Arnold Kling on Regulation

Arnold Kling has a new piece up on EconLib in which he discusses banking regulation and regulation in general. Since regulation is an oft-discussed topic on this blog, I thought I'd share a short synopsis of the article. Of course, the whole thing is certainly worth reading.

Kling's article centers around the idea that regulators face an information problem known as the "socialist calculation problem." No, he's not saying all regulators are socialists. Kling writes: "As Ludwig von Mises and Friedrich Hayek pointed out during the socialist calculation debate, central planners lack the information that is produced by markets. By over-riding market prices and substituting their own judgment, regulators incur the same loss of information." Since prices communicate information about the relative scarcities and demands for resources throughout the economy, ignoring or supplanting them can have serious negative consequences.


Kling discusses this problem in the context of the 1996 Basel Accords banking regulations and their contribution to the 2008 financial crisis. Of course, his overall point fits many other contexts. For instance, a given environmental regulation on ag production designed to deal with a "market failure" problem might be too stringent such that the costs of reduced efficiency in food production outweigh the environmental benefits.

A subsidy or tax on a certain market activity designed to reduce (increase) the effect of a negative (positive) externality may preclude the invention of or necessary investment in some other technique that might provide an even greater windfall to society. There's no way to know for sure because valuations of these externalities must necessarily be arbitrary. That is, they are not arrived at by the interplay of actors in a market but calculated by regulators who are subject to political incentives, not the incentives found in the profit and loss system.

Kling concludes that there is a better alternative to centralized regulation.

If we turn away from centralized regulation, it does not mean that we must fall back on some sort of brutal system in which unregulated individuals and organizations exploit weaker individuals with impunity. Instead, a competitive regulatory system can emerge. For example, instead of requiring a single regulator's approval for all medical drugs and devices, we could allow for competing agencies to certify the safety and effectiveness of treatments. Individual consumers could then make choices of remedies based on the certifications those remedies have received from these competing agencies. [This brings to mind another issue. If people in society are only offered one option in certification of a given service or good and are told that government regulators are very unlikely to make mistakes, they will be less likely to investigate for themselves the risk associated with said service or good. Allowing decentralized certification would incentivize market participants to more carefully assess not only providers of goods and services but also the quality of the provider of the certification. - L.R.]

In considering regulatory policy, we need to be more aware of the socialist calculation problem. Friedman and Kraus make a convincing case that the dangerous boom in mortgage-backed securities and house prices was exacerbated rather than mitigated by centralized regulations enacted with the intention of reducing bank risk. Once we recognize that regulators can be fallible, we will be inclined to look for alternatives to centralized regulation.

 If Kling is correct that the socialist calculation problem plagues regulators, it is critical that voters and society in general to be educated in sound economic theory.