I happen to be in that rare minority that believes that self-interest is the best and most effective regulator. Adam Smith pointed out to the world that an "invisible hand" called the market tends to promote both competition and market order. Market forces act quicker and more forcefully than bureaucrat’s to resolve problems, discipline investors, and punish consumer mistakes.


The proponents of increased regulation argue that this is a tried and failed philosophy and point to the housing boom and the recent financial crisis as proof of this. To them it was deregulation that caused the crisis. This “proof” however is complete nonsense, since we’ve never had anything close to Adam Smith's vision of laissez faire capitalism. In fact, during the years leading up to the financial crises of 2007-8, free market economic principles were violated repeatedly through government intervention and the lack of enforcing rules and laws against fraud essential to free market capitalism. The following are some of the real causes of the crisis.


  • The Community Reinvestment Act
  • Subsidization of Fannie and Freddie
  • Lax and fraudulent credit agency ratings 
  • SEC removal of leverage requirements 
  • The government mandating a ‘mark to market’ rule in the middle of a market meltdown
  • Elimination of the Uptick Rule which encouraged even greater short-selling
  • Loan applicant fraud
  • Loan officer fraud
  • Mortgage Broker fraud
  • Appraiser fraud
  • Lack of counter party risk, fraudulent securitization, no recourse to banks
  • No “skin in the game” for lenders

For a full discussion of the cause of the crisis click here. 


Since the financial crisis ended, almost all of the above violations have ended. The end came not due to government regulation, but through market discipline. For example, the total cessation of purchases of sub-prime mortgage debt occurred virtually overnight without one regulation being imposed. The market immediately dealt with the bad debt once it was exposed. Four years after the crisis ended, regulators are still trying to figure out how to word new regulations to deal with a now non-existent problem.


The few remaining causes of the crisis that still exist today only still remain because of government protection – the subsidization of Fanny and Freddie being the most conspicuous. If allowed to, the market would have disciplined and eliminated these two lenders long ago.


We don’t need more regulation, we need more deregulation. Rational deregulation would ensure greater market regulation and discipline. Yet deregulation is being blamed as the greatest cause of the past crisis. This is absurd. No one I know is calling for ending reasonable regulations that provide rules and standards necessary to protect society. Stop signs at intersections to prevent auto accidents are one thing; but a 2,000 page government document creating hundreds of new regulations that even the regulators can’t figure out is quite another thing.


If you really think about it, regulations are rules, and the human mind can only absorb, understand, and follow so many rules. Yet the government has passed thousands of rules and continues to pass more each year. The IRS code fills volumes of regulations which even the best accountants admit they can’t understand. No one can! And remember, regulators are bureaucrats, not policemen. They cannot enforce laws that prevent the Bernie Madoff’s from concealing fraud. Fraud is concealment, and it would take an investigator to uncover it, not a regulator.


The amount of new regulation has not only increased for financial institutions, it has also increased for small businesses at a huge cost to them and with dubious merit. They have stymied business throughout the country. Regulators and those that legislate and write the regulations are, for the most part, individuals who have never run a business. Yet they are hired by the government to tell professional businessmen how to run their businesses. This is why regulations and regulators usually do more harm than good. When you put amateurs in charge of professionals, you get what you deserve. Regulators are not only counterproductive but are almost always ineffective. I give you the SEC as a splendid example.


The insurance industry is the most regulated industry of all yet AIG committed fraud right under the regulator’s noses. Jamie Diamond, head of JPMorgan, told Congress that no less than a hundred regulators were in his offices when his bank lost over two billion dollars. Not one of them caught the trade. WorldCom and Enron both went bankrupt due to fraud and they were public companies traded openly on the New York Stock Exchange required to provide totally transparent audits to both regulators and shareholders. And let’s not forget that Bernie Madoff was audited by regulators quarterly for over a decade--yet regulators never caught on to his scam. The overwhelming evidence of history suggests that regulation in general is ineffective.


In Adam Smith's theoretical world there would be laws against the initiation of force, and against the use of fraud and coercion. Laws would be few, simple, and understandable. Yet Adam Smith would be the first to tell you that such laws will not end crime or prevent mistakes. Regulation will never prevent fraud or prevent financial crises. Neither will free markets. We live in an uncertain world where errors and crimes are committed and always will be. Those who argue that regulations will prevent errors of judgment or criminal acts, let alone crises, ignore both history and human nature.


I believe that the enforcement of laws against fraud and the simple rule, “buyer beware,” are just as effective as all the regulations regulators have ever created. Just as many people have been injured by regulations and regulatory incompetence as by individual fraud and ignorance – probably more. Regulation is no panacea. In fact the constant increase of regulation on American business is probably the number one cause of high unemployment and economic stagnation today.


Far more emphasis needs to be placed on ways to insure against the inevitable mistakes and crimes that accompany life in general. When government takes over the responsibility of protecting people from the mistakes of life, individuals lose their incentive to beware and diligent. Obviously government must provide laws and courts; and states should provide police to protect life and property. But that is all.


Today, regulation is being proposed on almost every front. Every aspect of economic activity is being tampered with in one way or another. (See my article “The Nanny State”.) Recently, a movement to bust up the banks has been gaining popularity. Almost all would agree with the proposition that a company too big to fail is too big to exist. But what is the remedy to the problem of our largest financial institutions being too big to fail today?


Adam Smith had the answer: let self-interest regulate the banks. Our problem today is that self-interest has been removed from banking operations. If there was a rule that simply stated that banks could not invest and/or trade securities with other people’s money; that all trading must be with the owners of the banks and their partners money, the kind of trading and leverage used would virtually disappear overnight. It is one thing to risk other people’s money and possibly lose it. It is quite another thing to bet your own money with no safety net. The profit motive is far more persuasive in achieving prudent banking practices than any regulator ever will be.


Self-interest is one of the most powerful motivators in the world. And self-interest is one of the best regulators in the world. The fact that we don't use it more is our worst mistake. Bank rules that required banks to hold a portion of the equity that they loan worked for years to regulate the quality of loans before the government removed that requirement. There is nothing wrong with having simple rules and standards in a society but fewer and simpler regulations based on self-interest and the profit motive is what is needed in this country -- not the attacks on self-interest and the profit motive that we hear so much of today.

Paul Nathan
August 11, 2012

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