We tend to view the world in terms of what exists now, instead of what could or should exist. A good economist never ignores the institutional framework, because it provides the incentives to which economic actors respond. A great economist, however, goes beyond the existing. He examines the institutional framework from a normative perspective. Why did the existing framework evolve? What political and business interests produced it? Can patches to the system improve it? Do we need a completely different approach to regulation?
A particularly incisive post on this comes from Cafe Hayek:
Thomas Sowell has said that economics helps you understand that there are no solutions, only tradeoffs. In that spirit, I want to recommend Arnold Kling’s study of the financial crisis, Not What They Had in Mind. My favorite quote from the essay is a variant on Sowell’s:
The lesson is that financial regulation is not like a math problem, where once you solve it the problem stays solved. Instead, a regulatory regime elicits responses from firms in the private sector. As financial institutions adapt to regulations, they seek to maximize returns within the regulatory constraints. This takes the institutions in the direction of constantly seeking to reduce the regulatory “tax” by pushing to amend rules and by coming up with practices that are within the letter of the rules but contrary to their spirit. This natural process of seeking to maximize profits places any regulatory regime under continual assault, so that over time the regime’s ability to prevent crises degrades.
The “Wisdom of Crowds” provides some insight as to why this occurs. Typically, a larger group of people is wiser than a smaller group. When the larger group (the industry being regulated) has financial incentives and the smaller group (the bureaucrats) have no financial interests (or limited in the sense of bribes, perquisites, future employment, etc), there is little hope for regulation succeeding. Either the regulatory body becomes “captured” or outsmarted.
Our regulatory focus is punitive. It is designed to build boxes based on “Thou shall nots.” Such an approach is always behind. It is always dealing with the last horse to escape from the barn. Such a strategy will always fail because of the innovation of business. Only a change in regulatory philosophy that is based on the free market as the policeman has any chance of working. The State mindset is unwilling or unable to recognize this. Hence we will move from one regulatory failure to the next.