Capture is part of regulation itself

Here’s a letter I sent to the WSJ about a week ago

by D. Pontoppidan, Summer Fellow at the Mackinac Center

Thomas Frank [“Obama and Regulatory Capture, June 24] calls the present moment a time “for a ringing reclamation of the regulatory project.” To protect consumers, he argues, we need regulation, and better people in charge, lest we suffer from “regulatory capture,” a concept developed by the Chicago economist George Stigler.

I am reminded of another Chicago economist, Milton Friedman, who once recounted the history of the Federal Register, which records all matters concerned with regulatory agencies in the United States. From its inception in 1936, the Federal Register grew from 2,599 pages and six inches of shelf space to 36,487 pages in 1978, the year before Friedman’s book ‘Free to Choose’ was published, taking up 127 inches of shelf space – a veritable 10-foot shelf. Though the Federal Register was not even able to tell me the number of pages they publish today, they did inform me that they now published on a daily basis.

There are two myths at play in Frank’s article. One is that a lack of regulation was to blame for the financial crash. The second myth is that the answer to regulatory capture is to get better people into regulatory agencies. The whole point, however, of regulatory capture is that it is an inherent flaw in the system. To quote Stigler himself, “The state—the machinery and power of the state—is a potential resource or threat to every industry in the society. With its power to prohibit or compel, to take or give money, the state can and does selectively help or hurt a vast number of industries.” Leaving consumers free to choose on an open market seems a better way of punishing those who deal in bad products.

Financial innovation comes from trial and error

By D. Pontoppidan*, Summer Fellow at the Mackinac Center

Here’s a letter I sent to the WSJ a couple of weeks ago:

We’ve recently heard of a new federal financial consumer agency which will have the power to scrutinize complex financial products, fit them with warning labels much like cigarettes or toys digestible by small children, and even ban them if they are deemed overly risky. Have we completely abandoned the belief in responsible consumers participating in the financial markets?

My primary concern is how financial innovation will come about in a situation like this, especially if the consumer agency becomes too strong. We all know innovation will not come from those monitoring the market, nor are innovative and bold new products likely to be viewed as safe or conventional when they emerge. I am reminded of the Japanese samurai who were paid in rice, and because of a series of bad harvests needed a stable method of converting their goods into coins. This in 1730 led to the establishment of the Dojima Rice Exchange, the world’s first futures exchange market. As it turned out, the system worked fairly well, and has since been implemented around the world. Other systems were flawed and failed. This process is known as creative destruction, and is how financial innovation is brought forth. Through trial and error. A market that includes everyone at all times and in all places, is better at testing and deciding on the value of financial products than a board of bureaucrats.

Robert Shiller, the Yale economist who predicted the financial meltdown, also suggested the expansion of a growing futures market based on the Case-Schiller indices that would measure house prices in large American cities. Such a market would be able to guide the direction of house prices much better than other systems, because it involves those who look for a rise as well as those who expect a fall. Similarly, we can imagine hedging against other macroeconomic factors such as inflation, interest rates and unemployment – the limits are endless. The question is, will financial innovation make it past the consumer protection agency?

*The author took a class on behavioral and institutional economics with Robert Shiller.