Why Most Market Regulation is Useless And/Or Harmful

Last Updated Aug 7, 2009 1:31 AM EDT

Justin, I think your half-way position represents conventional wisdom on financial regulation: we should do more, but no specific solution is obvious. You are setting yourself up to serve evil! As George Will writes, most regulation is championed by a confluence of Baptists and bootleggers, the first group with high motives, usually naïve, and the second more cynical group who hide behind them.

Regulatory efforts fall into three categories. The first is exemplified by things like short-sale downtick prohibitions, Glass-Steagall, and mortgage disclosure requirements, all of which are really irrelevant to protecting the retail investor. They create a lot of paperwork, but they don't do much, since profiteers quickly find ways to work around them. Think about all the current focus on High Frequency Trading. The idea that someone would be making a lot of money doing things most people do not understand is infuriating to many. But the reality is, computer trading of pennies should be of no concern to legislators interested in helping retail investors, whose long time horizons should make such activity completely irrelevant.

A second type of financial regulation is downright counterproductive, because it sows the seeds for future problems. Consider the Equal Credit Opportunity Act of 1974, a law which sat around not causing problems, until 1992 when Fed President Richard Syron realized he could use it as a club to get banks to lower home loan underwriting standards in the 1990s. As a reward for his efforts, Syron was made CEO of Fannie Mae, and he raked in $38 million before it failed. Another example is the Clinton administration law putting a surtax on millionaires, which created an incentive to focus on option-based compensation for corporate executives. That, in turn, fueled the excess focus on stock price that lead us right into the internet bubble.

Finally, there are a few regulations that are good. The portion of Sarbanes-Oxley separating the income of stock analysts from those doing corporate banking (equity issuance), spurred by the blatant conflicts of interest of the internet bubble, is a good thing. The rule against front running by brokers and specialists is a good thing (though poorly enforced). And laws against insider trading are good things.

Without regulation, markets correct themselves
Many people fear that if we don't do something, the market will stagnate like in the 1930s, even though many of us are now learning that do-gooder legislation had a lot of influence on why things stayed depressed for so long back then. In the bad old days prior to much financial regulation, or even a central bank, we had crises every twenty years: in 1819, 1838, 1857, 1873, 1893, and 1907. After a couple of years, though, things always got better, and growth was strong over this period. It is historical experience, not religious faith, that leads libertarians like me to believe that a free market actually creates the most wealth when left alone. But one needs a longer perspective to appreciate this, a virtue seldom associated with regulators.

Businesses lobby for regulation to stifle competition
Much regulation is really about preventing competition, under the guise of protecting a consumer from some wily salesman, so it becomes a sanctuary for scalawags. Because of regulation, Wal-Mart can't offer most simple banking services, and your insurance company cannot offer complementary services like investing in a money market account, a tax trust, or a CD, even though these are all services that fall under a similar silo of competence.

From an investment standpoint, I think avoiding risky investments is win-win for investors, in that it is best for the individual and for society. This means not investing in high volatility stocks, junk bonds, equity options, and the like. For the 95 percent of investors who have no conceivable investing alpha, the best strategy is to avoid costs from overtrading, and avoid risk by diversifying. As I argue in my book Finding Alpha, the market is inefficient to the extent investors emphasize risky investments too much, with the result that higher risk assets in most asset classes -- equities, bonds, currencies, and futures -- do not generate higher returns as compensation for their extra risk. Instead, they offer lower return and higher risk. Like most virtues, prudent investing is easy to understand but hard to do, since many people want to use their savings to get rich and not just save, believing they deserve to become rich via their risk-taking.

Bold regulation is the triumph of hope over experience, blindly holding on to the idea that markets are inefficient. Justin, your idea that someone in Washington, D.C. can help millions of investors by making it illegal to do what they want is fanciful, and we need less such irrational exuberance, not more.

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  • Eric Falkenstein

    Eric Falkenstein is an investment adviser for CapRock Advisers in Minneapolis. He blogs about economics and finance at falkenblog.blogspot.com. He is the author of Finding Alpha, published by Wiley Finance.