Real Regulators

by on December 24, 2008 · 32 comments

Don’t miss Jim Harper’s excellent post on the strange way people have responded to the failures of regulation on wall street. In a Meet the Press exchange, we learn that people reported Bernie Madoff’s suspicious books to the SEC, which chose not to do anything about it. And it was agreed around the table that the Madoff affair debunks “the idea that wealthy individuals and ‘sophisticated’ institutional investors don’t need the protection of government regulators.” “There’s no question we need a real regulator,” says CNBC’s Erin Burnett.

The problem is that we had a “real regulator.” Ponzi schemes and dishonest bookkeeping are already illegal. Had the SEC been so motivated, it had all the authority it needed to investigate Madoff’s books, discover the problems, and shut his firm down. In a rational world, this would be taken as a cautionary tale about the dangers of assuming that regulators will be vigilant, competent, or interested in defending the interests of the general public rather than those with political clout. Instead, we live in a bizarro world in which people believe that the SEC’s failure to do its job is an illustration of the need to give agencies like the SEC more power.

We of course see the same sort of confusion in debates over regulation of the technology sector. For example, the leading network neutrality proposals invariably wind up placing a significant amount of authority in the hands of the FCC to decide the exact definition of network neutrality and to resolve complex questions about what constitutes a network neutrality violation. Too many advocates of regulation seem to have never considered the possibility that the FCC bureaucrats in charge of making these decisions at any point in time might be lazy, incompetent, technically confused, or biased in favor of industry incumbents. That’s often what “real regulators” are like, and it’s important that when policy makers are crafting regulatory scheme, they assume that some of the people administering the law will have these kinds of flaws, rather than imagining that the rules they right will be applied by infallible philosopher-kings.

  • http://srynas.blogspot.com/ Steve R.

    Yes the regulators failed. But to go on and state that ” Too many advocates of regulation seem to have never considered the possibility that the FCC bureaucrats in charge of making these decisions at any point in time might be lazy, incompetent, technically confused, or biased in favor of industry incumbents.” does not get into the nuances of how to operate the internet in an equitable manner under free market precepts.

    It has been well documented that the ISP and telcos have euphemistically undertaken “traffic management” and that this has not been done in an open and transparent manner. Tim's statement can be re-written “Too many anti-regulation advocates never consider the possibility that the ISPs in charge of making these decisions at any point in time might act contrary to net-neutrality concepts for the sole purpose of maximizing their corporate profits through opaque business practices that abuse the customers.”

    Usually, the claim is made that the consumer will quickly discover the abuse and that market pressures will reign in companies so that they will once again operate within the idyllic principles of the free market. The anecdotal evidence unfortunately is that this is a naive and utopian concept. The Madoff affair scheme has evidently gone on for decades and the automotive industry has been failing for decades. In fact, the automotive corporate executive have apparently been operating their companies in an “incompetent, technically confused” manner. Now, in the “best” traditions of the free market, these corporate executives are now groveling to the government to bail them out of their incompetence. So the executives of our automotive and financial industties who have claimed to operate on free market principles, instead of accepting responsiblity for their failed actions now want socialism.

    My intent is not to defend the regulators, it is to point out that the free-market does not magically act in an instantaneous manner to correct market failures. Those who claim that the lack of regulation is nirvana are deluding themselves.

    In a perverse sense, one can say that the Madoff affair is really a reflection of what would happen to our economy without regulation. After all Madoff succesfully avoided regulation!!! So the Medoff anolgy, while it points to bad regulators also serves as an example of the pitfalls of the unregulated free market.

  • http://www.cato.org/people/jim-harper Jim Harper

    Thanks, Tim, for the kind words about my C@L post. And thanks, Steve R., for your comment. You won't be surprised that I have a few quibbles with it.

    I don't think the anecdotal evidence is as you describe it. The most significant example of non-neutral behavior was the Comcast Kerfuffle, discussed at length on this blog, and it was indeed handled poorly (opaque and clumsy in implementation, poorly explained when revealed).

    However, once Comcast's practices came to light, public pressure (read market pressure) brought Comcast to heel and prompted the company to make an arrangement to work with BitTorrent *before* the FCC could even get out of the gate.

    That's not an “idyllic” free market – it is the rough-and-tumble free market, which revealed the problem and brought about a cure before regulators even got involved. That's not perfection – just the better alternative.

    You're being either inaccurate or facetious in calling the automakers' groveling for a bailout the “best” tradition of the free market. Government bailouts are precisely contrary to the operation of the free market, and every credible advocate for free markets has opposed the various bailouts.

    Yes, some advocates for free markets sometimes reflexively slip into defending “business,” but I haven't seen anyone support bailouts as part of the free market. Treating the actions or interests of businesses as identical to free markets is a mistake for advocates on either side of debates about regulation.

    The Madoff affair could reflect would could happen in an unregulated market, I suppose, but it's what actually happened in a regulated market. He was violating real laws and regulations. A real regulator was supposed to enforce these laws and regs. People who relied on this regulator to protect them were wronged twice – directly by Madoff and indirectly by the regulatory system which they relied on, believing it was “on the beat.”

    The Madoff story does not point to the pitfalls of an unregulated free market. It points to the pitfalls of a regulated market, pitfalls that people seem amazingly willing to overlook, transfixed by the regulatory system they imagine, instead of focused on what's actually possible or real.

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  • http://www.techliberation.com Adam Thierer

    FYI… I used Tim's post as a launching pad for my critique of Lessig's recent Newsweek piece on reforming the FCC:

    http://techliberation.com/2008/12/24/lessig-on-

  • http://srynas.blogspot.com/ Steve R.

    First, I wish everyone a great Christmas and happy Hannukah.

    Yes, I was being facetious.

    As with Madoff, his ability to avoid regulation is equivalent to operating in an unregulated environment. Instead, I could have used the used the creation of the “innovative” collateralized debt obligations (CDO) as an example of a free market pitfall since these financial instruments were faulty in their structure. So one can say that the private sector in the creation of these instruments was: “incompetent, technically confused”.

    I do agree with you that regulation has its own pitfalls where people assume that they are protected by the regulatory system. The Madoff affairs was reported to regulators and they failed to act.

    After commenting, I was finally able to tract down a video on CNBC where Larry Kudlow discusses regulation. To me this was a very good panel discussion where Larry who normally calls for less and less regulation speaks of the necessity for a least some minimal regulation. The call by Larry for some minimal regulation on CNBC has been a recent development resulting from our the financial meltdown. It's interesting to see some of his panelist respond in great surprise: “I can't believe you said that Larry!”

  • http://www.au.org Alan

    The problem is that we had a “real regulator.” …Instead, we live in a bizarro world in which people believe that the SEC’s failure to do its job is an illustration of the need to give agencies like the SEC more power.

    No, the problem was not that we had a “real regulator”, it was that we had a derelection of duty. When people speak of having a “real regulator” they are not necessarily proposing greater power or authority. What they want is a regulaty authority that actually does what it is supposed to do. Nonetheless, it is reasonable to ask what greater authority or power might help the agency do better. Subpoena power and the ability to approve or even assign a firm's auditors might be in order.

  • steven

    Ever heard of a self-fulfilling prophecy?

    Regulation is never perfect but effective regulation can be constructed and enforced, IF there is the will to do so. When a society is ruled by an ideology that believes government is always the problem and that regulation shouldn't exist, there isn't going to be much incentive to do anything other than cynically connive to make sure that regulation fails and then to claim this as evidence of some eternal truth about governance. It isn't. Ideology matters. You get the kind of governance you want and the kind of governance you deserve. Why should we be surprised if regulation is a failure under the stewardship of people who are ideologically opposed to regulation?

    Human nature has always been corruptible. Some societies do a better job of reinforcing integrity in people than other societies do.

    Of course there were laws in place to try to prevent what happened. Those laws however, had become little more than an empty gesture. There was no real will to enforce the law because the rulers of the country had no real interest in effective regulation and even many democrats had long since bought into the notion that markets are self-correcting and policing and that regulation is an evil that should be abolished.

    There was time in this country, when a different ideology was dominant, where we had imperfect but more effective regulation because we believed in and intended to create effective regulation. Saying that we couldn't do so again is nonsense.

  • http://www.cato.org/people/jim-harper Jim Harper

    Steven – I'd be happy to learn more about this better, vanished time, but I think the evidence shows that economic regulation has generally failed to achieve what its proponents wish. (Granted, economic regulation is a little different from the SEC's role in the Madoff case, but many of the same dynamics apply.) And it isn't just during eras of ideological opposition to regulation, nor is it opponents of regulation that have found this.

    In his his recent paper on net neutrality regulation, the Durable Internet, Tim Lee describes how President Carter, Senator Ted Kennedy, and his then counsel (now Justice) Stephen Breyer recognized the inability of much regulation to fulfill the ideal imagined by its authors. A warning to all who *imagine* a regulatory regime for broadband provision that serves us well.

    You don't need to look at regulation through an ideological lens to recognize its inability to do much of what people imagine it can do.

  • http://enigmafoundry.wordpress.com eee_eff

    The problem is that we had a “real regulator.” Ponzi schemes and dishonest bookkeeping are already illegal. Had the SEC been so motivated, it had all the authority it needed to investigate Madoff’s books, discover the problems, and shut his firm down.

    Well Tim you have stumbled across the fact that no institution is perfect, and in this particular instance the SEC failed. That discovery is a very good argument for making the SEC better, not eliminating it.

    If someone dies at an Emergency Room, is that a argument for closing it, or making it better? Indeed some deaths are inevitable, Tim.

  • http://srynas.blogspot.com/ Steve R.

    First, CNBC a couple of days ago referenced Greenspan, so let me get this Greenspan quote out of the way. The New York Times had the following article: <a href=”http://www.nytimes.com/2008/10/24/business/economy/24panel.html?scp=2&sq=Greenspan&st=cse”<Greenspan Concedes Error on Regulation In that article, the Times writes:

    “But on Thursday, almost three years after stepping down as chairman of the Federal Reserve, a humbled Mr. Greenspan admitted that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending.

    “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,” he told the House Committee on Oversight and Government Reform.”
    —————————————————————————————————-

    No one likes regulation and I won't claim that regulation will solve all ills. My fundamental concern and what I am reacting too is the fact that regulators are automatically portrayed as incompetent boorish villains without examining the potential that some of the sacred concepts of the free-market may actually be flawed.

    Over at TechDirt, I wrote: “So if the private sector creates financial instruments that exist outside of the regulatory environment, that are structurally flawed, that are not transparent, and are not properly vetted resulting in many companies like Bear Stearns vaporizing it is somehow the fault of regulators?”

    Regulations may be considered an impediment to the free market, but it does NOT</> make people do things that would be contrary to free-market principles. The corporate executives who brought down our financial financial system did so in a willful manner. It is time for those who wish for an unfettered free market to examine how to “control” behavior that can destroy the system. Braden Cox wrote: “Remember being in grade school when a classmate’s rabble rousing would ruin it for everybody, and the teacher would hold back the class from going to recess? The other students would moan and groan and justifiably feel that punishing the entire class for one person’s misdeeds was unfair.”

    ————————————————————————————————
    On net neutrality we have the incessant whining “don't regulate us, trust us”. I fully agree with Tim's statement concerning the pitfalls of regulation: New regulations inevitably come with unintended consequences. Indeed, today's network neutrality debate is strikingly similar to the debate that produced the first modern regulatory agency, the Interstate Commerce Commission. Unfortunately, rather than protecting consumers from the railroads, the ICC protected the railroads from competition by erecting new barriers to entry in the surface transportation marketplace.

    The problem I have is that those who do not want regulation do not seem to want to provide you with a commitment that they will operate the net in a neutral manner. We simply are provided with vague references that the magical black box of the free market will take care of things. But we already know that the free market is subject to failure. If someone says they do not want over site and you ask for a guarantee but they refuse – would you trust them? There is a free market solution, they ISPs could offer a code of conduct.

    Unfortunately, that even seems too repressive to them. Essentially, we are being left with a situation where the ISPs can act in an arbitrary capricious manner where the consumer would have not rights. If I am to be treated this way then I would like to see them regulated.

  • http://www.au.org Alan

    Right on!

  • http://www.au.org Alan

    Right on!

  • steven

    I don't deny that regulation has unintended side effects. The goal is not to craft perfect laws and perfect regulation. The goal is to create an environment which, on balance, is more beneficial than harmful. This is always the best a society can do. Anything more is dangerous utopian dreaming. I think the middle of the 20th century provides a decent example. The post war, post depression era was relatively stable with a broad majority of the populations' boat's rising and a lessening of the social unrest of the previous years. I realize this wasn't simply a result of regulation and governmental intervention. Organized labor power, that developed in the first half of the century played an important part in rebalancing power. You will no doubt point to stagflation as the ultimate result, which I think is the wrong way of looking at it, just as I think it would be wrong to conclude that all subsequent deregulation was wrong based upon what we are going through now. My temperament is opposed to taking any set of ideas to the extreme. I think liberal ideas had beneficial effects early in the development of their political power and I think conservative ideas had beneficial effects early in the resurgence of their power. I also think both will collapse because of a refusal to recognize the limits of any idea and a blind desire to construct one tool to fit every job.

    I think it is really straining credulity to try to claim that madoff is the result of regulation. People didn't put their faith in madoff because they thought the government was standing there protecting them. They put their faith in madoff because of flaws in human nature, laziness, a psychological tendency to blind faith and idolatry of wealth and power, the tendency to put irrational faith in what they believe is one of their own. Had there been no regulation there would still be madoffs in the world and there would still be people willing to blindly turn money over to the gods of finance. I don't think there is a perfect regulatory system that can protect us from these realities but I think that we can set and enforce boundaries that help to mitigate against these nasty human tendencies and the predatory behavior that results from them. I also find it hard to believe that you really think that market mechanisms will always function as an acceptable limit on behavior. I hope your attitude is not that economic darwinism weeds out the stupid and weak because then you are arguing that society should tolerate human beings preying upon one another. I do believe that it is possible to create an environment where regulators can be pressured to behave with some degree of honesty and intent to engage in true oversight.
    You first, however, have to put into power people who believe that good governance is possible or people who believe that good governance is something more than keeping your hands off of everything.

    BTW, it is refreshing to see people who consider it worth their time to read replies and actually carry on an exchange with the people who respond to them. Thank You for that.

  • http://www.au.org ReACTIONary

    Right on!

  • http://www.au.org ReACTIONary

    Right on!

  • steven

    I don't deny that regulation has unintended side effects. The goal is not to craft perfect laws and perfect regulation. The goal is to create an environment which, on balance, is more beneficial than harmful. This is always the best a society can do. Anything more is dangerous utopian dreaming. I think the middle of the 20th century provides a decent example. The post war, post depression era was relatively stable with a broad majority of the populations' boat's rising and a lessening of the social unrest of the previous years. I realize this wasn't simply a result of regulation and governmental intervention. Organized labor power, that developed in the first half of the century played an important part in rebalancing power. You will no doubt point to stagflation as the ultimate result, which I think is the wrong way of looking at it, just as I think it would be wrong to conclude that all subsequent deregulation was wrong based upon what we are going through now. My temperament is opposed to taking any set of ideas to the extreme. I think liberal ideas had beneficial effects early in the development of their political power and I think conservative ideas had beneficial effects early in the resurgence of their power. I also think both will collapse because of a refusal to recognize the limits of any idea and a blind desire to construct one tool to fit every job.

    I think it is really straining credulity to try to claim that madoff is the result of regulation. People didn't put their faith in madoff because they thought the government was standing there protecting them. They put their faith in madoff because of flaws in human nature, laziness, a psychological tendency to blind faith and idolatry of wealth and power, the tendency to put irrational faith in what they believe is one of their own. Had there been no regulation there would still be madoffs in the world and there would still be people willing to blindly turn money over to the gods of finance. I don't think there is a perfect regulatory system that can protect us from these realities but I think that we can set and enforce boundaries that help to mitigate against these nasty human tendencies and the predatory behavior that results from them. I also find it hard to believe that you really think that market mechanisms will always function as an acceptable limit on behavior. I hope your attitude is not that economic darwinism weeds out the stupid and weak because then you are arguing that society should tolerate human beings preying upon one another. I do believe that it is possible to create an environment where regulators can be pressured to behave with some degree of honesty and intent to engage in true oversight.
    You first, however, have to put into power people who believe that good governance is possible or people who believe that good governance is something more than keeping your hands off of everything.

    BTW, it is refreshing to see people who consider it worth their time to read replies and actually carry on an exchange with the people who respond to them. Thank You for that.

  • http://srynas.blogspot.com/ Steve R.

    First, CNBC a couple of days ago referenced Greenspan, so let me get this Greenspan quote out of the way. The New York Times had the following article: Greenspan Concedes Error on Regulation. In that article, the Times writes:

    “But on Thursday, almost three years after stepping down as chairman of the Federal Reserve, a humbled Mr. Greenspan admitted that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending.

    “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,” he told the House Committee on Oversight and Government Reform.”
    —————————————————————————————————-

    No one likes regulation and I won't claim that regulation will solve all ills. My fundamental concern and what I am reacting too is the fact that regulators are automatically portrayed as incompetent boorish villains without examining the potential that some of the sacred concepts of the free-market may actually be flawed.

    Over at TechDirt, I wrote: “So if the private sector creates financial instruments that exist outside of the regulatory environment, that are structurally flawed, that are not transparent, and are not properly vetted resulting in many companies like Bear Stearns vaporizing it is somehow the fault of regulators?”

    Regulations may be considered an impediment to the free market, but it does NOT make people do things that would be contrary to free-market principles. The corporate executives who brought down our financial financial system did so in a willful manner. It is time for those who wish for an unfettered free market to examine how to “control” behavior that can destroy the system. Braden Cox wrote: “Remember being in grade school when a classmate’s rabble rousing would ruin it for everybody, and the teacher would hold back the class from going to recess? The other students would moan and groan and justifiably feel that punishing the entire class for one person’s misdeeds was unfair.”

    ————————————————————————————————
    On net neutrality we have the incessant whining “don't regulate us, trust us”. I fully agree with Tim's statement concerning the pitfalls of regulation: “New regulations inevitably come with unintended consequences. Indeed, today's network neutrality debate is strikingly similar to the debate that produced the first modern regulatory agency, the Interstate Commerce Commission. Unfortunately, rather than protecting consumers from the railroads, the ICC protected the railroads from competition by erecting new barriers to entry in the surface transportation marketplace.”

    The problem I have is that those who do not want regulation do not seem to want to provide you with a commitment that they will operate the net in a neutral manner. We simply are provided with vague references that the magical black box of the free market will somehow take care of things. But we already know that the free market is subject to failure. If someone says they do not want oversight and you ask for a guarantee but they refuse – would you trust them? There is a free market solution, the ISPs could offer a code of conduct.

    Unfortunately, that even seems too repressive to them. Essentially, we are being left with a situation where the ISPs can act in an arbitrary capricious manner where the consumer would have not rights. If I am to be treated this way then I would like to see them regulated.

  • http://www.au.org ReACTIONary

    Right on!

  • http://www.au.org ReACTIONary

    Right on!

  • steven

    I don't deny that regulation has unintended side effects. The goal is not to craft perfect laws and perfect regulation. The goal is to create an environment which, on balance, is more beneficial than harmful. This is always the best a society can do. Anything more is dangerous utopian dreaming. I think the middle of the 20th century provides a decent example. The post war, post depression era was relatively stable with a broad majority of the populations' boat's rising and a lessening of the social unrest of the previous years. I realize this wasn't simply a result of regulation and governmental intervention. Organized labor power, that developed in the first half of the century played an important part in rebalancing power. You will no doubt point to stagflation as the ultimate result, which I think is the wrong way of looking at it, just as I think it would be wrong to conclude that all subsequent deregulation was wrong based upon what we are going through now. My temperament is opposed to taking any set of ideas to the extreme. I think liberal ideas had beneficial effects early in the development of their political power and I think conservative ideas had beneficial effects early in the resurgence of their power. I also think both will collapse because of a refusal to recognize the limits of any idea and a blind desire to construct one tool to fit every job.

    I think it is really straining credulity to try to claim that madoff is the result of regulation. People didn't put their faith in madoff because they thought the government was standing there protecting them. They put their faith in madoff because of flaws in human nature, laziness, a psychological tendency to blind faith and idolatry of wealth and power, the tendency to put irrational faith in what they believe is one of their own. Had there been no regulation there would still be madoffs in the world and there would still be people willing to blindly turn money over to the gods of finance. I don't think there is a perfect regulatory system that can protect us from these realities but I think that we can set and enforce boundaries that help to mitigate against these nasty human tendencies and the predatory behavior that results from them. I also find it hard to believe that you really think that market mechanisms will always function as an acceptable limit on behavior. I hope your attitude is not that economic darwinism weeds out the stupid and weak because then you are arguing that society should tolerate human beings preying upon one another. I do believe that it is possible to create an environment where regulators can be pressured to behave with some degree of honesty and intent to engage in true oversight.
    You first, however, have to put into power people who believe that good governance is possible or people who believe that good governance is something more than keeping your hands off of everything.

    BTW, it is refreshing to see people who consider it worth their time to read replies and actually carry on an exchange with the people who respond to them. Thank You for that.

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