The overwhelming majority of discussion on regulation – even from the libertarian camp – seems fundamentally confused about the very nature of regulation. We are constantly subjected to debates about how much regulation, what kind of regulation, whether regulation is effective or even can be effective. What is its motivation – disinterested public policy or rent-seeking? Can it be smarter; can it be quicker? And on and on! And strangely, as a general rule, the libertarian, Austrian, anarchist (even minarchist) position always is to oppose regulation. Some oppose more than others, some reject all regulation, while some only reject most regulation. But the general drift is that regulation is to be rejected.
All this discussion, though, is based on the same fundamental confusion. It assumes that regulation is what the state does. It’s understandable that we’d fall into this trap, since the statists have largely staked out the definition of the term to mean just such state intervention. On the one hand are the regulation and the regulator and on the other hand is the market. The logical implication seems to be, without the regulator, the market is simply chaos. So, of course, in the interest of us all – almost none of whom like chaos in our lives – the market has to be regularized, subjected to rules, so that we may safely live near it. This is a fascinating and brilliant conceptual move executed by the statists. They define the term as their own, casting guilt by (dis)association on the market and in the very process generate their own raison d’action.
There’s just one tiny fly in the ointment of this intellectually clever and ideologically poignant story: far from being the antithesis of regulation, the market is regulation. Regulation is the entire raison d’être of the market. Everything the market accomplishes it does by making regular, effecting rules and generating action incentives. This is obviously true in terms of regulating the allocation of resources to their preferred use or spreading knowledge of relative resource availability. The making regular of these activities through the price system is obviously at the very heart of the market. However, even the idea of regulation as bulwark against excess and bad-dealing is central to the very purpose of the market. If people engage in risky behaviour, others, who are not willing to foot the bill for the fallout, will take some action – disinvest from a company, demand their insurance provider charge increased premiums for such people, or require upfront payment for some kinds of contracts. Risk taking becomes expensive, which is why success may yield great rewards, but the high price of risk taking ensures that the temptation of those high rewards doesn’t lead to excessive and destructive levels of risk taking. Below, I’ll use an interesting example from the recent financial crisis to illustrate.
The key point being established to begin is that libertarians of all types, Austrians and otherwise, are conceding vastly too much intellectual terrain when they allow statists to set the terms of debate as being between a wild, wild west market and the good and kindly corner cop who will keep the peace and enforce the rules. (As most of us now know, this characterization actually demeans the regulatory ingenuity of the “wild, wild west” (Anderson & Hill, 2004).) It is not a choice between an unregulated market and the wise regulation of the impartial state. And my point, here, isn’t the more obvious public choice one about the state’s perverse incentives, rent seeking and regulatory capture. (Stigler, 1971) My point is that the whole edifice of dividing the relationship into the regulator and the regulated is conceptually wrong. Since the market is a regulatory system, the choice is between a centralized, command and control, coercive regulator, on the one hand, and a decentralized, locally sensitive, negative feedback regulatory system, on the other hand.[1]
There is no non-regulated network of exchanges between people; it’s simply a choice of what kind of regulation will be used. For most readers, here, it’s not necessary to excessively rehearse the whole Hayekian business about the uses of knowledge in society. (Hayek, 1945) Knowledge spread out in a society is so diverse, so contingent, so fragmented, so tacit and so distributed that it defies calculability, even in the present moment, much less as a predictor of future outcomes. People sometimes don’t even know their own preferences until the very moment of being confronted with a choice. How is any central planner supposed to anticipate all this for everyone in the society? It is not just a data volume problem, it is a logical problem.
This is why even large companies, to survive inevitable diseconomies of scale, usually figure out that they have to decentralize, distribute agency discretionary powers to local units and departments. (Langlois, 2002) Even in the state, itself, the discussions over the last couple decades in public administration scholarship about horizontal governance and the autonomy of special operating units (including, though not restricted to, regulation) has acknowledged these inevitable facts. (McConkey & Dutil, 2006)
But, to repeat, it isn’t a matter of whether regulation is possible, but by what means it is to be attempted: centralized command and control coercion or decentralized, locally sensitive negative feedback correction. Consider a central (in both senses of the word) regulatory failure from the 2008 financial meltdown. There were, of course, a host of regulatory contributors: the Feds soft money, Fanny and Freddy’s implicit guarantees, the perverse effects of anti-redlining policy, mark-to-market requirements, and no doubt others. Here, I want to focus though on the argument by Jeffery Friedman and Wladimir Kraus in a recent book. (Friedman & Kraus, 2011) They point out that, in an effort to avert excessive risk taking, regulators virtually mandated a bubble in triple-A bonds.
With the recent hullabaloo about them, it’s easy to forget that these mortgage-backed bonds were identified as triple-A precisely because they were the safest investments.[2] This also creates a bit of a puzzle for those, like the well-intentioned, but mostly ill-informed, Occupy everywhere protestors’ story about banker and capitalist greed. As high risk investments present the greatest potential for profit, one would expect the greedy bankers to be buying up the lower rated, higher risk, greater potential reward, securities. And, when we factor in the moral hazard story, of a long, long history over recent decades of the U.S. federal state bailing out creditors, resulting in the heads-I-win, tails-you-lose relationship between risky investors and tax-payers, the propensity to invest in riskier financial instruments seems even more likely. (Roberts, 2010)
Yet, that’s not what happened. Instead, the bankers went crazy on the least risky and lowest yield, triple-A securities. As Friedman and Kraus tell the story, it’s no great mystery. Regulators, both in the U.S. and internationally (the Basel Accords), wanted the banks to maintain high capital reserves when engaging in risky investments, so they created regulatory regime schedules that trivialized capital reserves for the safest investments. Yet, bankers don’t only make their money from the risk-reward ratio, they also make it from the sheer amount of capital they have available to invest. Large scale investment in triple-A bonds allowed the maximum amount of capital for yet greater and greater volumes of investment. In other words, the regulators’ requirements actually, strenuously, pushed the banks to overinvest in the mortgage backed triple-A bonds. The regulator created the incentives to produce a bubble in triple-A securities.
Could this have happened under the decentralized, locally sensitive, negative feedback regulatory system of the market? Anything may be possible, given the wrong incentives, but in the absence of state command and control regulatory coercion, it doesn’t seem probable. Even if we ignore the likelihood of many investors to prefer the higher risk and potential yield of lower rated securities, market regulation would have militated against a financial bubble. Highly increased volume purchases of the triple-A bonds – i.e., increased demand – would have raised their prices. When the costs of the safer investments reached a price point at which the differential between those costs relative to the risk in lower rated securities was a reduced deterrent, investment would have flowed from the safer to the riskier investment (since there would have been no countervailing Basel-imposed benefits of staying with the triple-A bonds): the risk-reward ratio, at a certain price, for any investor, would eventually move from the safer to the riskier investment. Hence, the bubble in triple-A bonds would have been defused, based strictly on decentralized, locally sensitive decision-making. Consequently, the housing bubble would have never turned into a systemic financial collapse.
This is how negative feedback regulation works. Where there’s overinvestment, profits reduce; where there’s known but undervalued resources, investments will increase. When new costs are recognized, investments shift. This is as true for labour as for capital. If people are free to do so, they move to where wages are higher, decreasing wages where they went (through greater labour supply) and increasing wages where they left (through lesser labour supply). Yet, they also cause more demand for goods in the new market (and less in the old). [3]
There are of course always countervailing forces at work – cultural as well as political. In this, though, market regulation is not inferior to state coercive regulation, but the same. The ways in which they are the same isn’t of much interest; it’s how they differ that is important. One is insensitive to local knowledge, (as Friedman and Kraus put it) homogenizes mistakes, constantly generates perverse outcomes (see triple-A bonds discussion above), and is based upon violence and coercion. The other emerges from voluntary actions and relationships, creates heterogeneous solutions, through trial and error mutual self-learning, and, not only respects, but is dependent upon respect of liberty and property.
The market is regulation. And, seeing as the term regulation has taken on in the popular imagination associations of shelter, safety and wise rules and laws that protect us from chaos and destruction, we libertarians, Austrians and all freethinkers and free marketers can no longer cede this term and its comforting connotations to the statists. If it’s regulation against excess, greed, corruption and incompetence that is needed, not only can the market do that, it is the only regulatory method that actually can. It is not so much that the state fails at regulation as that the state is intrinsically incapable of regulation and the more it tries to compensate for its failures, the more coercion and violence it imposes on everyone. Every fruitless effort it makes to regulate through coercion simply undermines the only regulation that can possibly work: the free market. Perhaps in the future, we might be advised to describe regulation as the function of markets and call the state’s actions exactly what they are: coercive interference in regulation.
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[1] As I have here, I’d generally advise avoiding the common term “self-regulation.” Confusions about the “self” here, due to both psychological tendencies and common lack of precision in colloquial use, often misleads those who hear the term to think that it is proposing potentially harmful actors simply restraining themselves and being considerate. And, indeed, in some discussions of state regulation it more or less is (McConkey, 2003, pp. 20-26). Usually, such a suggestion is correctly dismissed as farcical. The self, in self-regulation as self-correcting, negative feedback, refers to processes outside of the control of any individual actor and his subjective preferences. When the thermometer mercury dips to a certain point, the heating doesn’t come on because it’s a good guy who wants to keep the family warm, but because specific dynamics kick in. It is through such impersonal dynamics that markets “self-regulate” – not good will.
[2] This is of course an entirely separate matter from any improprieties in the actual rating of bonds. It is though, from the perspective developed here, an interesting instance of gaming the system precisely to wedge higher risk-potential yield investments into the ostensibly safer instruments. It is in fact a workaround of market-insensitive incentives.
[3] For some discussion of how this negative feedback regulation works in the case of poverty: (McConkey, 2011)
Works Cited
Anderson, T. L., & Hill, P. J. (2004). The Not so Wild, Wild West: Property Rights on the Frontier. Stanford: Stanford University Press.
Friedman, J., & Kraus, W. (2011). Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation. Philadelphia: University of Pennsylvania Press.
Hayek, F. (1945). The Use of Knowledge in Society. American Economic Review , XXXV (4), 519-30.
Langlois, R. N. (2002). The Vanishing Hand: The Changing Dynamics of Industrial Capitalism. University of Connecticut. Department of Economics Working Paper Series.
McConkey, M. (2011, March 12). Markets, Poverty and the Snapshot Fallacy. Retrieved November 16, 2011, from Ludwig von Mises Institute of Canada: http://www.mises.ca/posts/articles/markets-poverty-and-the-snapshot-fallacy/
McConkey, M. (2003). Thinking Regulation: A Roadmap to the Recent Periodical Literature. Commissioned by the Privy Council Office, Federal Government of Canada. Toronto: Institute of Public Administration of Canada.
McConkey, M., & Dutil, P. (Eds.). (2006). Dreaming of the Regulatory Village; Speaking of the Regulatory State (Vol. 18). Toronto: Institute of Public Administration of Canada.
Roberts, R. (2010, April 28). Gambling with Other People’s Money: How Perverted Incentives Caused the Financial Crisis. Retrieved November 16, 2011, from The Mercatus Center: http://mercatus.org/publication/gambling-other-peoples-money
Stigler, G. (1971). The Theory of Economic Regulation. Bell Journal of Economics and Management Science , 3, 3–18.
Don't forget about private regulation http://bit.ly/uekIkO