Gerald O'Driscoll, Jr. On Inept Regulation vs. Free Markets

Gerald O'Driscoll, Jr., currently with the Cato Institute, wrote a masterful exposition of various aspects of the current US financial markets and economy in an editorial in yesterday's Wall Street Journal entitled "An Economy of Liars." It is an excellent example of why the field was originally known as political economy.

Among the more notable passages in Mr. O'Driscoll's editorial were these,

"Free markets depend on truth telling. Prices must reflect the valuations of consumers; interest rates must be reliable guides to entrepreneurs allocating capital across time; and a firm's accounts must reflect the true value of the business. Rather than truth telling, we are becoming an economy of liars. The cause is straightforward: crony capitalism.

We have now learned of the creative way Lehman Brothers hid its leverage (how much money it was borrowing) by the use of a Repo 105. The Repo 105 meant Lehman temporarily swapped assets (such as bonds) for cash. A Repo, or repurchasing agreement, is a way to borrow money. But an accounting rule allowed Lehman to book the transaction as a sale and reduce its reported borrowings, according to a report by the court-appointed Lehman bankruptcy examiner, a former federal prosecutor, last month.

Are we to believe that regulators were unaware? Last week Goldman Sachs was accused in a civil fraud suit of deceiving many clients for the benefit of another, hedge-fund operator John Paulson.

The idea that multiplying rules and statutes can protect consumers and investors is surely one of the great intellectual failures of the 20th century. Any static rule will be circumvented or manipulated to evade its application. Better than multiplying rules, financial accounting should be governed by the traditional principle that one has an affirmative duty to present the true condition fairly and accurately—not withstanding what any rule might otherwise allow. And financial institutions should have a duty of care to their customers. Lawyers tell me that would get us closer to the common law approach to fraud and bad dealing.

Congressional committees overseeing industries succumb to the allure of campaign contributions, the solicitations of industry lobbyists, and the siren song of experts whose livelihood is beholden to the industry. The interests of industry and government become intertwined and it is regulation that binds those interests together. Business succeeds by getting along with politicians and regulators. And vice-versa through the revolving door.

We call that system not the free-market, but crony capitalism. It owes more to Benito Mussolini than to Adam Smith.

Distorted prices and interest rates no longer serve as accurate indicators of the relative importance of goods. Crony capitalism ensures the special access of protected firms and industries to capital. Businesses that stumble in the process of doing what is politically favored are bailed out. That leads to moral hazard and more bailouts in the future. And those losing money may be enabled to hide it by accounting chicanery.

If we want to restore our economic freedom and recover the wonderfully productive free market, we must restore truth-telling on markets. That means the end to price-distorting subsidies, which include artificially low interest rates. No one admits to preferring crony capitalism, but an expansive regulatory state undergirds it in practice.

Piling on more rules and statutes will not produce something different than it has in the past. Reliance on affirmative principles of truth-telling in accounting statements and a duty of care would be preferable. Deregulation is not some kind of libertarian mantra but an absolute necessity if we are to exit crony capitalism. "

Mr. O'Driscoll reinforces several points that I've made in prior posts, i.e., fallible regulators and easily-influenced legislators are the reality in our system. It does no good to demand ever more complicated, restrictive laws, when those charged to implement them are less capable than those they are tasked to monitor. Or the laws themselves are written to benefit the currently-powerful.

There's quite a bit of Br'er Rabbit in the current Dodd financial regulatory "reform" bill. Firms such as Goldman Sachs, Chase, Citigroup and Morgan Stanley are quite aware that their special status as bailout candidates will confer upon them lower funding costs from counterparties than their competitors will pay.

Crony capitalism, indeed. Bi-partisan, to be sure, as well.

Those of us who advocate less regulation are often painted as greedy, anti-consumerist, anti-poor, pro-wealthy, and/or desiring a return to some mythical bad old era in the historical vicinity of the years prior to and including the Gilded Age and its so-called Robber Barons.

Being anti-regulation isn't about desiring to give the wealthy or powerful added advantages. Rather, it's fundamentally about acknowledging the inability of so much regulatory activity to deliver on its promise.

For example, SEC regulations mandate that annual reports of publicly-held companies be audited. Have you ever read the disclaimers on standard auditor statements in those reports? They make the concept a mockery.

For many years, I have believed that a much better solution would be for the SEC to drop the requirement. It's my belief that the major accounting firms would quickly offer their corporate clients much tougher, non-disclaimer audits, for a higher price, that would provide a much more credible seal of approval. Not every company could qualify for a clean bill of health under such scrutiny.

Instead, we have SEC-compliant disasters like WorldCom and Enron.

Regulators and regulatory processes are extremely fallible in the best of situations.

O'Driscoll is, I believe, correct to advise that it's better for parties to economic transactions to perform their own due diligence, take precautions as they see fit, and live with the consequences.

If regulators couldn't stop Madoff before his scheme grew to epic proportions, nor discover the Lehman Repo 105 tactic, why should we believe they will ever, under any existing or new regulatory framework, do a better job in the future?

Rather than trust in empty promises and imperfect regulatory schemes, let's stop trying to protect market participants from themselves, and let each be responsible for their own actions.

Free markets reward competence, innovation and appropriate risk management. Those who fail at these ought to lose their capital and be rinsed from the system, lest they become too large a drag on the productivity and growth in wealth, system-wide, that naturally arise from the efficient allocation of resources in a free market economy.