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Regulatory Capture

from Gene Epstein’s departing column at Barron’s- Keep Asking the Big Questions:

I often paraphrase Winston Churchill on democracy when confronting a critic of the financial markets: They’re the worst way to allocate capital investment, except for all the others. The markets will always be magnets for charlatans and irrational investors. But if allowed to operate, they tend to punish the irrational with losses, reward the careful with profits, and steer capital investment to its most urgent uses.

Call unfettered financial markets alternative A. While fraud will remain an actionable offense in any civil society, proponents of alternative B go much further, claiming that financial markets must be heavily regulated by government to curb mistakes and abuses. But this falls into the philosopher-king fallacy and its corollary, 20-20 hindsight. Are the human beings put in charge of the regulatory agencies immune to the corruption and lust for power that pervades some of the worst elements they aim to control? Economist George Stigler has put the term “regulatory capture” into economists’ vocabulary, showing that regulatory agencies almost inevitably get captured by powerful interests.

Had regulators at the Consumer Financial Protection Bureau asked the what-happens-next question, they might have considered that curbing payday lending at high interest rates might force many borrowers to go back to loan sharks, who use physically unpleasant means of collecting on their own high-interest loans. More damningly, when it comes to the causes of the Great Recession of 2008-09, government’s key role took place in plain sight.

The downturn wouldn’t have happened without the aggressive policies of government, starting in the early 1990s under President George H.W. Bush, which turned private mortgages into risky instruments. Regulators offered incentives to banks to load up on mortgages based on the view that nothing had changed to alter the relative safety of mortgage assets. Then the housing market collapsed.

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