Thursday, June 16, 2011

How Deregulation Hurts the Economy

Suppose that gambling were illegal. That restriction would be a governmental regulation. Then suppose that the government legalized gambling. That would be a deregulation.

Gambling can have victims, such as a gambler’s family, when the gambler squanders his earnings on games of chance rather than feed and house his family. Suppose then to avoid the deprivation to family members, the government bailed out gamblers. The government would give losing gamblers back their money, to avoid possible harm to their families.

What would be the result? Obviously there would be a huge amount of gambling. If one wins, one keeps the gains. If the gambler loses, he gets back his losses. The great increase in gambling would generate a huge amount of government spending in bailing out the gamblers who statistically would lose more than half the time.

The resulting huge increase in government spending would either stifle the economy with higher taxes or else generate an ever greater government debt. Either result would hurt the economy.

But which policy caused the damage? Is it the deregulation of legalizing gambling, or is it the subsidy to gambling? Clearly the damage to the economy would be caused by the subsidy. Without a subsidy, gambling could hurt individual families, but not the whole economy. The subsidy to gambling would generate major damage to the whole economy as deficits escalated, raising interest rates, reducing investment and growth, and ultimately resulting in a debt default.

The deregulation of the financial industry is similar to the deregulation of gambling. When speculators bear their own losses, this does not damage the economy as a whole. But when government bails out the losing speculators, that causes “moral hazard,” the taking on of excessive risk because the speculators know the government will share the losses.

Many journalists, politicians, and (sadly) economists have blamed the Crash of 2008 on deregulation. That makes it seem like there are no regulations, that anything goes, in finance. But in fact, there was only a small amount of loosening of restrictions on financial affairs. The Federal Reserve system was still there, regulating the banks. The FDIC was there providing deposit insurance as well as further regulation. The SEC was there regulating stocks and bonds to allegedly protect the public. The Community Reinvestment Act was still in force imposing yet more regulation. The Sarbanes-Oxley Act of 2002 had been enacted several years prior to the crash to regulate accounting. The FHA as well as the government-sponsored enterprises Fannie Mae and Freddie Mac regulated mortgages. State governments regulated insurance companies. Both the state and federal governments prohibited and regulated fraud.

Whatever freedom that banks, brokerage firms, insurance companies, mutual funds, hedge funds, and pension funds had to invest and speculate was not the cause of the “Great Recession” and financial crisis, just as the freedom to gamble does not bring down a whole economy. The cause of the recession and financial break-down was the enormous subsidies to the financial firms and to real estate holding. When AIG, Fannie Mae, banks, and others lost money on their mortgages and land-value derivatives, the federal government gifted them back much of their losses. Some of the funds have been paid back, but still, the fact that government will bail out a speculator makes him speculate too much, causing damage to the many homeowners and investors who do not get bailed out.

The regulation of fraud by the SEC did not prevent billions of dollars of ponzi-scheme fraud, despite warnings. One of the problems of regulation is that the bureaucrats end up serving the regulated industries. Economists call this “regulatory capture.” It is also referred to as a revolving door, as the regulators come from the regulated industry and return to it after having served the “regulated” special interests.

Regulations can either be market-enhancing or market-hampering. Marketizing regulations help make the economy more voluntary by prohibiting theft, and with liability rules making those who cause damage to compensate the victims. Interventionist regulations alter what would otherwise be honest and peaceful human actions. The deregulation of previous interventions is market-enhancing, and promotes prosperity if not linked to subsidy.

Public finance theory emphasizes the deadweight loss of the taxation of labor, capital goods, and funds, but subsidies are an even worse economic problem. Subsidies are pernicious because they have the appearance of helping, but have the implicit reality of being weapons of economic mass destruction.

The greatest subsidies are those least visible. The most vicious of all subsidies is the implicit subsidy to real estate, specifically land value, caused by public works and civic services not paid for by landowners. Governmental goods - streets, parks, transit, security, schooling, welfare aid - makes locations more productive, attractive, or affordable, generating higher rent and land value. The payment for these works by the affected landowners would take land values back down, but today the funding is almost all from taxing labor and capital.

This massive subsidy to land values redistributes wealth from workers to landowners, and even worse, generates speculation in real estate that carries prices beyond what can be afforded by households and enterprise. That makes investment stop, and then the economy falls.

The focus on deregulation is an example of people looking only at the superficial appearance, and not understanding the implicit reality. The main task of economics is indeed to enable people to understand the implicit reality beneath superficial appearances. The sad fact that even many economists are mesmerized by superficial appearance shows that most economists are not doing their most essential job.

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