Did Sam Waksal's family sell shares in his company ImClone because bad news was about to emerge about its cancer drug, Erbitux? Did the chief executive let his friend Martha Stewart in on the secret? Did America's star homemaker do wrong?

Mr Waksal has been charged with insider trading, while Ms Stewart insists she acted correctly. But the ImClone drama is not merely a story about personalities and share trading. It also bears on how a regulator's power generates financial uncertainty. Erbitux's future and ImClone's stock price both depended on the Food and Drug Administration.

The FDA has a reputation as a "good" agency, a faithful policeman that has for decades helped to ensure that US drugs are among the safest in the world. But it is also relatively secretive and capricious. If the FDA's procedure for reviewing drugs were more transparent and predictable, ImClone's shares would never have been quite such a high-stakes proposition in the first place. Regulation, especially unpredictable regulation, begets market volatility.

The economic uncertainty caused by regulation in the US health sector is not confined to cancer drugs. Take a related area, the medical device business. A review of its workings shows that regulatory uncertainty can damage individual firms. It also shows that heavy-handed regulation has the power to slow innovation.

America's medical device business has been enormously profitable and beneficial, creating many products that have improved the quality of life: cochlear implants that restore hearing; and heart stents, the fine metal tubes used to open clogged arteries and vessels that can add years to lives (one recipient has been vice-president Dick Cheney). And start-up companies have played a crucial role in this product innovation.

Fuelling their growth has been that most fickle form of investment, venture capital. In 2000, venture capital funds disbursed $98m (£66m) to pacemaker and artificial organ makers alone. But such cash can evaporate as fast as it materialises if venture capital funds think the prospect of future profits is too slim, or too uncertain.

Medical device makers confront two big obstacles when bringing a product to market, a Hudson Institute conference in Washington heard last Friday. The first is gaining approval from the FDA. The second is being endorsed by the Centers for Medicare and Medicaid Services, federal bodies that fix how much the government programmes will pay.

Since the nation's senior citizens are almost all insured through Medicare and Medicaid, a CMS decision on a product can determine whether a medical device finds a market.

The industry complains of difficulties with both regulators. In a KPMG survey of venture capital companies funded by the industry and presented at the conference, the companies complained about three FDA habits. First, the agency takes a long time - often more than a year - to decide on a product. Second, it imposes moving targets, shifting the requirements for approval over the course of the process. Third, venture capitalists find it moody: sometimes it is friendly to applicants and sometimes it turns hostile.

The process for establishing reimbursement rates for new products is also unpredictable, they say. The report tells of a company that developed a mobile device to identify misdiagnosis of nursing home patients. At first, the firm received $1,200 for the product. Then the authorities reclassified the item, dropping the reimbursement rate to $300. Since the product was used almost entirely for Medicare patients, this drove the company out of business.

Some also reported that both regulators had become more aggressive. The result, said Jonathan Osgood, a managing member of Cutlass Capital, is that "we will not invest if we are not certain about the FDA pathway and reimbursement".

Robert Ulrich of Vanguard Venture Partners reported a "retraction" of capital as investors switched to surer bets. The effect has been to deter innovation: highly experimental ideas become too uncertain to finance.

The companies described a different situation in Europe. Ron Dollens, president and chief executive of Guidant, a maker of cardiovascular devices such as heart stents, said that "approval is easier and [getting] payment is harder" in Europe. The latter was crucial. "If our organisation sold [all] our products at European prices, instead of making $509m, we would have lost $100m."

Mr Dollens noted that, at any one time, two-thirds of his firm's products had been on the market for less than a year. His firm is not atypical in this rate of change, which makes it all the more important that the industry sustain its relative attractiveness to investors.

One could object at this point that the venture capitalists and the medical devices makers are a hypocritical bunch. They gather in Washington to whine about the unpredictability of the nanny state but they would not have been attracted to this business in the first place if Nanny were not so generous. Medicare and Medicaid offer a sure and captive set of customers, once they have been secured. If venture capitalists want to live up to their name, they must accept a degree of uncertainty. And if they invest in drugs such as ImClone, or medical devices such as heart stents, the regulatory attitudes are part of the risk they run.

But this argument underplays the benefits that such products bring. It is fine to point out corporate greed and excesses when it comes to device-makers and pharmaceuticals companies. But it is worth recalling that innovation is a fragile flower that does not have to occur in the US. Nor does it have to occur in Europe. In fact, it does not have to happen at all. And how much worse off we would be if there were no attempts at Erbituxes, however flawed such attempts may be.

© Copyright 2002 Financial Times