arbitrage.”, source:

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