Posted by: N.S. Palmer | December 19, 2008

Back to Regulation: Part II

By N.S. Palmer, Ph.D.

“It is hard for us, without being flippant, to even see a scenario … that would see us losing one dollar in any of those transactions.”
Joseph J. Cassano, American International Group (AIG), August 2007. In September 2008, the U.S. federal government spent $85 billion to save AIG from bankruptcy.

“These errors make us look either incompetent at credit analysis or like we sold our soul to the devil for revenue, or a little bit of both.”
A managing director of Moody Investors Service,  which gave high ratings to investments that turned out to be almost worthless. An internal e-mail message, 2007.

“Hope springs eternal in the human breast; Man never is, but always to be, blest.”
–Alexander Pope, An Essay on Man (1733)

Hope is a wonderful thing. It enables us to carry on when, by all rational standards, we should throw ourselves under a bus. It’s what makes me think that I might win a Fields Medal, or that Honeysuckle Weeks is just waiting for my phone call.

But hope also has a dark side. When we want something to be true, our hope that it is true distorts our judgment. We seize on the flimsiest of evidence to justify our belief in what we want. As the columnist Fred Reed observes (echoing David Hume), “Emotion determines policy, and the mind provides a window dressing of plausibility.”

Sometimes, through luck and the sheer force of our persistence, our wishes come true. At other times, reality frustrates our fondest desires.

Welcome to reality.

Wall Street wheeler-dealers hoped that they could take subprime mortgages, package them artfully, wave mathematical models at them, and magically turn them into AAA-grade securities. Investors in those securities hoped that housing prices would continue to rise indefinitely. Investment-rating firms hoped that they could shade the truth a little bit, get paid a lot of money for doing it, and never get caught. And the Bush-Cheney administration just hoped that it could get out of Washington before the inevitable economic catastrophe hit “on its watch” and it received some well-deserved blame.

The dark side of hope is a fundamental reason why business self-regulation doesn’t work. Corporate owners and executives have a financial (and ego) interest in the success of their plans and their products. That distorts their judgment about what will work and what is too risky. It also distorts their moral judgment about what burdens and risks they can impose on their customers and employees, as well as about the methods they use to achieve their goals.

The New York Times put it well in its December 19, 2008 editorial “You Mean That Bernie Madoff?” The Times noted that the case of investment manager Bernie Madoff, who apparently bilked investors of $50 billion, is:

A stark reminder of how greed impairs judgment, duping some of the world’s supposedly savviest investors for decades. It raises once more a fundamental question of these times: Where were the regulators when all of this was happening?

In “Back to Regulation Part I,” I examined the reasons why rules are inevitable in any market or society. I also explored the supposed differences in principle between rules (or laws) and regulations, and some of the reasons why business regulation is needed.

In this article, I’ll look at how regulations should differ in practice from laws and why business regulation is justified. In the next,  final article in this series, I’ll discuss the different approaches to business regulation and which one works best to protect the public and society.

Laws and Regulations

Laws and regulations differ in five important ways. They are alike in a sixth way. In order for laws to be effective, they should ideally be:

  • General: Laws should apply to a wide range of related situations, without needing to spell out all the details of each situation. A law against reckless driving, for example, should apply regardless of whether the car is a Ford or a Toyota, on Main Street or Oak Street, or whether it’s driven by a man or a woman.
  • Stable: Laws should change infrequently if at all. What’s legal or illegal today should be the same tomorrow unless there is a compelling reason to change the law. One of the main purposes of law is to make life in society as rational and predictable as possible. When the law is stable, it means that people can know in advance if something they plan to do is legal. If the law changes too frequently, then they lose this knowledge.
  • Simple and clear: Laws should be simple and clear enough to be understood by average people in a society. Because most people are not lawyers, accountants, or police officers, that kind of specialized knowledge should not normally be needed to understand the law.
  • As few as possible: This is a corollary of the requirement that laws be simple and clear. If there are too many laws, it becomes impossible for average people to know all of them, whether through explicit learning or common sense. If average people cannot reasonably be expected to know all the laws, then they cannot reasonably be expected to follow them. In such cases, law fails in its role as a guide to action. It fails to make life in society as rational and predictable as possible.
  • Based on the society’s “common sense:” If laws are based on the society’s widely-held consensus about right and wrong, then people can have a good intuitive sense of what is legal or illegal even without explicit knowledge of the relevant laws. As Montesquieu said in The Spirit of the Laws, “Laws should be so appropriate to the people for whom they are made that it is very unlikely that the laws of one nation can suit another.” (One wishes that American neoconservatives had read that line before hatching their grandiose plot to turn Iraq and Afghanistan into American-style managed democracies.)
  • Consistent: Laws must not contradict each other or even seem to contradict each other. If two or more laws seem to conflict, then they are useless as guides to action because average people cannot know which laws to follow. That situation is ready-made for government officials who want arbitrary power to punish people they dislike. The elimination of arbitrary power is another vital function of law.

The way in which laws are created supports some of these requirements. Because laws are typically passed by a legislature, it takes more time to change them than is required for a government official to issue a new regulation. That fact would also make laws more general than regulations, if not for the unfortunate current practice of letting lobbyists write draft laws affecting their own industries.

Regulations for Specific Industries and Situations

Apart from the last trait of consistency, business regulations differ from laws with respect to the other five points. Naturally, the differences are a matter of degree:

  • Instead of being general, regulations must cover specific situations, such as banking practices.
  • Instead of being stable, regulations must be easy to change, sometimes quickly, to cover new problems or ways of doing business.
  • Instead of needing to be clear to people in general and to cover a wide range of life situations, regulations can be written for specialists in a particular industry to cover situations in that industry.
  • Instead of needing to be few in number or based strictly on common sense, regulations can be as numerous and specialized as needed because they affect people whose full-time job is to understand and follow them.

Is Business Regulation Justified?

Since the 1970s, people have been bombarded with non-stop preaching against business regulation and in favor of the unfettered “free market.” Much of this preaching was paid for by business itself. At its most explicit, it took the form of advertising, lobbyists, and paid public-relations spokespeople. At its most sleazy, it took the form of faked “TV news” videos that were produced by business interests to portray their activities in a positive light. Distributed to television stations, these videos were often broadcast on local news shows as objective reports, with no mention of their origin. The Bush-Cheney administration has done the same thing to present a favorable picture of its own criminal activities.

There’s also a more respectable side to the anti-regulation argument. Some economists — a rapidly-shrinking minority — believe that business regulation is always a bad idea. Usually on libertarian grounds, they have an almost unshakable bias against any attempt to protect people from the worst flaws of capitalism. As long as the president of a company doesn’t shoot one of his employees on national television or confess to poisoning jars of baby food, they believe that the government should let business do whatever it wants. Businesses are private property, and as long as no one proves that they have violated criminal law, what they do is no concern of the government.

That’s the view taken by organizations such as the Cato Institute and the Mises Institute. Such organizations are staffed by hard-core true believers who will never abandon their libertarian faith just because of a few pesky facts. (That’s also why they often detest Adam Smith, author of The Wealth of Nations and the founder of modern economics. He was ideologically impure and didn’t trust business.)

U.S. President Woodrow Wilson answered the anti-regulation argument very well in 1913, when businesses were far less regulated than they are even now after eight years of the Bush-Cheney administration’s deliberate regulatory neglect. Lamenting the failure of the courts to protect workers and consumers from giant corporations, Wilson wrote that the economy had changed since America’s founding and that the law needed to change to keep up with it:

It was no business of the law in the time of Jefferson to come into my house and to see how I kept house. But when my house, when my so-called private property, became a great mine, and men went along dark corridors amidst every kind of danger in order to dig out of the bowels of the earth things necessary for the industries of a whole nation, and when it came about that no individual owned these mines, that they were owned by great [corporations], then all the old analogies absolutely collapsed and it became the right of the government to go down into these mines to see whether human beings were properly treated in them or not; to see whether accidents were properly safeguarded against; to see whether modern economical methods using these inestimable riches of the earth were followed or not followed.” [Woodrow Wilson in his book The New Freedom (1913), quoted by Glaeser and Shleifer, “The Rise of the Regulatory State,” Journal of Economic Perspectives, June 2003.]

Another influential architect of American business regulation was Rexford G. Tugwell, an economist who became part of President Franklin D. Roosevelt’s 1930s brain trust to help devise “New Deal” policies. It was Tugwell, among others, who argued for regulations to give consumers and workers a fairer chance against the moneyed elites of that era. In his book The Economic Basis of Public Interest (1922), he argued that business regulation was justified on several grounds:

If people were in trouble because they were in a weak bargaining position, it was a simple duty of their government to give them protection … Also, under the general police powers, private business may be so regulated as to protect the health, morals, order, and safety of the community; the status of such businesses as private is in no way altered.

Certainly in 2008, the depredations of Wall Street and the banks have proven that they threaten the order and safety of the community — and indeed, of the entire world. What are we going to do about it?

That’s the question I’ll examine in the third and final part of this series.


Copyright 2008 by N.S. Palmer. May be reproduced as long as copyright notice and URL (http://www.ashesblog.com) are included.

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