On the Free Market and Regulation

In the past couple of weeks, I’ve heard various folks express opposing views on whether the free market theory remains valid in light of recent events, or on whether the U.S. has “too much” or “too little” regulation.

I think those folks may be getting hung up by such polarized views.

One of the problems we have painfully observed with free market theory recently is that it is a theory that depends on certain assumptions to be true – including those of rational behavior and efficient use of available information.  Reality contradicts those assumptions.

I know some free-market supporters are livid with the über-bailout, frustrated with government intervention in the market, when theory suggests that it is far more efficient to let the market correct itself, unaided.

I have to admit that position has a certain appeal to me…but it’s a good position to adopt only if participants in the market act rationally – making informed choices, governed by information rather than emotion – and with a goal towards maximizing profit.  Sadly, the markets are somewhat irrational, enough dumb investors exist, and fear and anxiety can flavor market movement as much as hard information, at least in the short term.

I would like to submit that given those imperfections in the market, a case can be made for government to be involved, at least to the extent of maintaining a level playing field, making the market, and in extreme cases, cooling the fires of excessively irrational behavior.

That position makes the fed’s über-bailout far more palatable to me.  Yes, there are issues with generating potentially $700 billion in new federal debt.  It may be that the bailout will only postpone an inevitable “rationalizing” of the market from the excesses of an “irrationally exuberant” recent past.  But a managed soft-landing seems wiser than a hard, panicked crash.

I realize that some folks, looking for someone or something to blame for the current troubles, have been making statements such as “this is what happens when we deregulate”, which usually meets a rebuttal along the lines of “the last thing we need is for our economy to be bogged down further with the burden of additional regulation”.

Perhaps rather than thinking of the need for more or less regulation, we ought to be asking if we have the right sort of regulation? 

It’s a little difficult to believe that I’m not arguing for “as little regulation as possible”.  After all, in my day job, I get to “enjoy” the miracle of regulation for several of the products I support.   For example, I’ve spent almost a year working on a new program.  I’ve been involved with about 700 filings as we seek regulatory approval from state insurance departments countrywide.  Considering the amount of time I’ve spent answering the same questions over-and-over, and the tweaks we’ve had to make to forms because a regulator didn’t like the phrasing in a particular form… well, is it any wonder that I cringe whenever the word "regulation" is uttered?

We have plenty of regulation in the business world.  Much of it is cumbersome, slow, and somewhat antiquated.

However, given some of the excesses that we have seen at AIG and various other financial services institutions…well, it’s hard not to wonder why there wasn’t a regulator looking over someone’s shoulder, ready to rein in corporate management when it started deluding itself?

I’m coming to realize  that the answer isn’t "more" or "less regulation".  Instead, perhaps thought should be given to ensuring that regulation act with an eye towards maintaining the level playing field.  Regulatory bodies should be nimble enough and have the skill sets to oversee effectively and adapt to changing conditions…but they should also step out of the way of activities that aren’t particularly material to the levelness of that playing field.

Could you imagine how different the business world might look today, if a regulator had asked questions and set guidelines governing AIG’s involvement with credit default swaps, rather than having so much effort expended on arguing over minor rate changes, or the punctuation of policy forms?