Government Intervention Run Amuck #19: The SEC vs. Madoff

by: Katy Delay

The Madoff scandal has the damaged investors looking for scapegoats--other than their own cupidity and Mr. Madoff himself, of course. Sooner or later the question had to be asked: Where was the SEC?

Now, goodness knows I am the last person in the world to defend the Securities and Exchange Commission. I don't know what their record is today, but in the 1980s one would have been hard-pressed to find a case where the SEC saved an investor a penny.

This may not be true today, I don't know. But what is certain is that they didn't do their job in the Madoff case, as Christopher Cox seems to be admitting publicly.

But is this really the SEC's fault? Yes of course it is; but it is also the fault of voters who elected the legislators who created the SEC in the first place.

Just like the FDIC, the SIPC, the PBGC, and (hiccup) now even the Federal Reserve, federal guarantee agencies can be grouped under the common heading "Lenders of Last Resort," a kind of national insurance policy for each risk involved (banks, brokerages, pension funds, and ... well, everything else).

The problem with national insurance policies is that, unlike private entities entering into any other venture, the government has no bottom line to manage.

A private insurance company would only insure risks it felt certain it could insure and survive. The government, on the other hand, insures whatever risks it thinks it must to protect the electorate, whether or not the government budget exists to pay for it.

This leads us to what economists call "Moral Hazard," where market players--who are not stupid -- take into account the fact that what they are about to do is insured by the government, which allows them to take on more risk than they ordinarily would.

This backfiring of intent is a well-known phenomenon in economic research. For example, wearing seat belts actually causes more accidents because people feel safer and take more risks while driving. It distorts the incentives, as economists say.

Thus the government that started out to be the protector of the consumer becomes a kind of Risk Devil, encouraging more risk-taking than is healthy, eventually guaranteeing havoc in the marketplace, creating its own program's ultimate failure, and harming the very constituents it intended to protect.

Government oversight may sound like a good thing; but it often ricochets. We might do well to abolish these entities and create in their stead citizen watch-dog groups that will use current legislation to police the bad guys but guarantee nothing and no one.

Read more about the hubris of the financiers who were hit by Mr. Madoff's game in this great piece by John Kay in the Financial Times yesterday. Also, read how Madoff investors are looking for people to sue. It'll just be a matter of time before they decide to sue the SEC -- which is us, by the way; and instead of abolishing the SEC, just watch: Legislators, responding to your demands, will strengthen it.

Good grief. We'll never learn.