To Which Side of the Mouth Should We Listen?

The talking heads amplify politicians who exclaim, “See, the greed-driven free market has killed us again. We need more regulation!”

Will Wilkinson says, “Hold on there, Senator Foghorn. I remember you justifying your job with the assertion that ‘free’ markets would not exist without a government framework of regulation and enforcement.”

Actually, Wilkinson says this:

In particular, the American economy is so far from textbook laissez faire that it is well-nigh-impossible to find a breakdown in market institutions that does not have some bit of government policy as a chief contributing cause. As I said in an earlier post on a similar theme, “The American economy is in fact a byzantine amalgam of market and state institutions enmeshed in a thicket of regulation.” So when part of it goes KAPUT it’s cheap to blow ideological notes on the trumpet of market failure, especially if you’re the sort of person who likes to go on and on about how advanced markets cannot even exist except within the framework of government law.

Hear, hear!

…the idea that there is this thing called "the free market" that governments tame or muck up with regulation is a fiction. Governments create the legal conditions for markets; markets shape what governments can do or are willing to do. Regulation versus free-market is a false dichotomy. Maybe in some theoretical universe, if we could start with a blank slate and construct society anew, it wouldn't be. But we exist in a web of markets and regulations, and the challenge is to respond to problems in such a way so that we decrease the odds of future crises.

And that is where AIG becomes instructive. Even good regulations can't prevent all future crises, especially ones that are the result of new technologies and changes that result from them. The capital flows, derivatives contracts and nearly frictionless interlinking of global markets today are the direct result of the information technologies of the 1990s. The implications weren't known until very recently, so it would have been nearly impossible for regulations to have prevented what is happening. But if good regulation can't prevent crises, bad regulations can cause them.

The current meltdown isn't the result of too much regulation or too little. The root cause is bad regulation.

Call it the revenge of Enron. The collapse of Enron in 2002 triggered a wave of regulations, most notably Sarbanes-Oxley. Less noticed but ultimately more consequential for today were accounting rules that forced financial service companies to change the way they report the value of their assets (or liabilities).

Senator Foghorn, you are a tool.