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Did Innovation Play a Role in the Financial Crisis?

It hasn’t been a good year for the reputation of innovation. The word has acquired some dubious associations of late thanks to its connection to the economic crisis that has thrown global markets into turmoil. You may have heard that the crisis was fueled in large part by “financial innovations” such as subprime lending, mortgage-backed securities, and collateralized debt obligations. While some argue that such products are perfectly sound if used properly, others say they amount to nothing more than good old-fashioned fraud. New York Times columnist Paul Krugman spoke for the latter group when he wrote that “…financial innovation [are] two words that should, from now on, strike fear into investors’ hearts.”

We’ll leave it to the pundits to assign blame, but the idea that innovation could be a force to “strike fear into investors’ hearts” should give you pause. This is exactly the opposite of what innovation is supposed to do. In any industry, the only people who should be afraid of innovation are the companies who are getting out-innovated by their competitors. How can innovation, which is supposed to be inherently positive, turn into an object of fear and loathing? What’s going on here?

The questions about what caused the financial meltdown are complex and will be debated for years to come. But perhaps some of the answers can be found in the new book The Game-Changer: How Every Leader Can Drive Everyday Innovation, by A.G. Lafley, chairman and C.E.O. of Procter & Gamble, and Ram Charan, author of Know-How. The book describes how from 2001 to 2007 the company managed to triple profits, expand its market cap by $100 billion and average 12%  earnings-per-share growth by changing its approach to innovation.

Early in the book, Lafley describes his philosophy on what defines innovation in a passage that’s particularly resonant when considered in the context of current events: “Invention is needed for innovation to take place. But invention is not innovation. In many companies, inventions that result in patents are considered innovations. These companies are often touted as innovative. In fact there is no correlation between the number of corporate patents earned and financial success. Until people are willing to buy your product, pay for it, and then buy it again, there is no innovation. A gee-whiz product that does not deliver value to the consumer and provide financial benefit to the company is not an innovation. Innovation is not complete until it shows up in the final results.”

Those last two criteria—that innovation deliver value to the consumer, and that it provide financial benefit to the company—bear closer examination. As far as financial benefit, the implosion of Bear Stearns and the billions of dollars of losses at other banks speak for themselves. The key to understanding why these particular innovations failed so spectacularly lies in their failure to meet the other criteria, that it must “deliver value to the consumer.”

Some experts (Alan Greenspan among them) argue that subprime lending did in fact deliver value to the consumer by offering credit to a segment of the market that had previously been denied it. If that had been the purpose of subprime lending, they would be correct. But that was not the purpose of subprime lending. The purpose was to create high-interest loans that could be packaged into mortgage-backed securities to be sold to investors. The consumers that the subprime market relied on were secondary to that purpose, not central to it. The products were designed to satisfy the needs of one consumer group—the investment community—at the expense of the other consumer group—the subprime borrowers—for the sake of profit.

To be sure, there’s nothing wrong with being motivated by profit. P&G certainly is motivated by profit, as its success shows. But P&G understands that in order for an innovation to succeed, profits have to be a result of the innovation, not a cause of it. If the goal from the outset is to make money, the product will be designed to achieve that end, not the ends of the consumer.

To put it another way, at P&G, the company’s innovations are guided by the goal of solving problems for consumers. Not so with the subprime mortgage crisis. Instead of solving a problem for customers, the banking powerhouses solved their own problem: how can we create a product that will make money?

The heart of P&G's approach to innovation is a program called “Living It” in which employees are sent to live with consumers for several days in their homes, eating meals with the family and going along with them on shopping trips. The goal of the program is to turn up the firsthand insights that will lead to genuinely innovative products. As financial companies try to make sure their next innovation doesn't end up in another crisis, they may want to take a cue from P&G.