Avoiding the Ignorant and Corrupt: How to Make Regulation (and Regulators) Work

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Revolving-door scandals like this one are a reminder that the housing and financial meltdowns of 2008 — not to mention the BP gulf oil spill and West Virginia’s Massey mine disaster — should have launched a great debate over how to regulate. Unfortunately, because one of our great political parties is having an intellectual meltdown, we’re still arguing over whether to regulate. But you don’t have to believe that regulation is socialism to recognize that regulation is tricky.

This latest regulatory mess, in which a former Securities and Exchange Commission enforcement official named Spencer Barasch is under investigation for doing legal work for alleged Ponzi schemer Allen Stanford, is already being described by Republicans in Congress as a black mark for financial regulation. Of course, for Republicans in Congress, everything is a black mark for financial regulation; they blamed the financial crisis on 30-year-old anti-redlining rules, and they’re still trying to gut the Dodd-Frank Wall Street reforms. Meanwhile, Republicans in Florida are blaming the housing crisis on overly stringent growth management, which is like blaming Donald Trump’s political problems on overly stringent restrictions of his freedom of speech.

Whatever. To the reality-based community, the meltdowns of 2008 reflected catastrophic regulatory failures, as opposed to the heavy hand of over-regulation somehow creating an epidemic of liar loans and over-leveraged financial institutions. The Barasch case has highlighted the sketchy revolving door between the SEC and Wall Street; one watchdog group found that in the last five years, 219 former SEC staffers disclosed plans to represent clients before the agency, which makes you wonder how vigorously they scrutinized those clients before they left.

In Barasch’s case, the answer seems to be: not vigorously. According to the SEC inspector general, he blocked efforts to investigate Stanford at least six times. That sounds less like a revolving-door problem than an in-the-tank problem, an extreme case of regulatory capture.

There are lots of gray areas in between. As Larry Summers pointed out during a recent conference at Breton Woods — it’s at the 25-minute mark in this video — it’s not easy to find competent regulators in complicated industries like finance, deep-sea drilling and nuclear power who don’t have strong ties to those industries. “We don’t want regulation by the co-opted, but we don’t want regulation by the ignorant, either,” said Summers, until recently President Obama’s top economic adviser.

Summers wasn’t arguing that there’s no point even trying to regulate; he dismissed that laissez-faire attitude as “nihilism.” He was arguing that non-nihilist economists who care about regulation ought to spend as much time thinking about how regulatory agencies work and what kind of incentives are driving regulators as they spend calculating the optimal requirements for Tier One capital and whatnot. Similarly, scientists and environmentalists have a legitimate interest in what oil companies should and shouldn’t be allowed to do. But when the regulators are partying and sleeping with oil executives, as they were during the Bush administration, it doesn’t really matter how strict the rules are.

Honestly, I’m not entirely sure what I think about these problems except that we ought to think more about them. The little I do know about regulations—particularly environmental regulations—would suggest that they work best when they focus on results rather than process, when penalties are swift and automatic, and when transparency allows competitors and the public to help (and force) regulators to do their jobs. Presumably, the less a Ponzi schemer has to disclose about his business, the more we’re all dependent on an effective regulator to catch him. And when investors can follow their money, it ought to be tougher to get away with fraud—even if regulators are ignorant as well as co-opted.

In the Bush era, many regulatory agencies were flagrantly co-opted. You had a timber lobbyist overseeing logging, energy lobbyists overseeing mining and drilling, and the head of the National Association of Manufacturers nominated to oversee consumer product safety. That’s what happens when people who don’t believe in regulation get to choose the regulators. But that’s not an unforeseeable situation. It’s going to happen again, especially if the GOP continues its anti-regulatory jihad. The challenge for people who do believe in regulation is to craft a system that works even when government is controlled by people who don’t.

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