I read a post by Steven Levitt of Freakonomics about a proposed new regulatory measure for financial instruments. The article highlighted a white paper written by Eric A. Posner and E. Glen Weyl on the events of the financial meltdown of 2008 and a proposed solution to prevent similar occurrences in the future. The paper claimed that the meltdown was the result of speculative investment using new financial instruments and that as a solution; we should create a regulatory agency which reviews the merit of possible new financial instruments and decides whether it should be made legal. The white paper makes the analogy that this agency would act on behalf of the financial industry the way the FDA acts to food and drugs in the US.
At first glance I think a regulatory agency for new financial products is extremely compelling. I think it could be seen in the financial crisis that existed ignorance on the part of the public in a system that is far too complex on which to expect the public to be completely informed. (just as it is unreasonable to ask the average consumer to intimately know the source and safety of food and drugs at their local grocery store, without information provided by the FDA)
One concern I have though, is that the in the case of the FDA there is a more concrete public opinion about the standards for health, but how would financial products be judged? The article describes that, “The agency would approve financial products if and only if they satisfy a test for social utility”. I find the wording “social utility” to be extremely vague and therefore the basis for my doubt in this kind of system. A quote I once read comes to mind “Ask advice to 5 economists and you will get 5 answers—6 if one is from Harvard”. Assuming this agency would be well informed in economic theory, is it not unreasonable to think there would be considerable difficulty in reaching decisions about new financial products’ merit? Or even existing ones?
I believe that the problems we encountered in the financial meltdown of 2008 were not the result of financial products which were inherently bad, but instead products that went unchecked and mis-rated. I think that maybe the role of an agency like the one recommended should be to fact check, to make sure that the things in which we invest our savings are actually the things (riskiness) they purport to be. I’ll grant you that there might be conflicts of interest when the government starts to rate the risk of certain investments, but I think the system we currently use contains the same degree of moral hazard, with two ratings agencies both of whom are paid to rate investments and are publicly owned companies.