Regulatory Redux

Story Highlights:

• Inevitably after markets fall and the economy shrinks, politicians scramble to "prevent" the next crisis. Though we can ease the business cycle, we can never fully tame it—and shouldn't want to anyway.
• Though some initiatives will be ill-conceived, not all regulation must be bad. The most radical plans won't likely pass muster and the better ideas could make markets more transparent and efficient down the line.

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Can you feel it in the air? ‘Tis the season of the summer sequel—that magical time of year when we celebrate special effects. (We're on pins and needles for the latest Terminator flick.) And guess what? History shows Hollywood's not alone. Economic downturns breed the regulatory redux as surely as summer spawns sequels. Inevitably, after markets fall and the economy shrinks, politicians scramble to "prevent" the next crisis.

Unfortunately, capitalism doesn't work that way. You can ease the business cycle but never fully tame it—and . With risk and return linked, milquetoast policy results in a milquetoast economy. And anyway, if we succeeded in curtailing competition here, we'd be at a distinct disadvantage globally. The whole world is hungrily competing these days, and that's what drives wealth creation and development.

Nonetheless, as blockbuster regulation proposals hit the headlines, investors should be discerning. Some will be ill-conceived, overcomplicated, redundant, or downright ridiculous. Think Jurassic Park II. But regulation isn't always bad—there will be some useful initiatives in there too. More along the lines of The Godfather II perhaps. Unfortunately, you probably won't see much by way of prequels—the feds notoriously add, tinker, and adjust, but very rarely go back to basics and work ground up.

How to know the difference? Check the intentions. Does the proposal bolster property rights or increase transparency? Then the market impact will likely be positive. We're already seeing moves to (contracts deriving their value from underlying assets, notably credit default swaps and the like) by way of central clearing houses. That's potentially a good thing. It'll make information public and markets more efficient. Or another idea on the table: Let's have systemically significant institutions that would kick in should their demise threaten markets. That might work too—it'd allow big, complex financial institutions time to wind down in an orderly manner, without risking taxpayer dollars. But, as always, the devil is in the details and good ideas in theory are a dime a dozen. So it's always imperative to see these things in action.

What about the bad? Does a measure assert undue control over free markets? Limit private property rights? Restrict prices? Covertly boost business costs? Dislocate wealth or artificially direct capital to places it wouldn't otherwise flow? That's usually the bad kind—and it's often emotionally targeted to punish a certain group or sector. Limiting executive pay in financial companies is a great example. Whether you agree with high pay packages or not, artificially depressing the price of labor—especially in a labor-intensive enterprise like finance—will only encourage talent to spend time and energy dodging the rules. Maybe that means going to other industries, maybe other countries. Free people vote with their feet, and a regulation-induced human capital drain is bad for industries and the economy as a whole.

This summer's regulation redux will likely yield gems and duds. But much of the most radical regulation likely won't pass muster. Extreme initiatives can be just as politically detrimental as no initiatives at all—they tend to alienate too much of the electorate. Notice how quickly that 90% tax on bonuses was tabled in the Senate? Alternatively, some of the good stuff may help down the line—we're all for increased transparency and more stable property rights. And beating the heat with a pleasantly surprising sequel in a wintry theater? That's okay with us too.