Myron Scholes on financial innovation and failure

When debating the notion that more regulation would repair the finance industry and keep us out of trouble in the future Nobel laureate Myron Scholes, one of the fathers of modern finance, makes an interesting point:

Economic theory suggests that financial innovation must lead to failures. And, in particular, since successful innovations are hard to predict, the infrastructure necessary to support innovation needs to lag the innovations themselves, which increases the probability that controls will be insufficient at times to prevent breakdowns in governance mechanisms. Failures, however, do not lead to the conclusion that re-regulation will succeed in stemming future failures. Or that society will be better off with fewer freedoms. Although governments are able to regulate organisational forms, they are unable to regulate the services provided by competing entities, many yet to be born. Organisational forms change with financial innovations. Although functions of finance remain static and are similar in Africa, Asia, Europe and the United States, their provision is dynamic as entities attempt to profit by providing services at lower cost and greater benefit than competing alternatives.

At the Free Exchange blog they comment

Looking at the recent and explosive growth of some financial derivatives, I wonder if something Schumpeterian occurred in financial innovation. Perhaps too much was invested in these products, thanks to an incomplete understanding of them and the risks they posed. Schumpeter predicts that such investment, in any industry, inevitably leads to a contraction. On the other hand, innovation is ultimately the only sustainable driver of long-term growth. It also, by definition, causes market fluctuations. Policies aimed at undermining innovation hinder an industry's ability to compete globally.

May be more regulation could help prevent another crisis, but it may also kill the goose that lays the golden egg.