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The Moral Hazard of Regulation

by Ron Paul

Since the bailout bill passed, I have been frequently disturbed to hear “experts” wrongly blaming the free market for our recent economic problems and calling for more regulation. In fact, further regulation can only make things worse.

It is important to understand that regulators are not omniscient. It is not feasible for them to anticipate every possible thing that could go wrong with whatever industry or activity they are regulating. They are making their best guesses when formulating rules. It is often difficult for those being regulated to understand the many complex rules they are expected to follow. Very wealthy corporations hire attorneys who may discover a myriad of loopholes to exploit and render the spirit of the regulations null and void. For this reason, heavy regulation favors big business against those small businesses who cannot afford high-priced attorneys.

The other problem is the trust that people blindly put in regulations, and the moral hazard this creates. Too many people trust government regulators so completely that they abdicate their own common sense to these government bureaucrats. They trust that if something violates no law, it must be safe. How many scams have “It’s perfectly legal” as a hypnotic selling point, luring in the gullible? Many people did not understand the financial house of cards that are derivatives, but since they were legal and promised a great return, people invested. It is much the same in any area rife with government involvement. Many feel that just because their children are getting good grades at a government school, they are getting a good education. After all, they are passing the government-mandated litmus test. But, this does not guarantee educational excellence. Neither is it always the case that a child who does NOT achieve good marks in school is going to be unsuccessful in life. Is your drinking water safe, just because the government says it is? Is the internet going to magically become safer for your children if the government approves regulations on it? I would caution any parent against believing this would be the case. Nothing should take the place of your own common sense and due diligence.

These principles explain why the free market works so much better than a centrally planned economy. With central planning, everything shifts from one’s own judgment about safety, wisdom and relative benefits of a behavior, to the discretion of government bureaucrats. The question then becomes “what can I get away with,” and there will always be advantages for those who can afford lawyers to find the loopholes. The result then is that bad behavior, that would quickly fail under the free market, is propped up, protected and perpetuated, and sometimes good behavior is actually discouraged.

Regulation can actually benefit big business and corporate greed, while simultaneously killing small businesses that are the backbone of our now faltering economy. This is why I get so upset every time someone claims regulation can resolve the crisis that we are in. Rather, it will only exacerbate it.

Dr. Paul is a Republican congressman from Texas.

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Comments

That large corporations often push for greater government intervention is a fact that goes back to the Progressive Era. I'm glad that someone has pointed out that it still happens today.

# posted at by economist

This arguement seems to be based on several false premises:
1) that regulations have to be so complex that only lawyers can understand them
2) that people are looking for a reason to abdicate responsibility

It is true that the world is full of people who don't want to be bothered by understanding the implications of their actions and automatically look to assign blame to someone else when their lack of attention causes them pain. I don't believe planning of the economy should be centered on such people, but rather planned so that hard working people who are willing to use their brains find the success they deserve.

I think of the phrase "Truth in Advertising" when I think of regulation. Just as it is illegal to market a product as something that helps grass grow if it acutally kills grass, I think it should be illegal to sell insurance if an institution does not have the financial ability to pay out on the insurance.

Insurance happens to be a legal term that is, by definition, regulated. CDS (Credit Default Swap) is the poster child for our current economic problems. To the layman it is insurance that a financial institution buys against the possibility of someone defualting on their mortgage. Since CDSs are not regulated they are not legally insurance. When AIG sold CDSs they did not have the ability to financially back them up. In fact they sold a false product to their customers (see Truth in Advertising). If CDSs were regulated (thus legally insurance) AIG would not have been able to get away with lying to their customers and such a huge fallout from the housing down turn would have been avoided.

In short, lack of regulation benefits big business whose lawyers have ferreted out a way to conduct legal shady business.

# posted at by O

If a company advertised its product to grow grass but instead killed it, that company would go out of business. Business cannot sell to consumers unless they are trusted. AIG should be allowed to go out of business for its poor judgment, but instead will be propped up by the government. The moral hazard is privatizing profit while socializing risk. The intention of regulation is to mitigate risk. But it instead creates the moral hazard of thinking we are safe because we are regulated. If one removes regulation then the onus is on individuals and corporations to be responsible for their decisions. Think how careful you are when you buy a used car from someone. This is a highly unregulated transaction. Yet, since caveat emptor, these transactions are not a political issue.

# posted at by Kurt Marhefka

In response to O's comment: try finding me a bill or law that would be easily understood by a non lawyer or accountant in less than four hours. I dare you.

# posted at by Green

In response to O's comment: try finding me a bill or law that would be easily understood by a non lawyer or accountant in less than four hours. I dare you.

# posted at by Green