The Emperors Have No Clothes

Financial Regulation and the “Money Power”

Not unlike the case with taxes, firms with the most elasticity, the “money power,” are the firms best suited to deal with regulatory legislation.  Contrary to popular biases, markets are naturally regulated by competition and the threat of losses.  Regulatory legislation that reduces these motivating factors can actually negate the regulation of markets and lead to many negative externalities.  This is known as “regulatory capture.”  

Let’s begin by noting that there has been no shortage of financial regulation over the last 30 years. The much-faulted era of deregulation is a laughable myth. If anything can be said to have failed in the run-up to the current financial mess, it is the regulatory state. (Of course, much else also failed, including the Federal Reserve System and housing policy). The idea that we suffer from a shortage of regulation is wrong. Therefore, the idea that we need more regulation to prevent a repeat of the debacle is worse than wrong.

Some advocates of regulation may agree that we don’t need more regulation but rather better regulation. I agree. We do need better regulation. But what does that mean? Once we understand the nature of markets and bureaucracies, there’s only one reasonable conclusion: Better regulation means regulation by market forces. Free markets are not unregulated markets. Instead, they are severely regulated by competition and the threat of losses and bankruptcy. Anything government does to weaken those forces simultaneously weakens the otherwise unforgiving discipline imposed on business firms (and their counterparties)—to the detriment of workers and consumers. Public well-being suffers.

Admittedly, this is a hard sell. Explaining how markets work when they are free of the government’s easy money, favoritism, implicit guarantees, and other perverse incentives takes time and the listener’s concentration. Denouncing markets, railing against greed (which of course never taints politicians), and calling for more government power makes for good sound bites.