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.   


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.


Person, yes I am in favor of a Consumer Reports approach to the FDA which would include more labeling and evaluation and less restricting.

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!

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.

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.

Well, it proves they thought about it.

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.


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.

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.

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.

"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.

The search for the risk-free return continues unabated.

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.

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?

Also let me add that the events we are currently witnessing could not have been predict by conventional risk modeling. For example not even a 99.99% VAR would have included the possibility of the complete demise of Bear Stearns. While bashing CDOs and the people that invested in these securities, keep in mind that the math behind these products were essentially sound ex ante. My point is that there were no objective measures by which a financial FDA could have banned CDOs.

Even if I lost my house, which I won't because it's paid for, but even if I did, I'd still be ahead of the vast majority of humans on the planet.

Status quo is worse than better, but better than worse. I'll take the status quo, thanks.

So, no bid contracts, wars and deficits, government bailouts, taxpayers on the hook, government didn't stop this crisis but some people think it can close the barn door after the horse is gone, banks failing because they are borrowed short and lent long because the fractional reserve system makes this viable, their hugeness makes them "too big to fail" when they fail when the inevitable shakeout comes, come again how's it the free market's fault?

And the regulation hawks still don't have two negative quarters to rub together.

Benjamin Grant:

My point was that the Bush administration people claim to be apostles of the free market. When free marketeers are in power or run businesses they talk the talk but don't actually walk the walk. They behave much as Adam Smith says a group of businessmen behaves when together. This fact seems to be conceded but then ignored by free marketers, including free market economists. The recommendations of free market economists often remind me of the joke about an economist, an engineer, and a physicist on a desert island trying to open cans of food. The engineer and the physicist ask the economist for his solution. He begins, "Assume a can opener..." The can opener is the free market-- an interesting theoretical entity that doesn't actually exist.

The FDA in its current state may have shortcomings, but I'm not convinced getting rid of it to enjoy the blessings of the imaginary free market would be an improvement.

You would be hard pressed to find a free-market economist in favor of the bail-outs.

I suspect this is an example of the no true Scotsman fallacy.

Peter S.,

Which bailout(s) saved the financial system from total collapse and the economy from depression?

One very quick measure for the "unsafety" of a financial product is whether the sellers specifically prohibit it from being part of any ERISA covered investment programs.

A "financial FDA" would quickly be elminated, as past experiences clearly show. Things like Glass-Stegal existed to prevent many of the things that made the 1929 Depression so bad.

Removing feedback mechanisms has been the goal of Wall Street for just over 2 decades. And the natural state of a system with no feedback is wild oscillation. We're heading back to the days when boom & bust were common and happened every generation.

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