The financial crisis of 2008 was caused in part by speculative investment in sophisticated derivatives ... financial firms invest enormous resources to develop financial products that facilitate gambling and regulatory arbitrage, both of which are socially wasteful activities. We propose that when investors invent new financial products, they be forbidden to market them until they receive approval from a government agency designed along the lines of the FDA, which screens pharmaceutical innovations. The agency would approve financial products if and only if they satisfy a test for social utility. The test centers around a simple market analysis: is the product likely to be used more often for hedging or speculation? Other factors may be addressed if the answer is ambiguous. This approach would revive and make quantitatively precise the common-law insurable interest doctrine, which helped control financial speculation before deregulation in the 1990s.
The problem is, even if you agreed with Posner and Weyl in principle, distinguishing between “hedging” and “speculation” is no easy task. That’s essentially what the Volcker Rule is trying to do, and it’s spawned a mind-bogglingly complex 300-page regulation. Craig Pirrog of the University of Houston goes even further in his skeptical take on the proposal.
“In sum, hedging and speculation are complementary; speculation is not always inefficient; and inefficient forms of speculation are not confined to specific instruments,” Pirrog writes. “Therefore, regulations designed to impede speculation by requiring the approval of specific products are misguided because impeding speculation interferes with efficient transfer of risk, and because the inefficient uses of derivatives cannot be reduced reliably by preventing the marketing of particular instruments.”