Wednesday, November 12, 2008

The Costs Of Regulation

Another regulatory failure

State regulation is on the rise. In the face of the biggest financial crisis in human history, the almost universal cry is for more regulation. Zealots like Tyler might rant on about the price in terms of future economic dynamism, but people faced with the risk of losing job and home just say fine: we'll take a bit less future growth if it avoids this nightmare.

So it's useful to get some reminders of just how costly regulation can be.

Today, there's much hilarity over the Evil Empire's decision not to rescind its ban on straight bananas:

"Curvy cucumbers, knobbly carrots, wonky aubergines and ugly artichokes will go on sale in shops again after unpopular European Union rules dictating the size and shape of fruit and vegetables are scrapped.

But the notorious regulation which dictates that "straight" bananas must be "free from malformation or abnormal curvature" will remain in place because "no objections from banana growers, buyers, traders or consumers have been received regarding this requirement".

Tyler will be firing off his objection later on. But the serious point is that these barmy unwanted regulations are reckoned to have forced the dumping of 20% of our annual harvest, on the grounds that it was "mis-shapen". Our food prices have consequently been ramped - purely so some distant commissar could impose his order on nature. Which was precisely how the Soviets managed to starve millions of their own people.

Then there's the backfiring regulation of sperm donations. Under new regulations imposed in 2005, all children from donated sperm were given the right to know the identity of their donor. The unintended but widely predicted consequence has now come to pass - a critical shortage of donors. Donor children have certainly got their rights, but unfortunately they won't able to enjoy them because they don't actually exist. Clunking fist regulation has literally snuffed out their lives.

Over and over, one-size top-down regulation throws up unintended consequences and unforeseen costs.

And it's not just that they stop Good Things, like sperm donation and cheap fruit and veg, from happening. Often don't even stop the Bad Things they were specifically aimed at.

For one thing, rules and regulations all too easily engender a false sense of security, allowing us to imagine everything is under control just because all the regulatory boxes have been ticked. There seems to be more than an element of that in the appalling Haringey case.

Worse, players game the regulations. For example, some of the current financial crisis was caused by so-called "regulatory arbitrage". Profit hungry banks and insurance companies found ways to circumvent their regulations by developing new financial instruments. These ticked all the right boxes and appeared to satisfy the letter of the rules, but most definitely not the spirit.

I've just been reading some history on British banking in the era before regulation, and a very interesting point emerges. At the outset of Victoria's reign banks didn't publish information on their reserve asset ratios (ie how much they were holding in reserve against potential loan losses), and there was no regulation to force them. Nobody knew how safe individual banks were, and bank failures were quite common.

But as the banking sector grew, individual banks did start to publish the information. And it wasn't because the regulators had forced them, but because their customers had become more selective. Customers wanted some assurance that their money was safe, and they wanted to know how well the banks were reserved. And as a direct consequence of this customer pressure, reserve asset ratios increased as Victoria's reign proceeded - banks became safer of their own volition.

Compare that with the regulatory world we've since moved to. Because we now have regulators, until recently most of us never gave a thought to how many reserves our banks held. Why bother? Our money would always be safe and warm in properly regulated banks. We know how that ended - a hugely expensive tax-funded bailout, and a pledge to spend even more on regulation.

Unfortunately, despite all these drawbacks and the evident recent failures, there's no stopping the current swing to more regulation. It's one of those Big Cycle things.



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