Financial Innovation

I promised I would say a bit more about my current publishing projects in this post - the projects that have been keeping me from posting for some time now. However, I am still too busy to talk about more than one of them right now (there are quite a few). I am working on a Handbook of Financial Ethics - a large, ambitious venture that will bring together 30 or s0 leading financial experts to tackle ethical issues in all areas of finance, from its theoretical justification to its institutions and practices. Of course, the current crisis will act like a force of gravity on the project - but its historical reach will be wider than that.
I am pretty excited about this. And, I have been thinking pretty hard about who to invite and what topics to include. I have more or less nailed things down now - though I expect to make some changes, in detail, in response to feedback from potential contributors.
Yesterday, one of the prospective chapter descriptions I outlined in the formal proposal concerned the ethics of financial innovation. We have been through a period of intense and rapid innovation recently. And, to put it mildly, things have not turned out as predicted. Hard questions arise as to whether the fancy financial tools that were supposed to strengthen markets have actually brought them to their knees.
On the one hand, finance theory dogmatists want to brush aside such questions, and thereby keep the path wide open for further innovation. On the other, there has been a concerted knee-jerk reaction from the enemies of capitalism (whatever that is) who want to shut everything down with draconian regulation. They are usually blissfully unaware that such regulation needs to be even heavier than they can probably envisage because attempts to shackle innovation in the past have only succeeded in stimulating a proliferation of cleverer forms of it.
Innovative financial methods are most likely to succeed after they have been subjected to real life trial and error (unfortunately many theorists tend to think that internal consistency and testing within abstract models in empirical isolation is sufficient). But, conducting experiments in the global economy is a bit like testing a substitute for dynamite in a crowded public place.
The problem here is this: financial innovation is too valuable to be subjected to preventative regulation, but too risky (especially, ironically, when it targets risk) to be unleashed willy nilly in the real world. One quick thought on this that struck me was: Why make trial and error an all or nothing phenomenon? Why not find ways of marking out certain areas of the economy in which experimentation can be carried out to test whether the new tools are fit for wider, or even global, use?
In the old days, before technology and deregulation linked everything to everything else, I suppose that used to happen - the world of finance was a black box, and nobody cared too much about its contents as long as the economic outcome was beneficial.