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The Worst Idea I have Heard Today
One idea that might prevent a repeat of the turmoil: a commission that would vet financial products before their release, akin [to] the Food and Drug Administration’s evaluation of drugs before they’re released to the market. McFadden suggested, “we may need a financial-instrument administration that tests the robustness of financial instruments and approves only the uses where they can do no harm.”
Nobel laureaute Daniel McFadden quoted at Real Time Economics. Do tell what will be left when we approve only things "that can do no harm."?
Might I also suggest that before calling for a financial FDA, Prof. McFadden should investigate what economists who have studied the matter have concluded about the safety and effectiveness of the real FDA.
Posted by Alex Tabarrok on August 21, 2008 at 11:07 AM in Economics | Permalink
Comments
I agree that banning such unapproved products is stupid, but what about the "Nudge"-like variant on it that I have proposed in the past: Label the financial products as "approved" vs. "would not have been approved". If someone wants a financial product in the second category, first make them apply for permission from a government agency. That government agency would simply approve everything it gets, but cost people a small amount of hassle and time. That extra work would be enough to steer people away from toxic products, while still allowing them -- and only giving a minor inconvenience -- for those who really want them.
Thoughts?
Posted by: Person at Aug 21, 2008 11:30:59 AM
How would you even test the "safety" of financial products? With drugs, the effects of the treatment are localized to the patient, so they can be characterized by controlled studies. Being able to perform controlled experiments where the subject of interest is the entire financial system just isn't possible.
Posted by: MattXIV at Aug 21, 2008 11:32:52 AM
Person, yes I am in favor of a Consumer Reports approach to the FDA which would include more labeling and evaluation and less restricting.
http://www.independent.org/newsroom/article.asp?id=1500
With regards to financial products we already have restrictions on who can use many advanced products. Note, however, that those in favor of more financial regulation would say that the issue is systemic risk (externalities) not the risk to individuals from making foolish decisions. In this respect, the case for FDA liberalization is stronger than for financial liberalization!
Posted by: Alex Tabarrok at Aug 21, 2008 11:39:48 AM
McFadden is a very good and creative econometrician, but there is nothing in his CV suggesting any insight into financial markets or financial products.
Person,
The problems we are facing right now has very little to do with people not understanding overly complicated products. Instead we have financial professionals causing trouble with instruments and transactions that are really just simple spot sales, options, or forwards. Such instruments have tremendous benefits but also allow for very high leverage, which is a big part of the current mess. And completely screwing up the incentives of the mortgage originators by allowing them to retain none of the credit risk associated with the loan is really just stupidity of the mortgage investors.
Posted by: Commenterlein at Aug 21, 2008 11:42:06 AM
Indeed Nobel laureaute McFadden is a great econometrician. His financial advice, however, reminds me of why I have never bought Diego Maradona's cds and Al Gore's books.
Posted by: E. Barandiaran at Aug 21, 2008 11:49:17 AM
completely screwing up the incentives of the mortgage originators by allowing them to retain none of the credit risk associated with the loan is really just stupidity of the mortgage investors.
Is it? Maybe, but it's awfully easy to attribute this to stupidity and move on. I think it's worth asking whether there are systemic problems that make this sort of behavior rational for individuals (or individual firms) but lead to big problems when everyone does it - a vaguely "Prisoner's Dilemma" sort of situation.
Broadly speaking I agree with Alex that the idea of having the Feds vet financial products this way is silly, but I find knee-jerk "leave the market alone" reactions troublesome too. There are systemic risks here - pretty big ones - and I think that deserves serious thought, not just a quick fallback on ideology.
Posted by: Bernard Yomtov at Aug 21, 2008 11:54:27 AM
This is just a step removed from the "Let's legislate away the problem!" school of thought. Two obvious problems: (1) You cannot test the robustness of a financial instrument outside the marketplace, unlike new drugs, and (2) the deeper issue is moral hazard and bailing out companies that deserve to take the losses for taking on too much risk.
Posted by: Jack at Aug 21, 2008 12:25:40 PM
So a libertarian think-tank thinks that government regulation (FDA) is bad.
And this proves what exactly?
Posted by: Lee at Aug 21, 2008 12:39:24 PM
Well, it proves they thought about it.
Posted by: Andrew at Aug 21, 2008 12:57:20 PM
Bernard,
"I think it's worth asking whether there are systemic problems that make this sort of behavior rational for individuals (or individual firms) but lead to big problems when everyone does it - a vaguely "Prisoner's Dilemma" sort of situation."
There is very big kernel of truth in that, even though I don't think it is a prisoner's dilemma. The behavior of the mortgage originators is perfectly rational, as is the behavior of pretty much anyone along the value chain as long as they are able to pass the risk along. I would even go as far as claiming that an asset manager on a 2-and-20 compensation scheme might rationally decide to load up on tail risk and hold these overpriced mortgage assets that are likely to deliver a good return in 7 out of 8 years, and to lose all their value in 1 out of 8. In the end though, the rents earned by all these folks need to come from somewhere, and that's where stupidity or ignorance come in. The folks who had put their money into hedge funds that delivered great returns by making levered investments into MBSs are good candidates.
Posted by: Commenterlein at Aug 21, 2008 1:34:33 PM
So a libertarian think-tank thinks that government regulation (FDA) is bad. And this proves what exactly?
That by itself proves nothing, but the argument advanced may prove something.
Posted by: Constant at Aug 21, 2008 1:45:02 PM
Lee,
We looked for statements from all economists, libertarian or not, who had written on the FDA. Libertarians have written a lot on the issue but I have no reason to believe, for example, that Peter Temin, Steven Wiggins, Alison Keith, or say Grabowski and Vernon consider themselves libertarians. It's been a while since Klein and I update the site so if you know of other economists who have written on the issue and who have taken a stand for or against liberalization then please do let me know.
Posted by: Alex Tabarrok at Aug 21, 2008 1:55:17 PM
Commenterlein,
Yes, I know it's not really a prisoners dilemma. I was just using the term very broadly to describe asituation where individual rationality adds up to group idiocy.
Aside from the sort of example you mention I was thinking of a broader problem with time horizons, similar to the hedge fund compensation issue. If you run any sort of company with investors, hedge fund, publicly traded bank, etc. there is an incentive to take risks that are unwise over their life, but produce short-term gains. Maybe you'll be gone by the time things hit the fan. Beside, if you don't, maybe the investors start complaining about your earnings being less than your competitors, and why aren't you cashing in on this or that like everyone else?
Of course there could be other structural problems as well. Remember portfolio insurance? Turns out everyone can't sell at the same time. If everyone assumes they are in a competitive market - that depth and liquidity are not issues, you have the makings of disaster. That may be a unique feature of financial markets, where nothing is actually "sold" or "bought" in the usual sense. Instead financial claims with varying characteristics are traded for each other. I think that matters.
Posted by: Bernard Yomtov at Aug 21, 2008 2:09:12 PM
How about a government "regulations" FDA?
I think it could be interesting, to see how the conflicting movitations work out, when you have a government administrative entity that gets its power from regulating the regulations of other government administrative entities. New regulations could only emerge of course, as they advance through various phases that demonstrate that they provide net benefit. Perhaps starting with computer models, advancing to limited human trials, before being phased out to larger publics.
Posted by: Hopefully Anonymous at Aug 21, 2008 2:10:35 PM
Person,
My thought is it's a great idea and that small acknowledgement of bounded rationality could make for much better outcomes.
If you check out my blog you'll see I like the idea of opting into libertarian freedoms better than having most people start with libertarian freedoms as a default state (making more "freedoms" like driving a car then like eating junk food). More specifically, I'd like to see more empirical testing of which approach results in better outcomes, and to learn more about the empirical tests that have been done.
Posted by: Hopefully Anonymous at Aug 21, 2008 2:18:22 PM
I think this is a great idea. As a Canadian I could make out really well in the investment markets after all the American money is locked out.
Posted by: Rob at Aug 21, 2008 2:35:59 PM
In the end though, the rents earned by all these folks need to come from somewhere, and that's where stupidity or ignorance come in. The folks who had put their money into hedge funds that delivered great returns by making levered investments into MBSs are good candidates.
Yes, the money did have to come from somewhere. But the question is whether these people were the proverbial "greater fools" or whether something more complex was going on. Sensible investments do go south sometimes.
Posted by: Bernard Yomtov at Aug 21, 2008 2:38:44 PM
@ Rob
Careful now...we'll all move to Canada if you keep that sort of talk up.
Posted by: Scott at Aug 21, 2008 3:01:01 PM
"Sensible investments do go south sometimes."
Absolutely. But I believe that sub-prime mortgages originated by agents who retain none of the underlying credit risk are not sensible investments. And I also believe that this should have been obvious, and in fact was obvious to a lot of people.
Here is a little anecdote: Three years ago we were thinking about adding a course on credit risk modeling to our MBA curriculum, in response to massive industry demand for people familiar with such models. The one objection that was raised repeatedly in our group was that there was a bubble going on in the credit market and that it was only a question of time before it would all blow up. We all agreed with this, but decided that it would be a good idea to offer the course anyway since there would probably be a lot of demand for people capable of sorting the coming mess out. Now it is possible that we were somehow blessed with market insight nobody else had, but I sincerely doubt it.
Posted by: Commenterlein at Aug 21, 2008 3:18:06 PM
"approves only the uses where they can do no harm."
Based on LTCM, wouldn't this allow us to outlaw government debt auctions. McFadden might be on to a backdoor way to force the federal government to run a balanced budget.
Posted by: Jay at Aug 21, 2008 4:34:30 PM
The search for the risk-free return continues unabated.
Posted by: Yancey Ward at Aug 21, 2008 4:52:19 PM
Do tell what will be left when we approve only things "that can do no harm."?
Mass starvation?
Or worse: think dihydrogen monoxide.
Posted by: at Aug 21, 2008 10:38:33 PM
We are currently witnessing the apostles of the free market (the ones in power, not tenured professors and libertarian pundits who keep the faith pure) saving investors and companies from the consequences of the market. We are also witnessing no bid contracts by the Pentagon with the approval and connivance of the apostles of free enterprise. In short, free market bull shit doth bestride the world like a colossus. How nice that you apparently urge the elimination of the FDA or its severe curtailment. That is an area as yet not effectively damaged by market fundamentalism.
Posted by: PeterE at Aug 22, 2008 2:01:27 AM
Alex Tabarrok thinks that it is a bad idea.
Quite an endorsement.
Wall Street is in the process of losing $1-2 trillion from "innovation" and we are told that the status quo is the best of possible worlds.
Of course, it's really a heads the "innovators" win and tails that taxpayers loose transaction.
As long as taxpayers are on the hook for financial market failures, regulation is mandatory.
Posted by: Peter Schaeffer at Aug 22, 2008 3:25:28 AM
How would you even test the "safety" of financial products? With drugs, the effects of the treatment are localized to the patient, so they can be characterized by controlled studies. Being able to perform controlled experiments where the subject of interest is the entire financial system just isn't possible.
If you donate a lot of money to powerful senator: Your financial product is "safe".
If you publicly oppose legislation of the party in power: Your financial product is "unsafe".
If your financial company is going to create lots of jobs in an area and you are willing to do a photo op with your local senator/congressperson: Your financial product is "safe".
If you are going to compete with an already established financial product: Your financial product is "unsafe".
Or are we supposed to pretend that rent-seeking won't happen?
Posted by: Rex Rhino at Aug 22, 2008 3:43:15 AM
