In a discussion in the WSJ, Paul Volcker had this to say about the impact of financial engineering:
“Now, I have no doubts that it moves around the rents in the financial system, but not only this, as it seems to have vastly increased them.”
This is an important and often overlooked point. Financial innovation has led to a significant increase in the rents that the financial sector is able to extract from the rest of the economy. Moreover, much of this increased rent is extracted from the taxpayer.
As I discussed earlier in more detail, incomplete markets kept the moral hazard genie inside the bottle. Financial innovation such as CDS and synthetic CDOs arose primarily to make markets more complete and enable the financial sector to maximise the rents that it could extract from the explicit/implicit guarantee of the state. The solution to the problem is not better regulation but the removal of the guarantee.