Government and Regulation

One argument about regulation that seems to be gaining traction through the recent financial crisis is "See, private action and enterprise is not infallible.  They can make mistakes that have costs for everyone.  Therefore they need to be regulated." 

I don't have time for the full refutation of this, but a few thoughts:

  • No one ever said that private actors in the economy are infallible or even universally honest.  However, no one has ever been able to make the case that government employees are any more infallible or honest. 
  • There are a couple of reasons government regulators are going to be demonstrably worse than the marketplace in making decisions.  The first is information -- a few actors in Washington can never have the same access to information as thousands of actors across the country or around the world.  The second is incentives -- while regulatory hawks cite private greed as a bad incentive in the marketplace, bureaucratic incentives can be at least as problematic.
  • Governments are subject to all sorts of rent-seeking initiatives, not to mention regulatory capture, that undermine regulatory effectiveness.  Just look at the bailout bill. Wooden arrows?

For some reason, the argument "private actors screwed up" seems sufficient justification for regulation.  The burden of proof should instead be "the government could have done better."

Here is a nice example of how regulation really works, from an interview with Warren Buffett:

QUICK: If you imagine where things will go with Fannie and Freddie, and
you think about the regulators, where were the regulators for what was
happening, and can something like this be prevented from happening

Mr. BUFFETT: Well, it's really an incredible case study in regulationbecause
something called OFHEO was set up in 1992 by Congress, and the sole job
of OFHEO was to watch over Fannie and Freddie, someone to watch over
them. And they were there to evaluate the soundness and the accounting
and all of that. Two companies were all they had to regulate. OFHEO has
over 200 employees now. They have a budget now that's $65 million a
year, and all they have to do is look at two companies. I mean, you
know, I look at more than two companies.

QUICK: Mm-hmm.

BUFFETT: And they sat there, made reports to the Congress, you can get
them on the Internet, every year. And, in fact, they reported to
Sarbanes and Oxley every year. And they went--wrote 100 page reports,
and they said, 'We've looked at these people and their standards are
fine and their directors are fine and everything was fine.' And then
all of a sudden you had two of the greatest accounting misstatements in
history. You had all kinds of management malfeasance, and it all came
out. And, of course, the classic thing was that after it all came out,
OFHEO wrote a 350--340 page report examining what went wrong, and they
blamed the management, they blamed the directors, they blamed the audit
committee. They didn't have a word in there about themselves, and
they're the ones that 200 people were going to work every day with just
two companies to think about. It just shows the problems of regulation.

The problem, of course, is that Fannie and Freddie were doing exactly what Congress wanted them to do -- systematically lowering mortgage underwriting standards.  They won't put it that way now, but that is  what spreading home ownership to lower income families really amounted to.


  1. Michael Miller:

    It was not only Congress. The Clinton administration also placed heavy pressure on Freddie and Fanny to dangerously lower their underwriting standards. The warning for this disaster was sounded back in 1999. But no one listened.

  2. Erica:

    I am from Canada and no, we are not a socialized state, but the gov't does like to interfere everywhere. They, and more frightening, all the people, seem to feel it is thier duty. And telling people that it is not our duty to give heiron addicts free needles, just makes them hate you. So whenver I hear about the States becoming more and more socialized, I want to cry. Where am I supposed to flee to if and when the NDP eventually take over Canada? There is no where else. Maybe I should just become a billionarie, buy my own naiton and let all people who believe in the free market, minimal gov't interference and that people need to take responsibility for themselves and support themselves can come live their with me.

  3. Joseph Hertzlinger:

    One possible analogy: If you think of the success of the 911 attacks as a failure of private initiative on our side, the regulatory response was to institute preposterous transportation regulations. Will a regulatory response to the banking crisis involve the equivalent of people taking off their shoes before boarding planes?

  4. Doug:

    Will a regulatory response to the banking crisis involve the equivalent of people taking off their shoes before boarding planes?

    We have that already. It's called Sarbanes-Oxley.

    The problem with letting politicians run the economy, or think they do, is that politicians don't make economic decisions: they make political decisions that have economic consequences.

  5. rxc:

    I used to be a government regulator, and I can tell you that it is not easy. The industry complains that the regulators strangle them. The Congress-persons whipsaw you back and forth between tighter regulation and less regulation. The non-regulated "stakeholders" complain about not being allowed to have a bigger say in what you do. And the lawyers and the judges and bean counters tie everything in knots with laws and decisions and processes that do not recognize that sometimes regulatory decisions are made based on a gut-feel, when it is not possible to calculate a result with any sort of accuracy.

    And, to top it all off, you cannot find people to work in Washington who have the skill sets you need to understand the stuff that the regulatee throws at you. The financial people cannot compete with Wall Street for financial analysts, the FDA cannot compete with pharma for doctors, and my agency could not compete with industry to get engineers to come to Washington, where housing prices were absurd.

    I think the politicians are at the root of all of this trouble, as they interfere to support their favorite political cause. It is not unusual for an agency to receive one letter from Congress, asking why they approved something, in light of "facts" that say they should not, while another Congress-person sends another letter asking why the approval was not done sooner, and with less onerous conditions. It is like having a board of directors with 535 members, none of whom agree on how the business should be run, or even whether the business should be in business.

    It will not go away. You have to live with it. And consider the alternative - we once had a system where the entire infrastructure of government, as well as govt policies, changed each time a new President was elected. Modern business could not exist in this sort of environment (it is what happens in third-world countries). You need a stable bureaucracy in place to even our the shifts that the politicians want to make when the power changes hands. The bureaucrats have to be at least somewhat responsive to the politicians, but they cannot change direction 180 degrees on January 20, each four years (or every 2 years!).

    It is ironic that Obama has been pushing "change" in his campaign, because that is the message that has been pushed on the government bureaucracy over the past 15 years, since Al Gore started to "re-invent" government. He and his friends in the accounting business, and then the financial friends of the Bush administration, pushed the government to embrace change, and do things more like businesses, taking more risk. Well, the bureaucrats did, and now we have the current financial meltdown.

    Those of you on this blog who complain about regulation - do you want the FAA to take more risks in regulating the safety of airlines, or the FDA to take more risks in regulating the drugs you need to stay alive, or the US NRC to take some more risks as it regulates nuclear power plants?