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.

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2 responses »

  1. Lindsay S. says:

    I read this same blog so you should check my post out as well! I understand what you’re saying about the vagueness of the term “social utility;” my interpretation was that this regulatory agency would assess whether it is reasonable to say the financial device could serve a good purpose and act as a successful investment vehicle. If it could pass that test, then the agency would allow it to enter the financial markets. However, if the agency found the financial instrument to be extremely risky and thought it seemed too difficult to predict if it would overall serve as a sustainable financial product, then they would not permit it to enter the markets.

    • Jim says:

      I read your post Lindsay and it helped me better understand the economists’ reasoning for supporting the formation of this kind of agency. There is something about it which still does not sit right with me. I disagreed that the products were the problem and someone commented on my post which essentially reiterated what you wrote, saying, “The products were the problem because they obfuscated the assets backing them.” Perhaps my lack of finance background is getting me confused, but here is my objection: I don’t think that there can be any type of financial product which is inherently bad. Instead I believe that they can be used to confuse people, but in these cases people should simply avoid them because it doesn’t make sense to invest in something you can’t understand. I don’t think that the bundles of mortgages which were sold on the open market to unwitting investors were bad. I’ll grant you they were extremely risky, but I think that it is the right of any investor to subject their savings to whatever risk they see fit. What I think was bad, was the way in which investors were lead to believe that these investments were solid because of the triply A ratings they received from reputable sources.
      I think just as the FDA informs me of the ramifications to health that food and drug products have, I believe that an agency such as the one discussed here should give me an honest view of the risk I assume in an investment.

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