Why Transparency is Better Than Regulation

Free markets and capitalism have gotten a bit of a beating lately in the press as they get blamed for the current economic downturn. In response, politicians are calling for increased regulation by the government, ostensibly to better “serve” the general public. Proponents of increased government regulation theorize that a relatively small number of government employees can effectively direct and control the actions of hundreds of millions of individuals better than those individuals can, and that increased prosperity and safety will be the results.

On the spectrum between tyranny (absolute government control) and anarchy (no government control), no wise person would choose to live on either extreme. We’ve seen what is accomplished with tyranny (Hitler, Stalin, Mussolini, Darfur, etc.) as well as with anarchy (Rwanda, Somalia, etc.) and absolute anarchy has a tendency to lead to tyranny in the end and sometimes vice versa and sometimes from one to the other and back again (French monarchy > French revolution > Napoleon). Obviously some regulation is good and necessary, and some individual freedom is good and necessary, and most arguments about regulation/deregulation are not about going to one extreme or the other, but rather a matter of how far we want to lean in one direction or the other while keeping our feet somewhere in the middle.

Proponents of regulation might argue that quite a bit of regulation is necessary to protect the public. This led to the FDA and the CPSC, and is on the brink of leading to new organizations in the financial sector. Perhaps these governmental bodies have served a purpose in making our food, drugs, and products safer, but they’ve also played a role in making life more dangerous. How? For one, by establishing rules that hinder or sometimes outright prevent the development of products that save lives. Government regulation makes it so expensive and time-consuming to develop new drugs that many drugs simply are never developed. But whereas a single inadvertent death from a drug is highly publicized, the news doesn’t report how many lives are lost as a result of drugs that could have been developed but weren’t, and so the FDA is incentivized on restricting the drugs that come to market rather than promoting the development of new drugs.

But this comes right to the point–what is the greatest incentive companies have to produce safe drugs? Is it fear of the regulatory hurdles of the FDA, or fear of the consumer? The FDA merely presents a series of steps to be taken. Companies predict the amount of money to be made off a drug, the cost of compliance with the FDA, and then decide whether the profits outweigh the costs. But the costs are fairly predictable. Far worse is the risk of a consumer lawsuit, which can be unpredictable, and far more costly than FDA compliance. FDA compliance might keep companies from forming in the first place, but the FDA doesn’t put companies out of business like lawsuits can. In other words, consumer lawsuits are a greater deterrent motivating companies to produce safe drugs than the FDA. In fact, the FDA actually protects companies that make bad drugs by giving those companies an excuse. That is, if a drug passes FDA compliance rules and then goes on to kill a number of people, the company can pass the blame to the FDA, since if the drug was dangerous they should have caught it.

Increased financial regulation will, like in the drug industry, serve to stifle the number of financial products being offered. The only products that will be offered will be those from companies so big that they can afford to deal with the onerous regulations. In other words, small, local companies will be forced out of the mix. This is why large companies often call for government regulation–it ends up giving the large companies monopolistic powers that are government-sanctioned and protected. It prevents small, nimble, customer-centric companies from popping up and displacing the large, slow, entrenched companies. In the end, it is not consumers who benefit, but large businesses and politicians who can claim to have protected the consumer.

Government regulation of the financial industry will not make it safer, and may make it more dangerous. Government-sanctioned institutions are thought by the general public to be “safe” and because of the trust between the public and the government, people become irresponsible. In the recent downturn and slew of bank failures we have seen people who lost hundreds of thousands of dollars because their bank accounts were only insured by the FDIC up to $100,000. Why didn’t these people have their money in separate accounts, each with a maximum balance of $100,000? In many cases it was in part because all they knew was that the government protects deposits. They thought the risk of a bank failure was unlikely, and they didn’t bother to research how much insurance there was. Even though for many of us the $100K limit seemed to be common knowledge, for many others it wasn’t. We can argue that these people who have been better off if there were no FDIC and it was up to them to make sure their money was held with a reputable and wise institution that could be trusted to not invest heavily in real estate and thus risk the entire bank. This increase risk would create an incentive for people to be more careful with their money. This would create an incentive for banks to make sure they don’t take unnecessary risks in real estate, and who knows, maybe the real estate bubble never would have happened and we wouldn’t now be in a down economy.

But how could consumers know which banks were safe? This is where transparency comes in. If regulation only went so far as to require certain rules of transparency, then consumers would have the information they need to make good decisions. But what if the information is too complicated? Then other businesses will pop up that distill the information and translate it into something that is understandable. People are willing to pay for that information, especially if it means protecting a $100K bank account from disappearing.

With the Internet transparency is even easier to achieve because information can be disseminated cheaply and easily. We’ve seen instances of companies brought to their knees by stories that proliferated not through the mainstream media, but virally over the Internet from person to person. Companies are afraid of internal whistleblowers, offended consumers, and litigation, more so than of government regulation. As mentioned, that government regulation actually protects companies.

A good example of how private industry can take over the role of government regulation is Consumer Reports. This company provides consumers with a means of easily determining which products are best. Companies have an incentive to make a good product so that it gets a favorable review in Consumer Reports, because products that rate favorably are sold more. And Consumer Reports by no means has a monopoly. These days anyone can set up a blog and review products, and when a product has problems the news spreads like wildfire across the Internet. Bad products are removed from the market because nobody will buy them, and good products succeed. There may be exceptions, but then again the government doesn’t have a perfect record either, and arguably a worse record than the private sector when it comes to exposing bad products.

In my mind, there is no need for the FDA, the CPSC, or any other governmental department to regulate products and services. What is needed are rules for transparency. Certain industries should have to report certain information according to strict guidelines so that consumers can compare apples to apples, and so that a secondary industry of information distillers can pop up and publish the information in ways that provides value to consumers. This would go much farther than government regulation to protect consumers, and would enable smaller companies that currently can’t afford government compliance to create new products that would enhance our lifestyles and perhaps save our lives. And of course we would save the tens of billions of dollars spent on these government departments, and those employees would be free to work in the private sector where they would increase the size of our economy rather than being a drain on it.