It used to be said that the reason market solutions were superior to government solutions was that the market had a Darwinian test. When market solutions proved ineffective, the proponents went out of business. When government solutions prove ineffective, the government never goes out of business. It doubles down.
It seems we’re in danger of seeing something like that in the aftermath of the Madoff Scheme. The Wall Street Journal nicely describes this dynamic in an editorial today:
We are now supposed to believe that the same SEC lawyers who couldn’t detect a fraud at a firm for which they were directly responsible would somehow have done so if only they had been able to examine other hedge funds that invested in Madoff Securities. Thus does every enforcement failure become an excuse for more enforcement, especially among law-school professors and journalists who specialize in hindsight.
But perhaps more regulations are exactly what we don’t need right now. There have been reports, for instance, that the various SEC inspections of Madoff’s business—at which the firm got a clean bill of health, somehow—were actually used to market investing with him by the various feeder funds that pumped billions into the Ponzi scheme. What if more regulation is actually counterproductive.?
Law professor Larry Ribstein makes this argument over on his website Ideoblog. He makes two important points.
- Regulation make investors too confident. “Corporate frauds arguably were facilitated because there was too much investor confidence, as indicated by investors’ willingness to ignore what the market knew about questionable accounting and to not question firms’ extravagant claims about unproven business plans. Overselling regulation might perpetuate this misjudgment and mislead investors back into the same complacency that contributed to the recent frauds…Fraud regulation and financial supervision are supposed to increase investor confidence. But given regulators’ inherent defects, there’s a real problem of investor over-confidence. What you want is healthy investor scepticism.”
- Effective regulation would be crippling to the economy. “A determined regulation advocate will insist that at some level we can really make investors safe. But even if that’s true, the necessary regulation would seriously constrain the kind of risky activity that is necessary to grow the economy. We’d have to distrust all innovation, particularly financial innovation, and turn business people into bureaucrats. Just what we don’t need right now.”
Wall Street hates those arguments because it wants investors to be confident enough to entrust their money to its financial advisors. So you can expect brokerages, hedge funds and banks to call for more regulation—but never enough to be effective, since that would shut down business. Many in the securities business want investors who feel safer than they are. Maybe this time we should end this confidence game.