Back in February Eric Posner and Glen Weyl, both of the University of Chicago and deservedly respected economic and legal minds, wrote a paper proposing a Financial Products Agency. The idea is relatively simple—just as the FDA must approve new food and drug products for consumption, an FPA should approve all new financial products with a test measuring for social benefit.
This is a terrible idea for at least three reasons:
First, an FPA would not have stopped the financial crisis. Let us assume for a moment that this FPA existed in 1998. Back then, when subprime debt began to pick up its pace, there was little understanding of the risk that was building up in the system. We can't just assume that having an FPA would mean regulators have somehow gained hindsight. Regulators were aware of what was going on to the degree that they had the resources to manage and the expertise to understand and didn't do anything then. Let's assume again that the FPA existed in 2004. Around that time regulators like Greenspan and Bernanke were well aware of the housing bubble but either did not think the risks were that big or did not think it was appropriate to step in. With rising housing prices (that all the regulators never thought would go down) masking the risks of subprime debt by preventing defaults, it is very hard to believe that regulators at this FPA would have done much to stop the risky financial products Posner and Weyl blame for contributing to the financial crisis.
Second, the model of the FDA is not a great idea unless you want to stunt markets. While the public has come to depend on the FDA to keep them safe there are regular outbreaks of diseases and complications with medicine. Even approved products can be misused. Beyond this, there are numerous cases where the FDA has prevented positive health outcomes, such as slowing down cancer prevention drugs for political reasons or sheer incompetence. And given the bureaucratic nightmare that is the FDA, it is impossible to know what drugs have not been pursued simply to avoid the compliance and approval costs and headaches. What we do know is that there is a growing problem of drug shortages in the U.S. and it is in part because of the FDA.
Finally, the whole argument for an FPA is based on the premise that derivatives contracts were significant contributors to the financial crisis. But derivatives—even the most risky contracts—are innocuous vessels. Blaming them is like blaming money for the crisis or computers. Though an argument can be made that there was too much money via central banks and too much computing power pushing high frequency trades, it is not the money or the computers but how they are used in connection with the other factors that caused the crisis. Derivatives contracts became a problem because the underlying assets they were being created with were misunderstood and financial institutions did not properly hedge their risk. If AIG had set aside the necessary amount of capital relative to its risk exposure, there wouldn't be as much carping about derivatives. If lending standards had not fallen so low, the subprime debt levels that did exist would not have been there to generate such a massive amount of unhedged, misunderstood, risky derivatives for subprime debt in the first place.
Unfortunately, despite these problems, the FPA finds the approval of NY Times business columnist Gretchen Morgenson, who wrote over the weekend regarding this proposed idea:
It is a refreshing rejoinder to the mantra on Wall Street — and in some circles in Washington — that financial innovation is always good and regulation is always bad. Bankers often argue that complex financial products are among America’s great inventions. But given that exotic instruments played a central role in the credit crisis, it is worth questioning the costs and benefits of such financial innovations.
I agree that it is always worth questioning and debating and wrestling with ideas. That is the best way to avoid getting tunnel vision on something. But in this case, the idea under consideration is not a very good one.
Ms. Morgenson makes the problematic assumption at the start of her column that regulators would somehow have behaved differently if there were an FPA before the crisis. "Imagine if there were a Wall Street version of the F.D.A.," she says, "How different our economy might look today, given the damage done by complex instruments during the financial crisis." But as we were just pointing out, there was lot of authority to limit Wall Street. Financial markets are and have been one of the most heavily regulated industries in the U.S. But the only thing that I can think of that would have actually changed regulator behavior prior to the crisis would be something that eliminated regulatory capture. An FPA, just like the SEC, would have been filled with bureaucrats more than willing to use a light hand on approval procedures to ensure they had a job with some firm after their civil minded spirit got drilled into the pavement of Manhattan with one to many luxury cars.
Then, Ms. Morgenson begins to lay out the case for the FPA, noting that the Posner/Weyl paper argues we should be able to regulate financial markets because they are different from the real economy, where a more laissez faire approach is good. The two leading problems with this argument are that:
- Financial markets are so interwoven with the real economy that you can't truly separate the two. Financial markets are the lifeblood of new businesses, which in turn are the lifeblood of the U.S. economy. So anything regulations that unnecessary restrict credit are actually hitting the real economy; and
- The problem is not a lack of rules but the absence of the right rules. If we learned anything from the crisis shouldn't a key lesson be that a lot of rules without regulators smart enough or inspired enough to enforce them winds up with meaningless protections and a false sense of security. It is foolish to depend on this regulatory crutch again and again. It is literally insane.
The next piece of the Posner/Weyl argument is that derivatives that are risky bear limited social utility and can cause system risk. I counter by arguing that:
- Just because something has limited social utility does not mean it should be restricted. Fantasy baseball may actually reduce productivity at work places across America, for instance, and may not get past a social utility censor. But I'll join up with an Upper Peninsula anti-government militia if the government tries to stop me from competing for glory; and
- Derivatives in a market that has too-big-to-fail banks may cause systemic risk—but the problem there is the bloated banks and the lack of handling failed institutions. If every bank had 75 percent capital requirements there would probably be very little derivative risk. Of course we'd also have a nonexistent banking system. The key here is to solve for moral hazard and improper incentives in the system, not try to limit financial activity on the other side of the equation.
Ms. Morgenson further carries the Posner/Weyl case forward by noting they also want the proposed FPA to measure financial instruments for "how they affect capital allocation, and whether they might add useful information to the marketplace." Again, a couple of points:
- How could an FPA really understand where capital should be allocated? Every regulator under the sun thought that capital flowing to the housing industry was a good idea during the bubble era. Imagine the FPA arguing in 2002 that there was too much capital flowing to the housing industry. It never would have happened, and on the off chance that our revisionist history unearths a Mike Burry to have influence in this FPA, the counter political pressure would have been too strong to let them do anything. Everything politically during the bubble was pushing capital towards housing. The Bush "Ownership Society" mantra. The previous decade's changes at Fannie and Freddie and FHA. Basel rules favoring housing. Even a massive accounting scandal at the GSEs failed to really derail their political or financial activities, so strong were the pressures to increase home ownership rates.
- And why should a financial product be disallowed if it doesn't provide useful information to the marketplace? If I want to structure a deal with my neighbor where we place a complicated bet on the outcomes of real estate values from the properties of people two streets over, with a few voluntary counter-parties financing the bet... why should anyone else care? Posner and Weyl may respond they would care if my personal failure on coming up short in the bet posed a risk to the financial markets. But I would again push back that the problem then would not be the derivative contract but the fact that the system was so poorly incentivized that I could become a systemic risk.
The Posner/Weyl paper says in the introduction that Dodd-Frank is an empty vessel and on this point we agree. My remarkes are not a defense of Wall Street today or the regulatory system. This FPA idea is just not the right response mechanism to that problem.