Jeremy Warner: Let's not throw the baby out with the bath water

Outlook It would be pretty serious, Lord Turner mused yesterday in a characteristically thoughtful and penetrating analysis of the credit crunch, if we lost the knowledge of how to manufacture major drugs and vaccines. "Yet if the instructions for creating a CDO squared have now been mislaid, we will I think get along quite well without it".

The point the Financial Services Authority chairman was making was that a great deal of the financial innovation of the past 10 years has turned out to be not just useless but positively dangerous.

Financial innovation which delivers no economic benefit can for a time flourish and earn for the individuals and institutions involved very large returns. In the years running up to 2007, too much of the developed world's intellectual talent was devoted to ever more complex financial innovations of dubious economic benefit.

It is hard to quarrel with Lord Turner's view. The evidence is before our eyes. Financial innovation that was justified as a way of making the world safer and more efficient turned out to have precisely the opposite effect. Much of it was merely a money machine for the individuals who sold it. Yet in addressing these failures, it is vitally important that Lord Turner gets the balance right between smarter regulation and the freedoms markets need to innovate.

You cannot have progress without risk, nor are you likely to get economically positive innovation without a great deal of frivolous, completely useless invention alongside it. CDOs, shadow banking and the like have deservedly given financial innovation a bad name, yet much of what we take for granted in the modern world would not be possible without breakthroughs in the way finance is conducted.

Where would we be without insurance, or dare I say it, even banking? The old-fashioned, conventional balance sheet banking which everyone now cites as the model for what we should go back to would in another bygone age of banking as little more than a collection of safe deposit boxes have been seen as the height of racy, unsafe, financial wizardry. Where would we be without the maturity transformation that modern banking allows?

Nor was there anything inherently wrong with much of the financial innovation now widely cited as the root cause of the crisis. In its place, it was perfectly fine and probably not as economically useless as Lord Turner suggests.

The problem rather was that, as the good times rolled, investors and bankers became increasingly oblivious to risk, as they always do in a boom, and in a process known by Wall Street veterans as "reaching for yield" ended up throwing caution to the winds and letting rip.

Even the most experienced of bankers and regulators find it very hard to interfere with this process once it is fully underway. Plainly there is something epic, or once in a century, about the present banking bust which points to clear fault lines in the system that had been allowed to develop over decades which can and now must be addressed.

Progress requires that adequate checks, balances and restrictions are introduced to make banking safe again. But whatever Lord Turner does, he won't be able to stop the capitalist system's propensity to bubbles. Regrettably, speculation and innovation have much in common.