Monday, May 3, 2010

Why the FDA Isn't A Model for Financial Reform

Cross-posted from The Agenda on National Review Online.

In Washington, the debate about financial reform has taken on a more bipartisan bent than did the battle over Obamacare. Most people think of health-care reform as an ideological debate about the nature of entitlements and the scope of the welfare state, whereas many of us see financial reform as a technocratic issue, in which both sides are working to achieve the best policy outcome.

But there are striking similarities between Obamacare and financial reform: both involve large swaths of the economy (U.S. health care spending is about 16% of GDP; the financial services industry is about 20%), and both have been dramatically affected, for better or worse, by policy decisions in Washington.

In this context, it is interesting to observe the debate around one element of the Democratic financial reform package: the creation of a new government institution, the Consumer Financial Protection Agency (CFPA), whose mandate would be to ensure that consumers aren't duped by predatory lenders. The plan's many critics, such as those at the Wall Street Journal, argue that the CFPA would (1) be redundant with existing government regulations and agencies; (2) place small community banks at a competitive disadvantage to the big "bulge-bracket" firms; (3) further tighten the supply of credit; (4) compromise important aspects of consumer privacy; (5) do nothing to address the actual causes of the 2008 crash.

Liberals, however, remain optimistic that a new CFPA could succeed at protecting consumers in ways that they believe that other government agencies have failed. Some, like Johns Hopkins political scientist Steven Teles, see the U.S. Food and Drug Administration as a model for how a successful CFPA could function.

Teles makes his case in the most recent issue of The Washington Monthly, in which he reviews a new book by Harvard political scientist Daniel Carpenter, entitled Reputation and Power: Organizational Image and Pharmaceutical Regulation at the FDA. Specifically, Teles argues that a key to the success of the CFPA will be where it is located on the big Federal org chart:

The story of the FDA as presented by Carpenter holds important lessons for liberals. First and foremost, while Americans' skepticism of government is strong, it is not insurmountable. Many Americans think of "bureaucrats" as either ineffectual or self-interested power grabbers, but few feel that way about employees of the FBI, the military, the Social Security Administration, or the National Institutes of Health. And because Americans view these agencies in a positive light, they and their representatives in Congress have been willing to grant them broad power and authority, and in some cases to allow them to exercise power that they have not been explicitly granted—proof that Americans do not oppose handing power to government when they believe it is in trustworthy hands. Just as important, as a result of their reputation these agencies have been able to attract talent that other agencies cannot.

Carpenter's argument has some important, if highly speculative, implications for our current debate on financial regulation. As many liberals have rightly noted, and indeed Carpenter himself argued in a recent op-ed in the New York Times, it may be dangerous to put a consumer financial regulator in a larger—and perhaps more finance-friendly—organization like the Federal Reserve. Yet there are lessons from Carpenter's own book that suggest there may be real advantages as well. The Fed is taken seriously by the financial industry itself, and because of its reputation and more attractive salary schedule it is substantially more able to attract talent than other federal regulatory agencies. If placed inside the Fed, the CFPA would be able to build a strong, clear organizational image (especially if it were given the insulation from the rest of the Fed that Senator Dodd's bill would provide, including near-complete control over its own budget). This would help foster the political will to grant the agency the autonomy it needs to effectively regulate the financial industry.

There are, however, two problems with this argument: first, the FDA is far from perfect; second, the successful aspects of the FDA have nothing to do with its bureaucratic location, and instead are due to factors that a CFPA wouldn't be able to replicate.

Let's start with the second argument first. Teles is right to point out that, when compared to other federal regulatory authorities, the FDA does its basic job reasonably well. It has, over time, evolved into a sophisticated regulator of the pharmaceutical industry, and does a good job of auditing clinical trial data at a level of rigor far exceeding that of the academic community. But these qualities are not a result of the FDA's bureaucratic location or its fiscal independence. They are due to the fact that medical science, by its very nature, is highly empirical.

If a new medical therapy, in well-controlled trials, clearly demonstrates that it outperforms the prior standard of care, the FDA will approve the treatment. To do otherwise would make little sense. Similarly, if a drug performs worse than placebo, say by causing significant liver toxicity, the FDA will quite sensibly reject it. The FDA's main regulatory role is to make objective assessments of factual clinical data. The same can't be said of the proposed CFPA. Is there anything objective about the definition of "predatory lending," especially in the current political climate?

Teles is also wrong to suggest that the FDA is a citadel of apolitical technocracy: any veteran of the FDA will tell you that FDA reviewers live in fear of being dragged into Congressional hearings. Their basic goal in life is to do their jobs, keep their heads down, and hope that nobody on Capitol Hill forces them to spend hundreds of thousands of dollars on lawyers.

When does the FDA arouse Congress' ire? Whenever it makes a decision that can be second-guessed in hindsight. And the only decisions that can be second-guessed in practice are positive ones. That is to say, Chuck Grassley doesn't come after you if you don't approve a drug that never makes it to market. Patient advocates might complain, but they won't sue you. On the other hand, if you approve Vioxx, and it later turns out that 0.3% more patients get heart attacks on Vioxx than on naproxen, U.S. senators start pounding tables and demanding answers.

Hence, in a classic manifestation of the precautionary principle, reviewers at the FDA are temperamentally biased against approving new drugs. When the precautionary principle is excessively applied, it causes far more harm than good: instead of protecting consumer safety, it delays or prevents life-saving drugs from reaching the market. In addition, due to increased demands from the FDA for larger, costlier studies, the cost of developing new drugs has skyrocketed. In 2001, according to the Tufts Center for the Study of Drug Development, pharmaceutical companies spent $802 million in R&D for every drug approved by the FDA. Today that number is estimated to be $1.3 to $1.7 billion.

Companies must recoup these costs in the form of higher drug prices, which in turn drive up the cost of health care. Similarly, we must worry that a poorly-structured CFPA will drive up the cost of borrowing, which will in turn cause a significant contraction in the economy, as individuals and small business find it harder to finance mortgages and purchase equipment.

Financial regulation is a highly technical subject, and it is understandable that many eyes in Congress glaze over when the subject is brought up. But the world paid a significant price for the way Congress elevated the ideology of home ownership above responsible lending practices. At this point, we cannot be assured that the current version of financial reform won't result in similar problems.

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