Dec 8, 2009
Real economic risk appears to have decreased over time as global economies have become more advanced and diversified. But market risks appear to have increased due to innovative financial instruments with unexpected characteristics. Is financial innovation a good thing?

EFF/KRF: We do not agree with the reading of the facts in this question. We know of no solid evidence that market risks have increased relative to the risks of real economic activity. Market volatility and the volatility of real economic activity were both extremely high in the great depression, and both declined thereafter. During the post WWII period, market volatility tends to increase during recessions, along with (and typically in advance of) the volatility of real economic activity. From 2002 to late 2007 the volatility of real activity was low and market volatility hit all time lows. With the subsequent onset of a severe recession, market volatility increased, along with uncertainty about future real economic activity. 

In short, we know of no reliable evidence that there has been a change in the relation between market volatility and the volatility of real economic activity. And we know of no evidence that financial innovation has increased market volatility. 

Putting the premise of the question aside, economic logic says that financial innovation should be a good thing since it should facilitate the flow of savings to the most profitable investments, and it should allow investment risks to be allocated more efficiently to those willing to bear them in exchange for higher expected returns.

Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
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Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.