Regulation: A Wild Swing of The Government Cudgel – June 28, 2010

With the progress of the financial “reform” bill, the time perhaps becomes ripe to discuss the less-than-thrilling subject of regulation.  (I note for the record, and not without some amusement, that the President’s Commission on What Went Wrong is not scheduled to submit their findings on the financial meltdown until after the November elections, and yet here we are passing legislation supposed to make sure it doesn’t happen again – whatever it was that happened the first time.  Reminds me of the Red Queen from Lewis Carroll – Sentence first! Verdict afterwards!)

Let me say for starters that the conservative position is most emphatically not that there is no need for regulation.  There are in fact two very good reasons for clear and effective regulation.  The first is to establish a known set of rules within which all parties must compete.  If everybody knows the boundaries of what is and is not acceptable behavior, then within those bounds they can kick and fight and bite and scratch to gain advantage, market share, and profitability.  The second is what is known as the problem of the commons.  Some of the costs of doing business are not borne by the businesses themselves but by the wider community – such things as pollution.  Regulation is desired and required to make sure these costs are effectively included in a business’s cost structure.
Having said that, it is also true that there is ample reason to be extremely skeptical of legislation that seeks to regulate.  Frequently the push to legislate arises because Congress is keen to be seen to be “doing something.”  So regardless of what the actual problem was, or how serious or widespread it was, laws get written that affect everybody, not just the malefactors.  A great example of this is the Sarbanes-Oxley act, which was thrown together in haste after the Worldcom and Enron financial debacles.  One of the most onerous provisions of that law was the one that required public companies of all sizes to have their internal controls audited, to ensure there was no cooking the books, and also to have the CEO’s become personally liable for material misstatements.  These two elements substantially raised the costs and the risks of doing business, for little appreciable gain.  Since 99% or so of public companies are honestly managed to begin with, the extra confidence these measures gave to the marketplace was minimal.  But the extra costs and risks were real – and New York started to see its pre-eminence as a center of global finance being usurped by less-heavily-regulated countries, as companies looked elsewhere to raise capital.
I’m also dubious when Congress passes laws designed to “help” people who have supposedly been victimized by some recent mishap.  It’s a virtual certainty that helping some groups in this way will, through some politically Newtonian force of equal and opposite consequence, harm some totally innocent group.  For instance, take the recently passed credit card rules, which limit the fees banks can charge, and otherwise constrains how and when banks can change interest rates.  This was meant to help people from being “victimized” by banks who, say, adjust the cost of their credit to changes in their payment history – this is known in the banking business as charging higher rates for riskier loans.  But the government says that’s abusive and put a stop to it.  The natural consequence is that credit for such people becomes much harder to get, and credit gets scarcer for everybody else as well.  If banks can’t compensate themselves for credit card risk, they will limit how much they do and make it more expensive.  Want to know one reason why the economy is taking so long to get back on its feet?  Credit (pun intended) in part goes to this “reform.”
Then there is the ironclad law of unintended consequences.  While lawmakers may be pretty confident in how the target of their legislation will respond (at least the first order of response), they are inevitably clueless about the actual result that will be visited upon society as people make the natural response to the government’s incentives.  One of the most damning examples of this was Lyndon Johnson’s Great Society legislation expanding the welfare state.  Johnson declared “war on poverty,” foolishly thinking that if the government gave enough money to poor people, they would be able to get on their feet and get their lives together.  A trillion dollars later and the blight of poverty has not noticeably retreated.  Because when people see the government is handing out money, they come and get it.  People don’t become self-supporting; they become dependent.  If the government is handing out money to help unwed mothers, then it becomes an advantage not to marry the guy who got you pregnant (this, as much as anything, is to blame for the epidemic of single mothers out there).
It goes on and on in programs designed to help people.  Rent control results in housing stock that is starved of investment, prices that are distorted, and people who live in the same little apartment for thirty years.  Minimum wage increases make the unskilled worker uneconomic because a shop owner can hire someone with skills and a work history for about the same wage – so the one who remains unemployed is the very unskilled worker the law was intended to help.
This new financial legislation is loaded with provisions the unintended consequences of which will be discernible only  in the years ahead.  And it is so complex – another 2,000 page monstrosity – that the unintended consequences will have UC of their own, compounding the Ooops effect as things play out.
There is another big reason to be skeptical about regulation, and that is the fallacy of precision.  The rules the government passes often are improper to achieve the desired regulatory objective, and yet because they are the official rules they must be followed.  A terrific example of this is seen in the BP Gulf Oil spill.  Not too many people are making a big deal of this, but one of the main reasons that the response was so inadequate when the oil started flowing was that the government required – as in, no two ways about it, do it this way – required oil companies to base their disaster contingencies on a model called the Oil Spill Risk Analysis prepared by the Interior Department.  This report, dating from 2004 when deepwater drilling was in its infancy, predicted that the worst case from a spill would be much less than actually happened – only an 11% chance of oil hitting the Gulf beaches.  And oil company response plans are prescribed by regulation, and have to be based on this outdated model.  Whaddya gonna do?
I’ve already talked about the issue of regulatory capture – it runs counter to most human interaction patterns to be continually suspicious and mistrustful of the industry people you regulate when experience shows them to be reasonable people who want to do the right thing.  So regulators naturally gravitate towards helping their targets.  Normally, this is not a bad thing – the industry is where the expertise resides, and getting close to those people can help a regulator become more knowledgeable and do his or her job better.  But it also means said regulator can take his eye off the ball just when it needs to be there.  A related problem is that, precisely because the industry is where the expertise is, they can frequently find their way around whatever rules the regulators post.  Just look at the problem of bank capital.  The Basel Committee has been trying for years to define and measure how much capital a bank requires to maintain an adequate cushion for risk and they are still not satisfied with the results.  Both the numerator (the risk positions the bank carries) and the denominator (the bank’s capital) are subject to lots of different measurements and definitions, and there is no one-size-fits-all rule that can be applied fairly.  And bankers are constantly finding ways of re-structuring and re-defining assets and capital so they can do more business and generate more revenue.
So we find ourselves in a pickle.  The world is complex and rules have to be laid down.  But the very complexity of things makes the rule-making an exercise in futility.
For these reasons and many others, conservatives prefer the notion of self-regulation.  This does not mean that every company gets to make up its own rules and decide for itself if it is following them.  Self-regulation generally means industry groups collectively establish best practices that suit objectives that often are government mandates (often the impulse is to avoid the heavy hand of government).  Industry groups that put their imprimatur on the practices of its members can give a “Good Housekeeping Seal of Approval” to such firms, without which prospective clients will avoid them.
There is a natural incentive, after all, to do the right thing.  A business’s reputation takes years to build up and can evaporate overnight.  And anyone who wants his/her business to succeed (and what CEO doesn’t?) knows that a tarnished reputation is one sure way not to do it.  BP will take longer to recover its reputation than it will to recover the cash it will spend to make amends in the Gulf.
I’m inclined to think that the best form of regulation is not the detailed, prescriptive, clumsy and unresponsive stuff we have now, but rather an objectives-based set of rules.  Very broad definitions about what constitutes fraud and illicit behavior, and let regulators bring action against those whose own actions cross those boundaries.  This, self-motivation, and industry self-regulation will accomplish much the same ends with much less collateral damage.
Such a system certainly would not be a cure-all.  Enrons will occur and people will be ruined, and the people that cause those problems will go to jail.  But don’t lose sight of the fact that much of the misdeeds of what President Obama likes to call the “few greedy people” in New York’s financial district were the natural consequence of government’s setting up the conditions for a bubble.  The Fed set the premium for risk exceptionally low by engineering negative real interest rates; the government fostered the bubble with Fannie and Freddie guaranteeing ridiculous loans at the behest of their Congressional masters.  The bankers predictably leveraged up and then the bubble popped.  Would more regulation have prevented that?
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