Default Rules and Regulatory Agency Design

I liked this Gretchen Mortgenson column discussing a paper from Eric Posner and Glen Weyl that proposes we should look to the FDA as a model for financial regulation. The framing, however, may not do a ton to clarify what the issue is for many people.

The way I would put it is this. We have two kinds of default rules for regulations of all sorts. On one model there’s a presumption that you can’t do something new. You need to write up some paperwork, send it to your supervising regulatory agency, they send some guys over to kick the tires, they run some tests, you go back and forth, and finally if you’re lucky you get approval. On another model, there’s a presumption that you can do what you want. Something new starts happening, maybe some folks complain, maybe the agency decides to discuss promulgating a new rule, there’s a comment period, there’s lobbying, and maybe something happens. The rule of default skepticism is something we use for new pharmaceutial products and also for new airplanes. The cost of default skepticism is that it radically slows the pace of innovation. In part that’s because getting regulatory approval even for something perfectly safe is a slow process. In part it’s because a strong default rule tends to stymie competition by making it extremely difficult for new entrants to find regulatory safe harbors. The application of these strong default rules is one important reason why passenger aviation is such a fairly static industry. Even if you look at a rare success story like Embraer’s climb into bigger and bigger jets, it’s occuring at what would be considered a glacial pace in most industries and it’s only happening thanks to the backing of a major national government.

In a lot of ways, I think the analogy to the FAA (which is what Paul Romer used) is a better one than the analogy to the FDA, since it puts the costs and benefits of switching the default rule for financial products in a clear light. John Cochrane, for example, wrote a response to Romer, which showed that he’s not only generally a skeptic of regulation but also happens to be a hobbyist pilot. As it turns out, FAA regulation is extremely burdensome on hobbyist pilots and the firms that try to serve their needs. On the other hand, the strong default rule has produced a very workable utility-like commercial aviation system in which people are able to fly around the country knowing that air travel is the safest method of them all.

I would say that even if there are some problems at the margin, we basically have this right. Making life fun for hobbyist pilots is nice, but giving the general public a justified sense of confidence that you would not be allowed to run an unsafe airline constitutes mission-critical infrastructure for the operation of the American economy and American society. For finance, a similar calculus seems to me to exist. Having the basic infrastructure of matching would-be savers to would-be borrowers is incredibly important, but having it be a dynamic and innovative sector seems less important than simply having it operate reliably.