While browsing some of the blogs on Freakonomics, I came across a very striking title: “Should New Financial Instruments Be Treated Like New Drugs?” In this blog, Steven Levitt (economist and co-author of the book Freakonomics and Super Freakonomics) discusses a recent “white paper” written by his colleagues, Glen Weyl and Eric Posner, at the University of Chicago. As the title of the blog implies, the Law professor and Economics professor are proposing that a government regulatory agency be created in the image of the FDA for financial instruments; banks would be forbidden to market any newly invented financial instruments until they were approved by this agency, just as the FDA must approve new pharmaceutical inventions before they can be prescribed by doctors. Weyl and Posner argue the need of such an entity is due to the “speculative investment in sophisticated derivatives” which largely led to the financial crisis.
When reading this, I immediately thought of Enron’s business plan, which we spent much time pondering last week. In the Harvard Business Case entitled Innovation Corrupted: The Rise and Fall of Enron (A), it is described how the derivatives end of Enron’s business expanded even more rapidly than its forward-contracting business and that these derivative products were “highly complex avant-garde instruments that challenged the understanding of accountants, auditors, and investment analysts” (Salter 8). It was also noted that a lack of regulation governing the use and disclosure of these new investment vehicles made the daunting task of understanding their potential value and risks far more difficult. Although this contributed to Enron’s collapse in the fourth quarter of 2001, much of this scenario recurred throughout the following seven years at other firms and ultimately led to the financial crisis of 2008.
Weyl and Posner are acknowledging the extreme risk of these products, as evidenced by the Enron case as well as the financial crisis. They feel the Dodd-Frank is Congress’s insufficient attempt to resolve this issue because it does not address the fact that financial firms devote great time and energy to creating financial devices solely for the purpose of gambling and arbitrage. This is why, they argue, every new financial product should be screened first by this regulatory agency to ensure it has some social utility before it can be marketed to the public.
I commented on this Freakonomics blog post saying I think it is a very well thought-out proposal. It is undoubtedly true that the complexity of certain financial products has resulted in far too much turmoil in the past and it makes sense that financial instruments submit to some approval process before they enter the market and start causing problems. As Weyl and Posner state and also as evidenced by the Enron documentary that Marko showed in class, so many of these investment vehicles are created solely on the basis of “arbitrage” in the markets, and this seems to be a very morally ambiguous goal worthy of further investigation.
The last thing I will note about this blog which struck me as very interesting is that Levitt, the author of the blog, points out at the end that his colleague Glen (who is proposing this financial FDA idea) was not recently convinced of the dangers of speculative investment products as a result of the financial crisis. He was one of the very few economists who back in 2007 was very concerned about the “social costs of arbitrage.” This immediately made me think of the New York Times article “How did Economists Get is So Wrong?” by Paul Krugman. Clearly, Glen was one of the few who did not turn “a blind eye to the limitations of human rationality” but rather recognized the riskiness and unsustainability of the speculative investment vehicles before the financial crash even happened. This makes me even more inclined to heed Glen’s proposal of this financial vehicle regulatory agency because he is clearly more attuned to the market than most.