Wednesday, November 19, 2008

The Case Against Regulation

(cross-posted at Upturned Earth, where comments are open)

Matt Yglesias displays his libertarian streak this morning, writing of the financial crisis:

Investors will be extremely reluctant to get involved in the exact kinds of products that recently crashed, everyone will worry that the first sign of housing price increases is a bubble, and regulators will be keenly aware of everyone’s pet theory of what went wrong. But the crux of the matter is that though the phenomenon of financial crises repeat over time, but no individual crisis repeats itself. The trick, if you can pull it off, isn’t to prevent a repeat of the current crisis, but to prevent (or mitigate) the next crisis which is something else entirely.

This, to me, has long been the strongest Hayekian and/or utilitarian argument against regulation. Much principled regulation is inherently reactionary, trying to solve yesterday’s problems, “fighting the last war,” as Yglesias suggests. Yet the circumstances that caused yesterday’s problems are unlikely to reoccur, making reactionary regulation largely worthless.

And while the trick is to prevent or mitigate the next crisis, this is a trick government is often ill-prepared to pull off. Rarely does government have the kind of information necessary to predict exactly, even approximately, where and how the next crisis will occur; thus, to the extent government regulators make good-faith efforts to move pro-actively, they are likely to regulate something that either does not require regulation. In so doing, the new regulation can either have no effect on preventing the next crisis or can even marginally worsen the next crisis by reducing the ability of the market to adapt to the changing conditions.

Worse, though, pro-active regulations are particularly susceptible to regulatory capture. The average person who could be affected by a new regulation is unlikely to get terribly involved in the debate over that regulation because the average person’s interest therein is purely theoretical or potential. For example, a regulation that will increase the entry costs into an industry will not inspire massive opposition from people who will be priced out of entering into that industry precisely because those people are not yet in that industry; they are not yet aware of the fact that their potential interest being affected by the new regulation. Indeed, they likely are not even aware that they have a potential interest if they haven’t yet looked into the possibilities of entering a particular industry.