Wednesday, April 02, 2008

How Can Regulation Be Outdated? Let me count the ways...

Peter Suderman wants to trademark the notion that regulations can become outdated for economic libertarians:

I continue to be bothered by the fact that despite [Obama's] recognition that the current financial regulation system is outdated, designed for another era, and his equal recognition that we've dealt "with threats to the financial system that weren't anticipated by regulators," the solution is, well, more regulators! It's as if he sees the consistent inability of bureaucracy and regulation to keep pace with market innovation and then says, "But if we just made it a little faster, maybe this time…"

But surely the issue isn't just "more" or "less" regulation. If you have regulation in place for a reason, and there are powerful incentives to get around it, you need to update your regulator strategies to address the regulatory arbitrage.

If the taxpayers are going to be insurers of last resort of certain financial transactions (and perhaps they should be), then like any other insurers, they need to control the insured's behaviour for excessive risk-taking. But when they do that, the insured has an incentive to find a way to keep the coverage and engage in the risk-taking. Sophisticated financial instruments make this easy, unless regulators are also sophisticated.

So a regulatory system can be "outdated" not only because it imposes unnecessary costs on those it regulates, but also because it no longer protects against the risk it is trying to mitigate.

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