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Regulation- Where Do You Draw the Line?

May 30, 2012

by J. Andrew Zalucky

Last Friday, I sat down with a couple of my bosses (one them a staunch conservative) and had a discussion with them to address the following question:

What should the role of the state be in regulating economic activity?

Since the mid-1800’s, economic growth across much of the world has been driven by market economies. If you want to get technical, you could restate this as “mixed economies”, as all modern societies are build on the trade-off between the individual interests of the private sphere, and the more general or “collective” interests of the public sphere. As evidenced by that discussion last Friday, most conservatives agree that there should at least be some “infrastructure of rules” for the system to operate in. And most also agree that real difference between those on the centre-right and centre-left on this matter is one of degree rather than principle. So what should this infrastructure of rules consist of? What limitations should we set for this trade-off?

Much has been made the impact of government regulation on job growth. While its obvious that the rules and standards set by government bodies will have an impact, its very easy to overstate this. As Slate’s David Weigel observed in a blog post last fall:

What percentage of layoffs can be traced back to job-crushing government red tape?

In every quarter, the answer is “less than one percent.” In 2010 Q4, only 0.25 percent of “layoff events” were the result of regulation. In 2011 Q1, it was 0.4 percent. In 2011 Q2, it was down again to 0.3 percent.

In his excellent book, The Birth of Plenty: How the Prosperity of the Modern World was Created, Dr. William J. Bernstein puts the question in a historical perspective:

The political right romanticizes the laissez-faire of the nineteenth-century America as the golden age of capitalist enterprise, free of confiscatory taxation and government interference in private enterprise. The plain facts belie this notion. In the modern West, economies prospered even as tax rates soared and government regulation of industry ballooned. Only the devastation of war temporarily slowed the pace of economic growth. Liberal democracies do have it within their power to smother prosperity, but only by income redistribution and government spending on a near-Communist scale, as occurred in England in the 1960’s and 1970’s.

One way to think about it is this: government has a role in the economy as a referee, making sure that companies obey the law and proceed in a transparent manner to protect the interests of its consumers and investors. The problem arises when the referee suddenly decides to start favoring one team over the other, or even worse, when the referee steals the ball and tries play along. if you want an example, one could point to the housing bubble of the mid-2000’s. Not only was the referee not doing its job, it actually helped facilitate the crisis by favoring certain entities and participating through Fannie Mae and Freddie Mac.

With this in mind, its very important not to understate the impact of regulations. I see it as critical that we maintain “public sphere” that represents our economic interest as a nation, and not just the individual interest of a particular company or economic sector. In other words, I don’t want to be just an employee or a consumer, I want to know that I am recognized as a citizen as well. As Paul Krugman wrote earlier this month in a column entitled Why We Regulate:

Just to be clear, businessmen are human — although the lords of finance have a tendency to forget that — and they make money-losing mistakes all the time. That in itself is no reason for the government to get involved. But banks are special, because the risks they take are borne, in large part, by taxpayers and the economy as a whole.

The problem comes when the government decides that it needs to “look like its doing something” to please voters when something crazy happens. This leads to a situation where a nuclear warhead is used where a bullet would have been just fine. This is not an indictment of regulation in itself (neither is it an indictment of liberalism I might add), but it does reflect poorly on the political culture that pervades both major parties at the moment.

Let’s use Sarbanes-Oxley (2002) as an example. Certainly the principle behind the legislation was a very good one: a culture at public companies (as opposed to partnerships, LLCs, and other arrangements) where management is transparent and employees bear responsibility for their own actions. There’s nothing wrong with that. Where the law runs into trouble is with Section 404, which requires management and auditors to provide information on the company’s internal control on financial reporting. Planning and implementation of such reporting can be very expensive, as many smaller business ended up spending nearly 3% of their revenues on compliance with SOX 404. This puts a disproportionate amount of pressure on smaller companies, as the larger ones can more easily comply with these laws. What would be a good way to work around this? Well, you could create a scale for these rules based on the size of the businesses involved. The Senate and the SEC did realize this of course…in 2007…5 years after the initial passing of the law. Like I said, rather than use the proper metrics to see how regulations could be properly implemented, the government went for the populist route and wanted to “look busy”.

(However, there is a positive upshot to compliance, as it creates the need to hire consultants to come in and help- something I’d be a fool to complain about…full disclosure: I happen to work at a management consulting firm)

Many of the same concerns have been leveled at the Dodd-Frank (2010) legislation, thrown together in the aftermath of the 2007-08 financial crisis. While massive in scope, the legislation fails in many keys areas and imposes an enormous set of rules which disproportionately effect smaller companies. In a perverse way, the bill throws even more power into the hands of huge firms like Goldman-Sachs which can afford to spend the money on compliance. I’ll never forget what I heard at a conference in 2010 after a presentation on Dodd-Frank when a gentlemen who worked in the energy sector stood up and piped, “So…when do we move to Singapore?”

At a conference last year, economist Nouriel Roubini remarked:

The problems of the financial system on Wall Street have not been resolved. People talk about Dodd-Frank [the Wall Street Reform and Consumer Protection Act in the U.S., signed into law in 2010], but have we really changed the system of compensation? Have we dealt with the corporate governance problem? Have we divided commercial banking and the more risky shadow banking and investment banking? No. So that remains.

So what do we have then? We have the principle that modern economies require a framework of regulations in order to function properly. BUT we have a situation now where the Executive and Legislative branch in the United States fails to properly create and implement those which both ensure fair play in the economy and protect the wider public. I certainly don’t have all the answers to these and other problems, so I’d be interested to hear from readers in the comments section (or on facebook and reddit). Though I do have a few ideas:

– Have the government hire an independent agency to totally gut and re-staff the SEC and other regulatory bodies
– Revamp the SEC’s powers so that it can do its job to enforce the law
– Simplify regulatory rules so that they are more easily understood
– Rework existing legislation so that it takes variance in size and complexity of different organizations into account
– Put Glass-Steagall back into place (under 100 pages long, imagine that!)

There will always be “bubbles” and “crises” so long as business, consumers, and investors are attracted to a certain market or idea. What the government needs to do is properly mitigate the effects these have on the public, and not exacerbate them through populism and favoritism, in other words: risk management. It’s not so much a question of whether or not the market should be regulated, but more of what those regulations actually are. As one of my bosses said, the formation of the public sphere is predicated on our desire to reduce risk- risks to our security, our well-being, etc, ect. And as my other boss said, if you want to know where the next bubble will be, its very simple:

Follow the money.

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