Categories
Economics Financial Crisis The Opinionsphere

How Financial Innovation Causes Financial Crises

Ezra Klein explains how financial innovation causes financial crises:

Investors want to make more money with less risk. Someone invents a financial product that appears to make investors more money with less risk — in this case, subprime securities. Demand for this new product explodes. But few understand this new product, and even the people who do understand the new product don’t know how it performs under stress (it’s a new product, after all). At the beginning, this actually helps the product: because its risks aren’t known, they’re ignored, and so it looks like a better deal than it is and sells more of itself than it should.

Then something bad happens. The new product shows its flaws. And precisely because no one really understands it, the market cracks. Investors all run away at once, as they don’t really have the tools to assess the situation. Where lack of knowledge about the product originally drove demand, now it accelerates flight.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.