New York Times columnist Gretchen Morgenson is arguing for a “pre-clearance” approach to regulating new financial products:
The Food and Drug Administration vets new drugs before they reach the market. But imagine if there were a Wall Street version of the F.D.A. – an agency that examined new financial instruments and ensured that they were safe and benefited society, not just bankers. How different our economy might look today, given the damage done by complex instruments during the financial crisis.
The idea Morgenson is advocating was set forth by law professor Eric Posner (one of my former profs) and economist E. Glen Weyl in this paper. According to Morgenson,
[Posner and Weyl] contend that new instruments should be approved by a “financial products agency” that would test them for social utility. Ideally, products deemed too costly to society over all – those that serve only to increase speculation, for example – would be rejected, the two professors say.
While I have not yet read the paper, I have some concerns about the proposal, at least as described by Morgenson.
First, there’s the knowledge problem. Even if we assume that agents of a new “Financial Products Administration” (FPA) would be completely “other-regarding” (altruistic) in performing their duties, how are they to know whether a proposed financial instrument is, on balance, beneficial or detrimental to society? Morgenson suggests that “financial instruments could be judged by whether they help people hedge risks – which is generally beneficial — or whether they simply allow gambling, which can be costly.” But it’s certainly not the case that speculative (“gambling”) investments produce no social value. They generate a tremendous amount of information because they reflect the expectations of hundreds, thousands, or millions of investors who are placing bets with their own money. Even the much-maligned credit default swaps, instruments Morgenson and the paper authors suggest “have added little to society,” provide a great deal of information about the creditworthiness of insureds. How is a regulator in the FPA to know whether the benefits a particular financial instrument creates justify its risks?
When regulators have engaged in merits review of investment instruments — something the federal securities laws generally eschew — they’ve often screwed up. State securities regulators in Massachusetts, for example, once banned sales of Apple’s IPO shares, claiming that the stock was priced too high. Oops.
In addition to the knowledge problem, the proposed FPA would be subject to the same institutional maladies as its model, the FDA. The fact is, individuals do not cease to be rational, self-interest maximizers when they step into the public arena. Like their counterparts in the FDA, FPA officials will take into account the personal consequences of their decisions to grant or withhold approvals of new products. They will know that if they approve a financial product that injures some investors, they’ll likely be blamed in the press, hauled before Congress, etc. By contrast, if they withhold approval of a financial product that would be, on balance, socially beneficial, their improvident decision will attract little attention. In short, they will share with their counterparts in the FDA a bias toward disapproval of novel products.
In highlighting these two concerns, I’m emphasizing a point I’ve made repeatedly on TOTM: A defect in private ordering is not a sufficient condition for a regulatory fix. One must always ask whether the proposed regulatory regime will actually leave the world a better place. As the Austrians taught us, we can’t assume the regulators will have the information (and information-processing abilities) required to improve upon private ordering. As Public Choice theorists taught us, we can’t assume that even perfectly informed (but still self-interested) regulators will make socially optimal decisions. In light of Austrian and Public Choice insights, the Posner & Weyl proposal — at least as described by Morgenson — strikes me as problematic. [An additional concern is that the proposed pre-clearance regime might just send financial activity offshore. To their credit, the authors acknowledge and address that concern.]