What do regulators do?

Posted by Marc Hodak on January 14, 2009 under Invisible trade-offs, Unintended consequences | Be the First to Comment

Why, they create regulations, of course.  But to what end?  The nominal purpose of regulations is to create the impression of increased safety or security.  For instance, regulating workplace safety nominally gets us safer workplaces.  Regulating food safety nominally gets us safer food.  Regulating financial service providers is supposed to make the markets safer for various participants.  People vote for regulations because it makes them feel safer.

Of course, one would hope that regulations create more than the impression of safety.  People want and expect that the safety is real.  Goodness knows, the costs of regulation are real–one would hope we are getting the benefits.

Larry Ribstein notes a great example of how the impression of safety can actually create greater danger.  When the SEC, the promulgators and enforcers of securities regulation, investigated then signed off on Madoff’s fund, they became an unwitting accessory to the confidence game that Madoff was playing with his clients.  In the case of the Swiss bank UPB, the SEC literally created confidence in an operation the bank would have otherwise treated with suspicion, costing their clients hundreds of millions of dollars.

Economically speaking, one would like the benefits of regulation to be greater than the costs.  Unfortunately, these things are difficult to measure.  The benefits are largely speculative, e.g., accidents that don’t happen, while the costs are relatively dispersed, e.g., a few dollars per item that may be sold by the millions.  The lesson, here, is that there is another cost–the cost of misplaced confidence.  If one believes that someone else is bearing the monitoring and other costs to improve their safety, then one is likely to save on those costs for themselves.  It’s easy to visualize that for every extra dollar I am forced to spend for regulatory compliance for a particular product, I might save a dollar or more that I would have otherwise spent for the Good Housekeeping seal on that product.  In other words, by taking on the regulation of a product or sector, the government is socializing costs that would have been otherwise borne by private actors, possibly with a net negative effect.

I don’t rely on any private tester of milk or beef because the USDA is certifying it for me.  I know that the SEC is watching over registered brokers and other market agents, so I can trust them.  Even if I thought the regulators did an inferior job versus a private certificate of approval, I’m not going to pay double for the inspection.  Government regulation will generally crowd out private regulation.

In the case of Madoff, UPB bore the private costs of regulation, but they also knew that the SEC actually looked into the fund’s operations, and gave it an OK.  Absent that OK, the bank would have relied on its internal analysts who were sounding warnings about Madoff’s fund.

Unfortunately, these kinds of regulatory embarrassments rarely improve regulation.  They more often end up increasing the costs of regulation on a thousand perfectly good firms for every crooked one out there, which can easily be a net drain on social welfare.  And then, the government enhances confidence among the credulous voters who have somehow come to believe in the effectiveness of government.

Then, another $50 billion goes poof.  And the regulators use that as proof that they don’t yet have enough money and power.