How Financial Innovation Benefits Society

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Even though world trade imbalances and lax lending standards played a role in the Great Recession by causing increased household debt in developed counties and real-estate bubbles that burst, financial innovation is needed and a net positive to our society. In addition to providing valuable credit and risk diversification services to companies and households, financial innovation leads to increased GDP which in turn results in decreased poverty, increased life expectancy, and has bettered the everyday lives of millions.

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Benefits of Financial Instruments

Financial instruments are a great benefit to society. Hedge funds for instance, are alternative investments that use pooled funds. These pooled funds are then invested using different strategies to maximize return for investors. These funds face less regulation than other types of investments, as they are only accessible to accredited investors. Hedge funds are particularly unique as they offer investors a chance at a higher return on their money than other investment vehicles such as mutual funds. Because often times hedge fund returns are uncorrelated with the stock market, they can serve as a diversifier for one’s portfolio, especially in times of increased market volatility, a down market or a recession. In addition to hedge funds, private equity is another financial instrument. Private equity includes both funds and investors that directly invest in private companies, or that engage in buyouts of public companies. This process enables companies to better exploit their potential. The capital that private equity firms and their funds provide allows companies to increase their development and remain independent. Moreover, private equity firms bring expertise and contacts to companies, which they can use to their advantage. This allows companies working with private equity firms to grow, innovate and become more competitive as a whole.

Financial Innovation Leads to Increased GDP

Gross Domestic Product is a better measure now than ever for the well-being of today’s society. We use it to compare ourselves to nations across the globe to assess which countries are performing well and which are struggling. Now the question becomes how does GDP relate to the concept of financial innovation? A recent study at the University of Netherlands led by Thorsten Beck attempts to combat this question. It was found that financial innovation can and will stimulate countries economic growth (GDP) in different ways and aspects. Innovation takes into account the massive expansion of credit card usage, and also describes we how both interest rates and currency swaps can drive our society forward and boost GDP. All of this innovation gives companies and people an improved lifestyle that their ancestors could never achieve.

Innovation is a key factor in the development of a society. First of all, innovation along with investments and competition make up the backbone of the financial system. All three of these help us meet world needs and requirements, improve the efficiency of the financial system and social welfare, and also contribute to economic advancements across the globe. Additionally, innovations improve both the efficiency and equity of the financial services sector. Despite these enhancements in the financial services sector that innovation provides, this deregulation and innovation can contribute to fragility within the financial sector, and the potential for economies to have massive decreases during natural economic downturns or bear markets. While we as a society should consider the possible negative effects of financial innovation, the benefits in this case outweigh the potential side effects.

Society Benefits from Increased GDP

Because increased GDP results from financial innovation, it’s fair to question whether society truly benefits from this GDP increase. As a matter of fact, it does. Increased GDP leads to decreased poverty, increased life expectancy and other health benefits, and a general increased livelihood. Looking at the United States since 1900 helps paint this picture. It was economic growth that has reduced U.S. poverty from roughly 50% in 1900, to 30% in 1950, to 12.1% in 1969. The statistics are even more telling for African Americans. Poverty was reduced in the 20th century from 75% to 25% through economic growth. It was innovation and increased GDP that made the elimination of child labor possible as well.

As a matter of fact, the living standards of the poor in America today (In terms of real wages) are equivalent to the living standards of the middle class 35 years ago, if not the middle class in Europe today. With sustained, vigorous economic growth, 35 years from now the lowest income Americans will live at least as well as the middle class of today.7 If real income growth for the lower class can be kept constant at just 2% a year, these people’s incomes will have more than doubled after 40 years. By implementing pro-growth policies, such as deregulatory measures in the financial sector, the lower class could see an increase in real compensation from 2% to 3% a year. With this 3% increase, it would only take 20 years for their incomes to double and they would triple after 40 years. That is the most effective anti-poverty program possible. Thus, we shouldn’t strive to limit the earning potential of the wealthy, but instead strive to income the quality of life of the lower class.

Beyond the increase in lower class income that financial innovation leads to, rising GDP leads to economic growth and medical innovation. Throughout human history, life expectancy has typically ranged from 25-30 years. However, life expectancy has rapidly increased from 30 years to about 75 years in since the mid-1700s. In the United States alone, average life expectancy has increased by more than 50% since the year 1900. Moreover, infant mortality has dropped from 10% 100 years ago to less than 1% today, and the mother’s chance of death from giving birth was 100 times greater in 1900 than it is today. In addition to Americans living longer, financial innovation and rising GDP has led an increase in household luxuries. For instance, just a little over a century ago in the year 1900, utilities such as running water, flushed toilets, gas, electrical heat and vacuum cleaners, were only available in 20% of households. Moreover, in the 1950’s, less than 20% of homes had appliances such as dishwashers and microwaves. Now 80-100% of American homes have these common day luxuries. Furthermore, fewer than half of homes built in 1970 had two or more bathrooms and by 1997, 90% did.

In conclusion, increased GDP, much of which stems from financial innovation is a huge net benefit to society. Because of this GDP increase, poverty has decrease, life expectancy has risen, and American’s everyday lives have bettered overall. Although there are several arguments in favor of regulating financial institutions and can lead to bank fragility and losses during a recession or financial crisis, financial innovation provides valuable credit and risk diversification services to companies and households.

03 December 2019

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