Finance, Meet Pharma
We’ve known for a while that both the processes and products of the pharmaceutical industry need to be regulated. The roots of this regulation stretch back over a century, but it’s been since the Kefauver-Harris Drug Amendments were passed in 1962 in response to thousands of severe birth defects caused by the drug thalidomide that drug manufacturers were for the first time required to prove the effectiveness and safety of their products to the FDA before marketing them. Since that time, we’ve created huge obstacles in terms of time, money, and evidentiary rigor between drug manufactures and the market; on average, it takes about 10-15 years and hundreds of millions of dollars for a drug to make it from the lab to the pharmacy. And as we come to a greater understanding about conflicts of interest and prescribing patterns, we also regulate the activities of pharmaceutical companies at even smaller level, such as when and to whom they can give pens or free lunches.
In stark contrast, we have the financial industry. In this domain, no one needs to prove the safety or effectiveness of financial products such as derivatives and mortgage-backed securities. This is because we make two major assumptions about such products based on economic theory: we presume first that they have sound internal logic and second, that the market will correct problems and mistakes if something goes awry with one of these new inventions.
In theory we could make the same argument for pharmaceutical products as well. Medications are also developed based on logic—in this case chemical and biological—and a group of experts assume that they will be effective based on this logic. We can also assume that the market would weed out bad medications, just as it weeds out unsuccessful companies and products. How would it do this? Well, people who take bad medications would become ill or die, other people would find out, and over time this process would preserve the demand for medications that work well—the same logic that is applied to financial products. Despite these parallels, there’s an incredible lack of symmetry in how we view regulating these markets.
People remain highly suspicious of one market (pharmaceutical), and far less so of the other (financial), but when we compare the systems in broad strokes, their similarities are evident. A paper I read recently got me thinking more about this comparison. In both cases, the industries in question get more money if people use more of their products, and both use salespeople to convey information about their products to consumers. So far that’s pretty standard fare in business. Less common is the similarity that these salespeople have incentives such that they benefit from selling the product, but lose nothing when it fails. Moreover, in both cases the product is complex and difficult to understand, even at the expert level. Additionally, there is substantial asymmetry in the knowledge of salespeople versus that of consumers. And in both cases, the stakes are very high, with physiological health and financial health in question. And while death rarely occurs as a direct result of financial products, the damage they can do is immense (see the financial crisis of 2008).
Yet we apprehend the dangers inherent in a free pharmaceutical market while remaining generally oblivious to those in the financial. No one protests along libertarian lines of letting pharma be free, or shouts from a podium that if the government just stayed out of our treatments and medications, amazing and innovative new cures would suddenly appear. Why then don’t we see the need to regulate the financial market?
I believe that one of the reasons for this discrepancy is that the casualties and damage done in the pharmaceutical domain are far more apparent. When things go badly in medicine, it’s easier for us to quantify them and make clear causal connections. Whereas in the financial market it’s generally the case that lots of people lose some money, but people rarely lose everything. Moreover, in the financial market, there are never just losers, there are always winners as well—someone will gain a lot from a losing transaction, and that’s frequently chalked up to how the system works. With pharmaceutical losses, the injury or death of patients far exceeds any gain the company might make (and then lose in litigation). Also, with medications, the counterfactual is generally much stronger. There are people who took a drug and those who didn’t, and often a clear comparison of the difference emerges. In economics it’s far more difficult to make a causal connection, after all, there is still debate over whether the first and second bailouts helped anyone other than the institutions that got paid directly.
Given the similarities between the markets, and the differences in how we tend to regard them, I think we need an FDA-like entity and process for financial products, because if we don’t have a counterfactual, we can’t compare and measure the value of their products. We could call it the FPA, for Financial Product Administration. One example of a financial tool that the FPA could test is high frequency trading. Companies are going all out to profit by being the fastest to buy and sell stocks, owning them for fractions of a second; they even go so far as to buy buildings closer to the stock market to make trading faster. The logic behind high frequency trading is that companies can take advantage of even tiny price fluctuations. And it’s possible that in principle they’re adding to the efficiency of the market, but it’s more likely that they increase volatility, and frighten people off the market, and therefore have a negative effect. It’s an understatement to say that this strategy is focused on the short term, whereas investment ideally is about a longer-term commitment. But regardless of one’s beliefs on whether high frequency trading is ethically sound, it would be nice to know for sure if it makes the markets better or worse off before allowing it.
By the way, one thing I appreciated most about the paper that inspired this post is that the authors are from the University of Chicago—home of the free market champions. That’s a departmental seminar I wouldn’t mind sitting in on.