Re: How to Make Regulation Work

  • Share
  • Read Later

In his post today, Mike Grunwald bravely admits that “regulation is tricky” and “I’m not entirely sure what I think about these problems.”

Here’s one way to think about: As a general rule, regulations that require large numbers of fallible human government employees to ferret out wrongdoing are destined not to work very well. Just look at Prohibition, or Bernie Madoff. While some regulators will show great diligence and foresight, others with inevitably turn out to be lax, or corruptible, or incompetent. As a result, the regulatory system will often disappoint.

Far more effective are the regulatory systems that simply force businesses to pay for risk and failure. For example, when worker compensation laws forced factory owners to bear the cost of workplace injuries, factories very quickly became much, much safer. Safety was made more lucrative than hazard, and thus we harnessed the power of the profit motive to address the problem of dangerous workplaces. Fatal accidents on the job are down some thirtyfold in the roughly 100 years of workers comp.

In some cases, the government doesn’t even need to be involved, as long as failure comes at a price. At the dawn of the Industrial Revolution, owners of New England textile mills decided to set up a self-funded system of fire insurance. What happened when the cost of fires came from their own wallets? Textile mills were built virtually fireproof.

In this sense, the crash of 2008 wasn’t a failure of too much regulation or not enough regulation. It was a problem of the wrong kind of regulation. Financiers did not expect to pay a price for buying or selling bad loans—indeed, they structured their complicated instruments specifically to avoid paying for failure. Financial institutions behaved recklessly because they judged that recklessness would be cheap—and indeed, for most of them, the price has been negligible. They were bailed out, dusted off, recapitalized, patted on the fanny and sent trotting back into the game.

The solution is to put a high price on reckless dealing. One way of doing this in financial markets is to raise capital reserve requirements at banks, which both Mike and I support.