Financial Engineering and Economic Development∗

In countries with well functioning credit markets, increases in financial activity often take the form of financial engineering. We use a structural framework to characterize and quantify the connection between financial engineering activities and economic development. In our model, producers split the stochastic cash flows they generate to create securities that appeal to investors with heterogeneous tastes. Lowering security creation costs leads to more financial investment but the effects on capital formation, output and aggregate productivity are small at best, and may be negative. Much of the investment boom caused by increased financial engineering activities is spent on security creation costs and rents, with little or even negative effects on development and productivity. These findings could help explain why the correlation between financial development, growth and productivity is weak at best among high income nations.