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Economics no image

Published on March 22nd, 2012 | by Saira Khan
Image © [caption id="" align="alignleft" width="350" caption="New York Stock Exchange, Evan Leeson ©"][/caption] In the aftermath of the 2008 crisis, there are calls for tighter regulation of financial markets and products, including sophisticated derivatives. Critics of greater financial regulation argue that it interferes with efficient resource allocation. But from the mid-2000s onwards, the financial system was rigged to ensure a small percentage of people became rich without regard for society or the economy. Rather than financial markets protecting people from fluctuations in the valuation of their goods, insuring them against risk and spreading it across the economy, it has become a venue for people betting on all sorts of speculative endeavours. Is more or less regulation beneficial for the financial system? Can free markets do better things than regulators? Have the lessons of the 2008 crisis been learnt or does speculation still control our markets? As the Economist highlighted, America, supposedly the land of the free, is full of ridiculous regulatory laws; a Florida law requires vending-machine labels to urge the public to file a report if the label is not there; children’s lemonade stands in Bethesda were shut down as they did not possess trading licences. But when it comes to serious issues like the economy, this regulation becomes a problem. The Dodd-Frank Act of 2010 was written with the aim of inducing greater transparency, preventing excessive risk-taking, and authorising the take-over of too-big-to-fail banks by regulatory authorities with the purpose of winding them down. But this bill is far too complicated at 849 pages, and mandating 400 rules, half of which were not finalised and demanded regulators fill in further detail. One section, the ‘Volcker rule’ -- aiming to curb risky propriety trading by banks -- includes 383 questions that break down into 1,420 sub-questions. The problems that arise from such complexity are many-fold; not only may we find a large number of people in danger of wearing orange jumpsuits because they are unsure of what they can and cannot do, we may also find that complexity, particularity and regulatory arbitrage allows room for loopholes and continued fraud. Furthermore, if they so choose, congressmen could easily amend this lengthy bill to their advantage without anyone noticing the difference. On January 29th of this year, Eric A. Posner and E. Glen Weyl from the University of Chicago published a paper entitled ‘A Proposal for Limiting Speculation on Derivatives: An FDA for Financial Innovation’. This proposes that financial products (i.e. bonds, shares, treasury bills, annuities, etc.) be tested for safety and efficacy in the same way that pharmaceuticals are tested by the Food and Drug Administration and pre-approved before being sold to the public. Posner and Weyl assert that many financial instruments may promote hedging or speculation yet generate no social value. Pre-approvals by regulatory bodies will be granted on the basis legitimacy and demand projections founded on prior experiments, in the same way that mergers have been regulated by anti-trust authorities for decades. They will draw upon common laws and modernise them through economic analysis. Posner and Weyl are not advocating a revolution, but rather a reversion to a time before speculation ran out of control, before the 1990s. This all sounds very sparkly, but of course, there are points worth disparaging in their argument. Foremost, that the goals of financial regulation are consumer protection and the prevention of a systemic breakdown. Testing products does not ensure that an institution’s superior sophistication is not used to exploit an individual consumer’s lack of knowledge. Furthermore, we cannot compare economics so tightly to a science as it has social and environmental aspects – we cannot ‘test’ products as there are hundreds of financial centres around the world and testing involves a sample under specific conditions. If the US and UK go through FDA-style regulation, what is to say Shanghai and Mumbai will not implement the product anyway? Moreover, this kind of controlled testing can prove inefficient due to an ever-changing economy – in the mid-2000s, sub-prime mortgages would surely have been pre-approved by the testing, but only because housing prices were appreciating. They turned out to be quite averse to economic benefit by the late-2000s when the housing bubble burst. This shows that regulations based on testing or experience fall through when applied in the changing environment of the real world. So what is the alternative? Simplicity. Not in the sense of Stalinist extreme regulation or chaotic free capitalism, but of pragmatism. We need simple principles like that a financial institution should not sell a product that a consumer has no chance of benefiting from or does not understand – i.e. they should not fool people. There should be audits against a company’s ability to do this. Regulation should not be carried out on products but on companies. Without fundamental principles, institutions will adhere to product regulation but continue to purposefully rip-off consumers in the long-term. The establishment of these principles should be in the hands of Congress but their enforcement in the hands of regulators. Does this award the unelected too much power? Not if they are held accountable. Naturally, this is a proposal that would not be kindly received by Wall Street. They would not make -- comparatively -- enough money and may be subject to a quantity of frivolous lawsuits from consumers. They would much rather prefer to have the protection of pre-approved products to sell at their will. Furthermore, is the assessment of whether a product is in consumer interest any easier than assessing individual products themselves? Not particularly. Nonetheless, we must not get caught up in the notion of ‘more or less’ regulation; it is not a matter of quantity but of quality; it is question of sensible or not sensible regulation. But if we actually knew the difference between dangerous speculation and valid investments, there would not be any need for this, and it is dubious as to whether we should place our faith in regulatory bodies to figure this out. At least we can establish that throwing a host of regulatory laws at the market, such as in Dodd-Frank, will not necessarily solve excess, false bubbles, liar loans, or be cost-beneficial. As the market evolves, so does its market-players.

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Dodd-Frank and an FDA for Financial Innovation

New York Stock Exchange, Evan Leeson ©

In the aftermath of the 2008 crisis, there are calls for tighter regulation of financial markets and products, including sophisticated derivatives. Critics of greater financial regulation argue that it interferes with efficient resource allocation. But from the mid-2000s onwards, the financial system was rigged to ensure a small percentage of people became rich without regard for society or the economy. Rather than financial markets protecting people from fluctuations in the valuation of their goods, insuring them against risk and spreading it across the economy, it has become a venue for people betting on all sorts of speculative endeavours. Is more or less regulation beneficial for the financial system? Can free markets do better things than regulators? Have the lessons of the 2008 crisis been learnt or does speculation still control our markets?

As the Economist highlighted, America, supposedly the land of the free, is full of ridiculous regulatory laws; a Florida law requires vending-machine labels to urge the public to file a report if the label is not there; children’s lemonade stands in Bethesda were shut down as they did not possess trading licences. But when it comes to serious issues like the economy, this regulation becomes a problem. The Dodd-Frank Act of 2010 was written with the aim of inducing greater transparency, preventing excessive risk-taking, and authorising the take-over of too-big-to-fail banks by regulatory authorities with the purpose of winding them down.

But this bill is far too complicated at 849 pages, and mandating 400 rules, half of which were not finalised and demanded regulators fill in further detail. One section, the ‘Volcker rule’ — aiming to curb risky propriety trading by banks — includes 383 questions that break down into 1,420 sub-questions. The problems that arise from such complexity are many-fold; not only may we find a large number of people in danger of wearing orange jumpsuits because they are unsure of what they can and cannot do, we may also find that complexity, particularity and regulatory arbitrage allows room for loopholes and continued fraud. Furthermore, if they so choose, congressmen could easily amend this lengthy bill to their advantage without anyone noticing the difference.

On January 29th of this year, Eric A. Posner and E. Glen Weyl from the University of Chicago published a paper entitled ‘A Proposal for Limiting Speculation on Derivatives: An FDA for Financial Innovation’. This proposes that financial products (i.e. bonds, shares, treasury bills, annuities, etc.) be tested for safety and efficacy in the same way that pharmaceuticals are tested by the Food and Drug Administration and pre-approved before being sold to the public. Posner and Weyl assert that many financial instruments may promote hedging or speculation yet generate no social value. Pre-approvals by regulatory bodies will be granted on the basis legitimacy and demand projections founded on prior experiments, in the same way that mergers have been regulated by anti-trust authorities for decades. They will draw upon common laws and modernise them through economic analysis. Posner and Weyl are not advocating a revolution, but rather a reversion to a time before speculation ran out of control, before the 1990s.

This all sounds very sparkly, but of course, there are points worth disparaging in their argument. Foremost, that the goals of financial regulation are consumer protection and the prevention of a systemic breakdown. Testing products does not ensure that an institution’s superior sophistication is not used to exploit an individual consumer’s lack of knowledge. Furthermore, we cannot compare economics so tightly to a science as it has social and environmental aspects – we cannot ‘test’ products as there are hundreds of financial centres around the world and testing involves a sample under specific conditions. If the US and UK go through FDA-style regulation, what is to say Shanghai and Mumbai will not implement the product anyway? Moreover, this kind of controlled testing can prove inefficient due to an ever-changing economy – in the mid-2000s, sub-prime mortgages would surely have been pre-approved by the testing, but only because housing prices were appreciating. They turned out to be quite averse to economic benefit by the late-2000s when the housing bubble burst. This shows that regulations based on testing or experience fall through when applied in the changing environment of the real world.

So what is the alternative? Simplicity. Not in the sense of Stalinist extreme regulation or chaotic free capitalism, but of pragmatism. We need simple principles like that a financial institution should not sell a product that a consumer has no chance of benefiting from or does not understand – i.e. they should not fool people. There should be audits against a company’s ability to do this. Regulation should not be carried out on products but on companies. Without fundamental principles, institutions will adhere to product regulation but continue to purposefully rip-off consumers in the long-term. The establishment of these principles should be in the hands of Congress but their enforcement in the hands of regulators. Does this award the unelected too much power? Not if they are held accountable.

Naturally, this is a proposal that would not be kindly received by Wall Street. They would not make — comparatively — enough money and may be subject to a quantity of frivolous lawsuits from consumers. They would much rather prefer to have the protection of pre-approved products to sell at their will. Furthermore, is the assessment of whether a product is in consumer interest any easier than assessing individual products themselves? Not particularly. Nonetheless, we must not get caught up in the notion of ‘more or less’ regulation; it is not a matter of quantity but of quality; it is question of sensible or not sensible regulation. But if we actually knew the difference between dangerous speculation and valid investments, there would not be any need for this, and it is dubious as to whether we should place our faith in regulatory bodies to figure this out. At least we can establish that throwing a host of regulatory laws at the market, such as in Dodd-Frank, will not necessarily solve excess, false bubbles, liar loans, or be cost-beneficial. As the market evolves, so does its market-players.

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