‘Caveat Emptor’ no help to investors

In the wake of the 2008 financial crisis, the conventional wisdom is that financial markets need to be more tightly regulated. That is certainly true, but the problem is as much about who is doing the regulating as it is about the regulations themselves.

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act represents America’s biggest financial regulatory reform since the Great Depression, but its success will ultimately depend on having competent and honest regulators who cannot be compromised by lucrative employment opportunities dangled by the regulated.

The dominant global financial players’ failure to rein in their greed set the stage for the last economic crisis, and it was hardly the first time; under-regulated markets went on a murderous rampage.

Common-sense regulation ensures that a buyer can be confident that the item being purchased possesses all the advantages the seller claims, and that any disadvantages are clearly identified. This allows the buyer to make a rational decision about whether the item is actually worth the price. Many libertarians assume sellers will always inform the buyer of pertinent factual information because the seller knows that economic success ultimately depends on a reputation among potential buyers.

At the other extreme is the idea that sellers are inherently Times Square shell-game scammers who can’t be trusted to provide clear, honest, information about their products’ advantages and disadvantages, so  the buyer must accept sole responsibility for obtaining all necessary information about whatever products he or she may purchase. This is the spirit behind the popular Latin phrase: “caveat emptor,” or “let the buyer beware.” Responsibility for regulating private firms rests with government agencies staffed by highly qualified managers and analysts who regard “public service” as the noblest of callings and their surest path to heaven. ┬ĚThere are at least two real-world problems with this concept.

The first is that it depends on a large supply of trust fund babies to staff these government agencies free to devote their professional lives to “public service.” Sadly, the supply is nowhere near sufficient. Most of the intelligent and well-educated people they require emerge from graduate school burdened by crushing student loan debt that forces them to opt for the most lucrative job they can find.

The second problem flows naturally from the first. Many gifted, well-educated, young people see government regulatory agency job as stepping stones to lucrative private sector careers. They can develop useful contacts with key players with the firms they are supposed to regulate and impress the contacts that their “hearts are in the right place” as far as the regulated firm is concerned.

So it’s scarcely a surprise that there’s a parade of people marching back and forth between lavish private sector executive suites and the basic steel-desk offices of agencies like the Securities and Exchange Commission.

If we want federal regulatory agencies that prevent financial debacles, we have to end close the revolving door.

To make that work, we will need to address the economic concerns of gifted but highly indebted people. We could pay them much higher salaries for government jobs or subsidize their student loan burdens in return for their committing to careers in public service. Perhaps we could make up some of the difference with generous pensions, health benefits, and perhaps even offer them college scholarship for their children.

It’s awfully hard to be serious about regarding financial markets when you need a program to tell the regulators from the regulated.

originally published: August 31, 2013

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