Preventing the Next Financial Overdose

Financial overdoseNew drugs are vetted by the Food and Drug Administration before they reach market. Should the same process be considered for new financial instruments?

Two professors at the University of Chicago, Eric Posner and E. Glen Weyl, think so. In February they published a paper arguing that regulators should approach financial products the way the FDA approaches new drugs. They suggest that the potential dangers of financial instruments “seem at least as extreme as the dangers of medicines.”

Their idea is that there would be a federal agency, designed along the lines of the FDA, which would test new financial products for social utility. In their analysis, products that serve only to increase speculation would be rejected. Products that help people hedge risks would be approved. The goal would be to deter financial speculation, or gambling, which contributes to systemic risk.

Certainly, their proposal has gotten pushback from those who believe that financial innovation is always good and regulation is always bad. Yet, given the fact that exotic instruments contributed to the credit crisis, it is valuable to review their proposal in a more detail.

Professors Posner and Weyl would distinguish between financial markets-where institutions lend money, trade securities and make investments and the real economy, where people trade goods and services. They believe that the real economy should be largely unregulated but the financial markets need regulation.

Furthermore, they don’t believe that disclosure alone is enough for financial instruments. “In pharmaceuticals, we could allow a company to sell whatever it wants as long as it tells the people the product might work but also might cause your head to fall off,” said Professor Posner. But, “we don’t do that because people will ignore the information, so we draw the line and say, ‘You can’t buy the product’.“ The same logic, they say, should be applied to financial instruments that could be harmful.

It’s unlikely that their proposals will become reality anytime soon. However, their comments may someday help to limit financial overdoses in the future.