Monday, January 2, 2012

Three kinds of regulation

I am often asked, "doesn't the financial crisis mean we need more regulation?" It's one of those maddening questions, because the answer is "that's the wrong question," which gets you nowhere.

For regulation is not "more" or "less," something you just pour into a cup until you've had enough like a good beer. Regulation is most of all "smart" or "dumb." Dumb regulations produce the opposite of their intended effects, have all sorts of unintended consequences, or get used for fully intended but pernicious consequences like driving out competition. Smart regulations don't.

The main lesson of the financial crisis is not that we did not have "enough" regulations -- we had hundreds of thousands of pages of regulation.  The lesson of the financial crisis is that most of those were "dumb" regulations. Their massive unintended consequences led to a fragile financial structure. Yes, we need financial regulation, but "smarter," not necessarily "more."

This observation is commonplace, but there is a second dimension of regulation on my mind as I think about Dodd-Frank and where we're headed. Let us call it "law, rules, or discretion."

"Regulation" can be enshrined in law. It is a law in the state of Illinois that you can't go over the posted speed limit.  The limit may be too high or too low, but you know exactly where it is, and you have clearly defined rights. The cop has to measure a speed and you can defend yourself in court. The law is passed by legislators who must be reelected, so there is a mechanism, albeit imperfect, to fix it.

Often, the details of a regulation are too complex to sensibly be enshrined in law, so Congress delegates rule-writing authority. The FAA writes the regulations governing air safety. Those regulations may be maddening, overly complex, stifling of innovation, but they are at least clear rules: Do x y and z and you get your pilot's license. You can appeal the FAA's decisions by reference to written rules. And there is an open rule-making and fixing mechanism, more effective in this case than acts of Congress.

And then there is discretion. Congress empowers "czars" who can do as they see fit, and tell businesses after the fact how to operate. They issue thousands and thousands of pages of rules, but the rules are often vague, impossible to satisfy, and serve to limitlessly expand rather than limit the discretionary power of the regulator.

This is really the basic problem with the Dodd-Frank approach to financial regulation. The Financial Stability Council can simply "determine" you pose a "systemic risk," and that's it. (Yes, there is an appeal process, but without an objective standard, it's hard to see how anyone will beat a "determination.") The Fed can then tell you how to run your business, in any way that it deems appropriate. Imagine what chaos would result if "speeding" were defined simply by the cop's authority to "determine" that your speed poses a "risk to the traffic system."

We pride ourselves that we are a society based on the rule of law. Well, if not law, at least rules, clearly and publicly written, with limits on government power and right of recourse. We abandoned the model that an unelected aristocracy would direct our affairs as they saw fit.

The aristocratic temptation is understandable. If you can't define "systemic risk" it's tempting to just put a Wise Regulator in charge who will know it when he or she sees it. But we became a society of laws not based on whim or philosophy, but on hard experience with the discretion of even the most benevolent aristocrats. An experience we seem, alas, destined to suffer again.