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Scandalous Regulators

Mises Daily: Tuesday, December 11, 2012 by Mark
Thornton

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Editor's Note: Business scandals often lead to calls for greater regulation.
Yet, as economist Mark Thornton shows, in so many recent scandals, regulators
have been among the chief culprits.

The Democratic Party had its message on the economy well-prepared for the
recent election. From President Obama to his campaign directors to campaign
advisor-hacks, all the way down to the local party patsies, the message was
uniform and well rehearsed. “We do not want to return to the failed economic
policies of four years ago. Those policies caused the economic crisis that
almost put the country back in a great depression. We cannot return to the naïve
policy that deregulation is good for the economy.

The Romney campaign essentially left this crucial talking point unchallenged.
When confronted with this charge from the Obama campaign, Romney’s response was
to concede that capitalism requires regulation to work, but to insist that the
regulation cannot be excessive and burdensome, or ultimately the consumer will
be hurt.

This is an entirely unsatisfactory response. The problem is that Romney and
his campaign do not really know how capitalism works. They do have some idea of
how the actual interventionist economy works. That is the economy where Romney
made all his money. However, it is not a platform from which you can see how an
economy works without interventions, regulations, and “favorable” injections
from the Federal Reserve. Romney made his money during a time of “easy money”
under Alan Greenspan.

What the Democratic spin boils down to is that a lack of regulation allows
greed and irrational behavior to destroy the economy and hurt consumers.

This simply is not true. When you look at the cases where this was supposed
to exist, you find the Democratic party spin is wrong. Regulations do not make
markets safer, more efficient, or work better for consumers in anything but a
superficial sense. Regulation only provides “confidence” and assurance
that only leads to crisis. Regulation does not produce harmonization of markets
or insurance for consumers.

Regulation simply does not work. It is designed with hopes of success, but
with no mechanism to achieve this success. We hope for efficiency, but what we
get is bureaucracy. We hope for effectiveness, but what we get is rules and red
tape that serves neither producer nor consumer. We hope for safety, but what we
eventually get is chaos. Let us take a look at the prominent cases where
regulation was supposedly lacking and examine the real cause of chaos.

The Bernie Madoff scandal involved Madoff’s tightly controlled firm taking
client money and supposedly generating spectacular and consistent investment
returns. However, Madoff was not really a great investor; he was running a Ponzi scheme where he used
investors’ money to pay for redemptions by his clients. Most of the money
apparently went into his own pockets.

First, how did he get away with this scheme for so long? It was not because
he was unregulated. He was officially under the scrutiny of the Securities and
Exchange Commission (SEC), the Financial Industry Regulatory Authority, and
probably other government regulatory agencies. Despite ever-increasing budgets
and staff, and even warnings from outsiders, the SEC failed to act.

Second, how did he finally get caught? He was only caught after the stock
market crashed and investors sought to redeem large amounts of their funds. He
confessed to his sons that he was operating a Ponzi scheme and his sons turned
him into authorities.[1]

If the stock market had not crashed, Madoff might still be celebrated as a
genius investor. Many said that Madoff’s investment returns were too good to be
true. Experts agreed that they could not be true, and still the SEC failed to
act. The fact that he was licensed and regulated by the government gave
investors in his firm “confidence” that Madoff’s investment strategy was truly
the work of a genius.[2]

The housing bubble and the financial crisis that followed are considered a
classic case of a lack of sufficient regulation, which in turn permitted
unmitigated greed and irrational behavior to cause a massive amount of manic
speculation.

The idea that banking and finance are unregulated is just plain laughable.
There are various regulatory agencies at the state, federal, and international
level. Thomas Woods reports that there are over 12,000 bureaucrats devoted to
financial regulation in Washington DC alone and that inflation-adjusted spending
on it has tripled since “deregulation” began in 1980. There are at least 115
agencies that regulate the financial industry at the state and federal levels
alone.[3]

Three regulatory factors that contributed importantly to the crisis and its
magnitude were as follows:

1. Regulation of credit rating agencies resulted in toxic assets being
labeled AAA trustworthy.

2. The regulations and requirements imposed on banks forced them to make bad
loans under the Community Reinvestment Act.

3. The squabble between competing federal regulatory agencies prevented
credit default swaps (CDS) from operating in a transparent and liquid market
place.

The housing bubble is a classic case of how regulation cannot prevent such
problems, but can only help increase their magnitude. The biggest regulator of
money, banking, and housing is the Federal Reserve. It is the dominant umbrella
regulator, and it caused the housing
bubble with its long policy of easy credit from 2001 to 2006. Chairman Alan
Greenspan denied a bubble could exist and about the same time, his Vice Chairman
Ben Bernanke even provided words of encouragement for an audience of independent
community bankers:

Our examiners tell us that lending standards are generally sound
and are not comparable to the standards that contributed to broad problems in
the banking industry two decades ago. In particular, real estate appraisal
practices have improved.[4]

Other officials at the Federal Reserve would continue to laud Federal Reserve policies
and the financial innovations such as mortgage back securities and credit
default swaps well into 2007. They were the cheerleaders for the housing bubble,
providing confidence for both leaders and speculators.

Another example: the BP Gulf oil spill was certainly a tragedy, especially for the company.
Being so far off shore and drilling for oil in such deep waters made it seem
that there was absolutely no government regulation. The government had no assets
to stop the oil spill or to prevent it from spreading. We all had to just sit,
watch, and wait for the company itself to fix the problem.

The irony is that the reason that BP was drilling in such an inhospitable
environment was precisely because of government intervention. The Federal government
prohibits drilling in the relatively safe and shallow eastern Gulf of Mexico and
permits it in the deeper; more storm prone western Gulf of Mexico. Federal
regulators also administer a tax and fee structure that encourages oil companies
to drill primarily in the deepest, riskiest regions of the Gulf.

Federal regulation of oil drilling rigs is conducted by the Mineral
Management Service (MMS). They are supposed to conduct monthly inspections of
these massive rigs, publish reports and issue safety citations when necessary,
and put rigs on a regulatory “watch list” for any rig with repeated safety
violations.

Well that simply did not happen. The inspections were not held on a monthly
basis. Inspectors spent little time on the rigs during inspections; they often
relied on the company itself for safety information, and issued very few safety
citations. Sadly, regulators actually designated the Deepwater Horizon rig's
safety record as exemplary and based on that track record the agency
named the rig a model for industry safety in the year prior to the disaster.[5]

In fact, the MMS never required compliance with regulations related to
inspecting the blowout preventer device, which ultimately caused the spill to
spiral out of control.[6]
The reason MMS was lax in its duties and even allowed company officials to write
up its reports[7]
is probably because MMS employees were accepting all sorts of kickbacks, bribes,
and other benefits.[8]
Officials in charge have expressed regret, and promised it won’t happen again:
at least for the next couple of years, for sure.

As these examples illustrate, when examining this type of scandal, you do not
find unregulated firms fleecing their customers. What you do find are highly
regulated firms that are being pushed and pulled by regulations into unstable
and unethical activities. Enron is another good example. It was probably
regulated by more agencies than any company in existence and yet it created a
gigantic mess that was never noticed by regulators, but had to be uncovered by a
single independent financial analyst.[9]

The regulator is portrayed as a public-spirited specialist. They know the
public good. They know the results that are expected. They know how to
bring about those results. It is as simple for them to regulate their corner of
the economy as it is for Emeril Lagasse to make crab cakes or for Martha Stewart
to make a simple doily.

The public is told that regulators do not cause problems; they prevent them.
They police the economy. They are the watchmen that have been endowed with the
wisdom, ability, and selfless devotion to the public good.

There are indeed many people who work as government regulators that are very
smart and well-trained that have public spirit and the public good in their
hearts. There are also plenty of cads and knuckleheads that work as regulators.

The problem with government regulation is that you cannot fine-tune the
regulations: nor can you perfect the regulatory work force in such a way to make
regulation work in anything but a superficial way. The truth is that
regulation instills confidence in the public so that they let down
their guard and makes them less cautious while at the same time distorting the
competitive nature of firms in the marketplace.

After every economic crisis there are calls for new regulations, more
funding, and more controls. Economic wisdom dictates that we be ready to contest
those calls when the next crisis of the interventionist state occurs.[10]

Comment on
this article.

Mark Thornton is a senior resident fellow at the Ludwig von Mises Institute
in Auburn, Alabama, and is the book review editor for the Quarterly Journal
of Austrian Economics. He is the author of The Economics of Prohibition,
coauthor of Tariffs,
Blockades, and Inflation: The Economics of the Civil War, and the editor
of The Quotable Mises, The Bastiat Collection, and An Essay
on Economic Theory. Send him mail. See Mark Thornton's article
archives.

You can subscribe to future articles by Mark Thornton via this RSS
feed.

Copyright © 2012 by the Ludwig von Mises Institute. Permission to reprint in
whole or in part is hereby granted, provided full credit is given.

Notes

[1] Lieberman, David; Pallavi Gogoi, Theresa Howard, Kevin McCoy,
Matt Krantz (December 15, 2008)."Investors
remain amazed over Madoff's sudden downfall". USA Today.

[2] http://en.wikipedia.org/wiki/Harry_Markopolos

[3] Thomas E. Woods, Jr., Rollback: Repealing Big Government
Before the Coming Fiscal Collapse, Regnery Publishing Inc., p. 60

[4] Bernanke, Ben S. 2006a. Speech to the Independent Community
Bankers of America National

Convention and Techworld, Las Vegas, Nevada, March 8. Available at:

http://www.federalreserve.gov/BoardDocs/Speeches/2006/20060308/default.htm

[5] http://www.nola.com/news/gulf-oil-spill/index.ssf/2010/05/federal_inspections_on_oil_rig.html

[6] http://www.nola.com/news/gulf-oil-spill/index.ssf/2010/06/bp_says_mms_never_enforced_blo.html

[7] According to my sources, it is apparently common for company
officials in many industries to fill out forms that are meant to be filled out
by regulators.

[8] http://www.nola.com/news/gulf-oil-spill/index.ssf/2010/05/gulf_region_minerals_managemen.html

[9] http://scottgsherman.com/investigations/onenron.php

[10] http://mises.org/daily/1773

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Mark Thornton is a senior resident fellow at the Ludwig von Mises Institute
in Auburn, Alabama, and is the book review editor for the Quarterly Journal
of Austrian Economics. He is the author of The Economics of Prohibition,
coauthor of Tariffs,
Blockades, and Inflation: The Economics of the Civil War, and the editor
of The Quotable Mises, The Bastiat Collection, and An Essay
on Economic Theory. Send him mail.

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