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.]
Yes, there is the knowledge problem in centralized bureaucratic decision-making. But I think libertarians err in assuming that free-markets would otherwise generate the sort of information that enables people to avoid what this author has correctly labeled “the knowledge problem.” For example, the author writes:
“They [investments] 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?”
First of all, it is not necessarily true that the expectations of private investors will prove to be accurate or that the information generated by these expectations will be correct. Just because decision-making is taking place in the private sphere does not mean that the information it produces will be correct, efficient, or optimal. This is where I part ways with libertarians. They seem to think that free markets will somehow free us from the recurring phenomena of failing businesses, unemployment, and economic recessions. This is just not true. Massive unemployment would still recur even in a perfectly free market economy because knowledge, no matter how widely diffused, is never perfect.
So, this post is right to criticise efforts at government regulation, but it errs, in my opinion, in believing that private economic activity would perform just fine in the absence of government regulation. That is just not so.
The only advantage to the private market is that it allows heterogeneous activity. People can make their own decisions based on their own expectations. The problem with government regulation is that it HOMOGENIZES and STANDARDIZES what would otherwise be heterogeneous activity. It forces people to conform to some mandated, standardized course of conduct, and if the governmentally-imposed standard is incorrect, which it will almost always be, then EVERYONE suffers. At least in a private market, people are free to experiment with different ideas and opportunities. The rub, however, is that most of these ideas will turn out to be wrong. And nobody can predict in advance who will be correct and who will be incorrect in their entrepreneurial activities. On this point, see Armen Alchian’s 1950 paper on Evolutionary theory. He correctly showed that successful businessmen are successful, not because they have the right incentives, but rather because they were just lucky. It is all a matter of luck. The right place at the right time. That is all. It is just one big roll of the dice.
Oops. I spoke too soon. Everything I wrote above can just be replaced with this excellent passage, taken directly from the author of this post himself:
“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.”
That statement is just perfect. This perfectly captures the problem, IMHO. No talk of free markets and economic efficiency. Frankly, none of that is necessary. All we need to do is point out the flaw in government regulation. That is they key.
The fatal conceit is alive and well in academia.