How Should We Respond to Regulatory Failure?

Jun.11.10 | About: iShares U.S. (IYF)

I keep reading arguments that start with the fact that regulators have been imperfect in the past and use it to argue that we should eliminate (or substantially reduce) the amount of regulation that is imposed. However, just because regulators missed things in the past like Bernie Madoff, the financial meltdown, and the risks that BP was taking does not imply that regulation ought to be reduced or eliminated.

If there is a lot of crime that should have been prevented but wasn't, do we disband the police department or try to figure out how to make it better? It would be silly to suggest that the answer to the failure to prevent crimes is to get rid of the police, and it's equally silly to assert that the solution to poor regulation is to quit trying to regulate. Yes, it's possible that in some cases the regulation can do more harm than good (the equivalent of a law that imposes more restraints, i.e. costs, on the law-abiding than it produces in terms of the value of the problems it prevents). But for the most part, we are trying to prevent behavior that has significant costs, e.g. oil spills, financial meltdowns, fraud, etc., and throwing our hands up and saying there's nothing we can do about it is not the answer.

Another argument I hear is that regulators will always be behind, that innovations in, say, the financial market will always stay one step ahead of attempts to constrain their behavior. However, in general criminals are always one step ahead of law enforcement, or at least they try, but we don't conclude that this means we should quit trying to enforce the laws. Instead, we do our best to keep up with the latest attempts to evade the law by enhancing, for example, the technical abilities of the police so that they can match the abilities of those trying to use digital or other technology to commit crimes that go undetected.

Regulators certainly made mistakes, and there is plenty of room for improvement, but does that mean we should abandon attempts to regulate? Of course not. We need to figure out how to do a better job at regulation just like we need to try to improve the ability of law enforcement to prevent and solve crimes when crime gets out of hand -- we generally add resources to police departments when there is more crime than we can tolerate -- and our response to regulatory failures ought to be the same.

So sure, get rid of the unnecessary regulation where you can find it, but for the most part, problems such as BP and the financial meltdown are not the result of too much regulation. The problem is the existence of outdated rules that failed to keep up with changes in the industry, the lack of effective enforcement due to not having enough regulators, not being able to match the skills found in the private sector, and so on, all of which are best solved by giving more attention and resources to regulatory issues, not less.

I'm pushing this argument to its extremes, more so than those making it intend, but saying that regulators failed, therefore we need to get rid of regulation, is not the conclusion we should draw. If regulators weren't up to the job, or if the regulations were inadequate as in the case of the unregulated shadow banking sector, then we need to strengthen our ability to regulate. Those on the right pushing the "government failed" message in response to recent crises are, in my view, making a pretty good case for expanding the size and scope of the regulatory agencies.