The Black Box Blows Up

Apropos of Danielle’s post on transparency: kudos to journalist Stephen Mihm for his prescient Jan. 27, 2008 article on “The Black Box Economy.” Here’s a taste:

[W]hen the mortgage crisis broke last summer, it opened a window on [a frightening situation]: . . . A staggeringly complex financial instrument that most Americans had never heard of, and which many financial writers still don’t fully understand, [had become] in a matter of months the most important influence on home values in America. That’s not how the economy is supposed to work – or at least that’s not what they teach students in Economics 101.

The reason this had been happening totally out of sight is not difficult to understand. Banks of all stripes chafe against the restraints that federal and state regulators place on their ability to make money. By cleverly exploiting regulatory loopholes, investment banks created new types of high-risk investments that did not appear on their balance sheets. Safe from the prying eyes of regulators, they allowed banks to dodge the requirement that they keep a certain amount of money in reserve. These reserves are a crucial safety net, but also began to seem like a drag to financiers, money that was just sitting on the sidelines.

“A lot of financial innovation is designed to get around regulation,” says Richard Sylla, professor of economics and financial history at NYU’s Stern School of Business. “The goal is to make more money, and you can make more money if you don’t have to keep capital to back up your investments.”

I find Sylla’s comment particularly interesting in light of the famous business method patents case State Street Bank. Is there any way to quantify the degree to which once-celebrated “financial innovation” was merely avoidance or evasion of regulation?

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