Monkey Business

Cover me, when I sleep
Cover me, when I breathe
You throw your pearls before the swine
Make the monkey blind
--Peter Gabriel

Current economic problems have unleashed calls for increased government regulation. Presumably, the penalty of economic loss levied on market participants for taking imprudent risk in free market systems is not enough. Some degree of control is deemed necessary. This control transfers authority for production and distribution decisions from private hands to the State. State ownership and control of economic resources and their allocation is known as socialism.

Cries for increased regulation always coincide with periods of dramatic declines in market prices and economic activity, which should tell us something about the behavioral motives behind regulatory campaigns. These cries are usually grounded in the argument that people are prone to irrational extremes when making economic decisions. Regulators are charged with clipping those extremes in order to temper boom and bust cycles.

Such arguments, of course, are quite circular, because individuals charged with oversight hail from the same species who purportedly makes foolish buying and selling decisions in market environments. Who oversees the regulators when pangs of foolishness taint their decision-making processes?

The fact is that we currently spend more on government oversight and regulation than at any time in our economic history. Yet, examples abound of regulatory 'failures' (e.g., Madoff, CDS, front running, etc.).

Regulation is a form of inspection. A fundamental axiom of Total Quality Management is that control programs dependent on high levels of inspection are rarely effective. Research suggests that inspectors generally miss about 20% of all defects present (Juran 1988: 18.86). Inspection errors may be due to cognitive constraints, or they may be more political in nature.

Meanwhile, market participants who think they are 'covered' by regulatory programs are prone to do less due diligence when making buying and selling decisions. Less due diligence means more risk taking. As such, regulation is a breeding ground for moral hazard.

Before blaming free markets for current problems, intellectually honest individuals should try testing a hypothesis that excessive regulation and accompanying moral hazard are root causes of our economic hardships.

References

Juran, J.M. 1988. Juran's quality control handbook, 4th ed. New York: McGraw-Hill.