A Prescription to Prohibit Poisonous Products

What if there were a Financial Products Administration equivalent to the Food & Drugs Administration? That is, an agency that reviewed new financial products before they were introduced to potential customers, and would keep toxic instruments out of the marketplace.

That's the interesting suggestion explored yesterday by New York Times columnist Gretchen Morgenson (full story, here).

Morgenson's column is based on a paper published in February by two University of Chicago professors (one of law and the other of economics). Their proposed new agency would "approve financial products if they satisfy a test for social utility that focuses on whether the product will likely be used more often for hedging than for speculation."

Hedging risk is generally considered economically beneficial, while speculation (a.k.a. gambling) is not.

As Morgenson points out, nearly four years after the financial-markets implosion that rocked the entire national economy, regulation of the questionable instruments that underlay that implosion is still a battleground issue.

The Chicago professors argue that bad financial instruments are "at least as dangerous" as bad medicines.

It is not the main purpose of our proposal to protect consumers and other unsophisticated investors from shady practices or their own ignorance. Our goal is rather to deter financial speculation because it is welfare-reducing and contributes to systemic risk.

Moreover, they note that while Dodd-Frank attempts to address the issue, it is, at best, "an empty vessel", because "it authorizes agencies to regulate without giving them much guidance as to how to regulate."

Morgenson finds it "refreshing" to find someone who thinks that financial innovation isn't always a good thing. She notes that "bankers often argue that complex financial products are among America’s great inventions." (cf. Goldman Sachs' Lloyd Blankfein as bankers "doing God's work.") She adds,

But given that exotic instruments played a central role in the credit crisis, it is worth questioning the costs and benefits of such financial innovations.

This paper could be a starting point for an interesting discussion. But -- given the polarized paralysis of political punditry -- I'm not counting on anything but screaming matches.