Saturday, March 28, 2009


In Washington right now there is a great deal of squabbling and pontificating regarding the role of regulation is our finacial system. It is accepted as given that regulation is fundamental, that it is necessary to the functioning of the economy. Now it may in fact be the case that government regulation in some manner is a better way, and some might argue, the best way of ensuring market integrity, but this does not establish that it is the only way.

Economic activity is much older than the government regulatory schemes about which we fret right now. Trade occurred between tribes and loosely organized city-states and between farmers and tradesmen without a noticeable bureaucracy. The function which is now served by regulation was once served by skepticism, explicitly recognized as the principle of caveat emptor. One has to think that if banks and other financial institutions had to rely only on their own evaluation of financial risks, and had to bear the consequences of evaluating poorly, then there would have been no credit default swaps, derivative financial instruments and "opaque transactions."

It may certainly be argued that the novel financial instruments, which emerged under the noses of regulators, did have beneficial attributes, such as increasing liquidity, etc., but the more skeptical banker would be expected to rely on more conventional means of ensuring the same, i.e. having people that take out loans pay them back.

The net benefit of regulation is undoubably positive but that does not mean that there is not a down side. If people generally retained the skepticism of our more saavy ancestors, the consequences of regulatory failures would be much less severe. When regulators do their jobs poorly, such as when the investigator who examined Bernie Madoff's books could not figure out where the investment returns came from but let Mr. Madoff continue to pretend to make them, that is arguably worse than having no regulation at all. Like domesticated animals that have lost their survival instincts, and thus are incapable of providing for themselves, so too are Americans who have been gulled by the existence of regulatory schemes into thinking nothing bad can happen to them.

When people remain responsible for the results of their own voluntary transactions, there is an inherent limit to the amount of damage done by nefarious or poorly designed schemes. It takes thousands of people to make a disaster. But when assurance against calamity is relinquished to regulators, it takes only the ineptness or corruption of a few individuals to cause a fiasco.

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