Monday, June 14, 2010

The Gulf Spill, the Financial Crisis and Government Failure

By Gerald P. O'Driscoll Jr.

The Gulf oil spill and the global financial crisis both demonstrate the failings of big government. Partisan politics obscures the linkage, with the consequence that each political party repeats the mistakes of the other as its turn to govern arrives.

First, consider the oil spill. BP and its contractors are surely responsible for the accident. They may also be responsible for a poor response. The nature and scope of legal culpability is yet to be determined. What is the government's role? Offshore drilling is a dangerous activity with potential undesirable consequences now actualized. For this reason, as we have learned, it is heavily regulated. The agency directly responsible for regulating the activity is the Minerals Management Service (MMS) of the Department of the Interior.

Government regulation is intended to protect the public interest against bad or irresponsible behavior by private parties. In the case of offshore drilling, the federal government has assumed the role of solving a collective action problem. Potentially all Americans benefit from the drilling, but those living in coastal areas suffer disproportionate harm from mishaps. The government theoretically negotiates on their behalf and establishes rules to protect them.

Obviously, regulation failed. By all accounts, MMS operated as a rubber stamp for BP. It is a striking example of regulatory capture: Agencies tasked with protecting the public interest come to identify with the regulated industry and protect its interests against that of the public. The result: Government fails to protect the public. That conclusion is precisely the same for the financial services industry.

Financial services have long been subject to detailed regulation by multiple agencies. In his book on the financial crisis, "Jimmy Stewart is Dead," Boston University Professor Laurence Kotlikoff counts over 115 regulatory agencies for financial services. If more hands in the pot helped, financial services would be in fine shape. Few believe such is the case.

Advocates of heavy regulation promise that risky behavior by banks can be controlled and limited by regulators. There are two major reasons such efforts fail. I have already discussed the first: regulatory capture.

The second source of regulatory failure is the knowledge problem identified by Nobel Laureate Friedrich Hayek. The knowledge required by regulators is dispersed throughout the industry and broader economy. For regulation to work, that dispersed knowledge must be centralized in the regulatory agency. To successfully accomplish this requires central planning of the industry, if not the economy. But the local knowledge of specific circumstances of time and place cannot be aggregated in one mind or agency. We know that is impossible, and that impossibility was the reason for the collapse of the Soviet Empire and the transformation of the Chinese economy.

Regulatory practice represents islands of central planning in otherwise decentralized market economies. If we add back in the problem of regulatory capture, then we get industries coddled and protected by government. When business and politics become intertwined we move from market economies to crony capitalism.

Read the rest here.

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