Sunday, May 02, 2010

What Milton Friedman got wrong

Friedman had two fundamental problems with business regulation. His first is that the business would capture the regulator, and therefore use regulation to establish monopoly power. My field leads me to find this line of argument compelling: real estate developers love (regulatory) barriers to entry that keep competitors from building.

His second, though, is just wrong. He argues that in order to preserve their reputations, businesses will self-regulate. Among other things, this ignores that managers often have short-term horizons. It also ignores that when large businesses implode, they leave victims with whom they never engaged in a transaction in their wake. BP did nothing illegal--how's that reputation thing working out? And having now read a whole lot on Goldman-Abacus (including the SEC complaint, the response on GS's web site, the offering circular, and excellent commentary from James Surowiecki, Yves Smith and others), it is not clear to me that Goldman did anything illegal or actionable (but I could be persuaded to change my mind). It is just that what it did (including investing long in CDS) should be unambiguously illegal and actionable. I can't think of anyone who had a bigger reputation franchise than Goldman.


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Richard H. Serlin said...

"His first is that the business would capture the regulator"

We have a long history of regulation still doing far more good than harm. Look at banking regulation post depression until the recent Republican dismantling. Look at anti-pollution regulation. Look at product safety regulation.

Plus, this problem could easily be obliterated with an amendment banning business political spending, or public campaign financing so generous that there's little incentive to cater to businesses for their money.

David Barker said...

Neither regulators nor markets are good with rare, catastrophic events. When they don't happen, we become complacent. When they do, we overreact.

Reputation, not regulation, is why most products are safe. Regulators can't possibly police everyone - firms make good products voluntarily to build reputation.

Wall Street is different - due diligence is expected. Anyone who bought from Goldman out of trust deserves to go out of business.

Milton Friedman got it right!

Richard K. Green said...

Except, David, that it would have taken a $500,000 backup switch to prevent the accident--and government regulators did see this coming. They were preventing from acting.

Sometimes I think you didn't just imbibe the Chicago Kool-aid--you were hooked up to an IV drip!

David Barker said...

MMS was "prevented from acting" by being captured. They raised concerns to get attention, were lobbied, and backed off. According to the NYT, regulators “frequently consumed alcohol at industry functions, had used cocaine and marijuana, and had sexual relationships with oil and gas company representatives.”

Before MMS was established in 1982 the US Geological Survey significantly undercharged oil companies for royalties for many years. I once wrote a paper on federal royalty income and the data from those years were a complete mess.

Regulatory capture is bi-partisan and long-standing.

Kool-Aid comes in different flavors. I tasted them all at LSE, Berkeley, and Chicago, but it took a few years in business to learn the truth about government, taxes, and incentives.

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