Regulation and innovation

When all hell broke loose in the financial system three years ago, the federal government assured us that it was working hard on a set of new regulations that would deal, once and for all, with the problem of greed on Wall Street. The presupposition for such lofty promises is that greed is not a part of our fallen human nature but a product of controllable material forces.

Unfortunately, believing that we can reform the heart of man through legislation can only inspire bloody utopias. The best we can hope for is to promote an institutional framework that civilizes greed and channels our material aspirations in a socially beneficial way.

Reading a bit of Friedrich Hayek could help our regulators understand why their good intentions are misguided. Most of the efforts of Congress to overhaul the financial system last year may have been wasted or worse-they could turn out to be counterproductive, creating the perception that anything not explicitly prohibited by the letter of the law is right.

But there is a much more fundamental reason why we should not put too much trust in regulations: They can only try to "fix" known problems, i.e., the ones created during a previous economic meltdown. Does anyone really believe that the next recession will evolve in the same way as the last financial crisis?

Whatever regulations we design today, they will inevitably prove to be inadequate. Entrepreneurial people will always look for and find profitable ways to avoid the costs of the existing restrictions. In a way they are like the naughty teenagers who, when threatened with punishment for using the word "rape," replaced the banned verb with "grape." This forces the regulator to pile rules upon rules, never able to predict the next innovations and prevent their negative consequences. Backward-looking government officials are doomed to play catch-up with forward-looking private entrepreneurs. Asking the government to save us from ourselves means giving it ever-increasing powers, thus making the most arbitrary rule legal.

As Hayek wrote in The Road to Serfdom: ". . . and in this way a democracy may set up the most complete despotism imaginable."