Does Madoff scandal show need for greater regulation?

(People’s memory is short. In less than one hundred years, history repeats itself — in both countries.)

Sheldon Richman analyzes Los Angeles Times columnist Tim Rutten’s opinion regarding supposed failure of deregulation (can the deregulation please stand up and show itself?) as supposedly exemplified by Madoff scandal. Rutten writes:

The lesson is one that becomes clearer with each excruciating turn of the Wall Street screw. The long, bipartisan experiment with financial deregulation has failed utterly. The argument that a return to rigorous oversight will somehow stifle Wall Street’s ‘creativity’ is no longer convincing. Whatever its theoretical costs, regulation is dramatically cheaper than intervention. And absolutist insistence on the superiority of ‘individual choice’ and ‘free markets’ now is exposed as so much vacant rhetoric. Any system that permits a scam artist like Madoff to deceive not just widows and orphans but also sophisticated investors, like Fairfield Greenwich Group’s Walter Noel and Hollywood’s Jeffrey Katzenberg, isn’t a market at all; it’s a shooting gallery.

Richman answers:

The last sentence is a tip-off that something is wrong with this outlook. Financial regulation is usually proposed to protect the unsophisticated. People knowledgeable about finance and securities presumably can take care of themselves. But what makes the Madoff scandal so noteworthy is that the most sophisticated types were taken in, even though several experts sounded alarms. Why?

The other thing to note about Rutten’s position is that there has been no relevant financial deregulation to speak of. In fact, since Enron’s collapse, regulation has intensified and the regulatory budget has grown. The SEC already requires investment and hedge-fund managers with assets over $100 million to file quarterly reports. Under prodding from outside, the SEC looked at Madoff’s operation more than once but found no major problems. Moreover, Madoff’s alleged crimes involve fraud. Have any laws against fraud been repealed?

Contrary to Rutten, whose prejudice against “individual choice” and “free markets” is palpable, these two facts — sophisticated victims and pervasive regulation — demonstrate the failure not of the free market (which did not exist) but rather of regulation.

How can that be?

Begin the obvious: a false sense of security is worse than none at all. When people believe government is protecting them from bad financial services, they are more vulnerable to scams than if they knew they had to protect themselves. The government’s huge regulatory apparatus broadcasts one unmistakable subliminal message: Have no fear because Big Brother is watching over you. Is it any wonder that people are less wary than they would be if they did not believe that?

As long as government plays a regulatory role — or people believe it does — they will assume that key activities are being monitored. And even when an activity is known to be unregulated, the implication is that if regulation were needed, government would be doing it. Why else did worldly investors fall for Madoff’s self-described “giant Ponzi scheme”?

The call for regulation assumes — without grounds — that government can protect investors from con men. But government regulators have never been able to make good on that promise. Con men prosper no matter how much the government regulates. They often understand the system better than the people running it. (Madoff was an insider!)

Looking to government regulation for security merely adds another avenue for corruption. Ordinarily people are cautious when someone promoting a product stands to profit by its sale. But regulators are supposedly disinterested and don’t profit by their activities. All they want to do is protect the public interest — and they have the state’s imprimatur vouching for them. That’s the theory at any rate.

In fact, they are human beings like us all, with the same kinds of motives and goals — and temptations. To the extent we think they are saints, we make ourselves vulnerable to scams. (Speaking of Ponzi schemes, check out Social Security and Medicare¹.)

What’s the solution? Super-regulators to watch the regulators? And who watches the super-regulators? Face it: there is no security in regulation. Rather, there’s only a dangerous illusion of security, not to mention a drag on economic growth as the bureaucracy interferes with honest traders.

The claim of free-market advocates is not that we need no protection from the unscrupulous. Rather, it’s that protection is maximized by undiluted market discipline — profit and loss — and buyer-beware skepticism.

_______________
¹ When I said as much last Shabbos before kiddush in a conversation regarding Madoff scandal, a local socialist said (admittedly, as a joke) that my political views are somewhere right of Genghis Khan. :) Perhaps I should send him this post.