Regulation, Part I: Two Views of Regulation

There are two ways to look at regulation. One, you can set up a system to police itself, so that the institutions of the system operate in a way that optimizes the chance of the desired objective(s) coming to pass. Two, you can hand over the policing of the system (as opposed to the policing of the abuses of the system) to something external — in today's world, usually the State — hoping that the threat of coercion from the outside will force people to act in what are considered appropriate ways, whether or not the system allows people to act in the "appropriate ways."

Any accountant can tell you (or should be able to tell you) that it is far more effective to set up a system that embodies regulation, that is, a system with its own internal checks and balances, than to try and impose them from the outside by increasing the burden of regulation designed and intended to coerce desired results. External regulation may or may not even make sense when considering an organization's mission, the existing institutional environment, or, especially, the dignity of the human persons involved.

For example, it is much better to separate "Payables" and "Receivables" both physically and administratively, making it difficult or impossible for a single individual or group to have control over incompatible functions. This systemic regulation is much more efficient and cost-effective than simply forbidding individuals or groups having control over incompatible functions to do anything wrong. Separation of function makes it more difficult either for honest mistakes to be made, or for actual wrongdoing to take place. Simply forbidding certain acts cannot prevent honest mistakes, and, worse, imposes no structural check or balance to make the forbidden act difficult or impossible without a great deal of effort.

All of this has to do with a fundamental change in how we view regulation. Consistent with the dignity of the human person, regulation should be designed to reinforce the system itself and encourage desired results, not run counter to the whole idea of a system itself and try to force desired results, whether or not the capacity exists to achieve the desired goal. The system itself must be designed to be self-regulating, not have control imposed from the outside. Unfortunately, what we've seen develop in government as well as law and economics is the belief that people must be forced to do whatever people in power want them to do, thereby attaining some bureaucrat's or academic's idea of utopia.

Thanks to the current financial crisis, we see the results of attempting to force people to act in what politicians and academics believe to be desirable ways instead of setting up and maintaining the system so as to allow people to act in desirable ways. The repeal of Glass-Steagall and other regulations in the early 1980s affecting financial institutions removed structural, internal regulation that relied on people acting in most cases to their own advantage, and replaced it with coercive, external regulation that tries to force people to act contrary to their own advantage.

What naturally resulted seems to have surprised virtually everyone: people acted to their own advantage within a system where it was very easy, simply by ignoring external regulations, to gamble and speculate with other people's money, even steal it with impunity, as long as nobody thought to ask the wrong questions. The system, gutted of internal, self-regulation, couldn't — and didn't — send up any signals that would cause people to ask such questions.