Monday, July 11, 2011

Why more regulation is not the answer

Many people associate pure free-market capitalism with a complete lack of regulation. This is not the case. Regulation is the primary reason free-market capitalism works so well. But in a capitalist system, the regulations are market-based instead of based on politically motivated bureaucrats telling people what they can and can't do.

Under capitalism, people act in their own self-interest and pursue profits. That's a good thing. Profits are a signal that an entrepreneur is doing something productive by creating something worth more than the sum of its parts. If someone can produce a good or service for a cost below what people are willing to pay for it, he makes a profit, and in doing so, creates wealth, prosperity, and a higher standard of living for everyone. Some people try to create goods or services, but in doing so lose money. Those people create a whole that is worth less than the sum of its parts. The market will force them to either increase efficiency or quality. If not, they will be forced out of business or purchased by a competitor who's doing a better job of meeting the public's desires.

Bailouts, government guarantees, subsidies, and all other methods of socializing private risk undermine the regulation imposed by free-market forces. These things artificially encourage people to take risks they would have otherwise avoided. For example, if someone else is paying your bar tab, you're probably going to drink more than you otherwise would. This is an example of a phenomenon called "moral hazard." When the risk side of the risk/reward calculation is removed, you're no longer in the realm of free-market capitalism and moving closer to totalitarianism and fascism.

The bank bailouts are a good example of this. So were the bailouts of the GM and Chrysler unions. The FDIC is even a huge example of moral hazard.For example, people pay practically no attention to the financial condition or solvency of their banks. After all, why would they? They're FDIC insured! In other words, no one cares if their deposits are in a bank that is over-leveraged because if it fails, the FDIC will bail out the depositors. Without the FDIC, people might pay a little more attention to the financial condition of their banks. Banks would probably compete based on financial security, as opposed to free toasters, interest rates, and how quickly they can rubber stamp a home equity loan to finance a boat. Because Fed policy has been setting interest rates at damn near zero for way too long, the only way banks can make money involves lots of leverage. That dynamic is a huge part of our current mess.

And while getting rid of the FDIC sounds terribly drastic, it is essentially insurance paid for by the banks. There's no good reason why this couldn't be done through private insurance.

There are a lot of people who think that we just need smarter regulations implemented by smarter and incorruptible regulators. But we're just as likely to end up with Tim Geithner as Sheila Beir. We're a hell of a lot more likely to get Geithner than God. I've never understood why government regulators are expected to be any smarter or less corrupt than private ones. Who's going to regulate them?

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