The Regulatory Pendulum and Electoral Guillotine

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The conventional wisdom is that market regulation goes through booms and busts as the public oscillates through its love-hate relationship with the capitalist ethos. When all is well, high-earning executives are the embodiment of capitalism's well-oiled wealth distribution machine at work. When all is not well, they are the embodiment of the structural deficiencies inherent in a capitalist society that favor those on top. Moving in sympathy with public sentiment, the regulatory pendulum swings from what some consider under-regulation to what others consider over-regulation, blowing past the inevitable resting point, and pausing only at the extremes.


This phenomenon has a simple, albeit unscientific explanation that would surely disappoint Galileo. During booms, deregulation is less contentious since the public is punch-drunk on the boons of capitalism's bounty. And so, during booms, politicians can garner campaign funding from and scratch backs with those that have an interest in deregulation, all without taking much of a public flogging. During busts, regulation is politically advantageous since the public will be eager to blame someone for the economic malaise. Those who benefited the most during the preceding boom make easy targets, and so politicians can earn points with the electorate by appearing outraged at the conduct of under-regulated, overpaid executives. My sources tell me that this is to go on, back and forth, in perpetuity, leaving reason and prudence by the wayside.


Getting What You Want


Some might say that this process is inefficient, since the market swings back and forth from poindexter to cowboy, missing opportunities in the former case and betting the farm in the latter. I agree. However, there's also an argument to be made that this behavior pattern is preference maximizing, at least at the time it occurs. Simply put, during booms, the public is wide-eyed and wants to believe that one day they too will have a CEO haircut and a Learjet. During these times, the public wants to see business at work, unfettered by those pansy leftists who just want to choke the life out of the American Dream. During busts, people are frightened, crave security, stability, and most importantly, someone to blame. The public will quickly abandon its love of well-oiled hairdos and private jets, and demand an accounting for the harm that's been done. In each case, our elected representatives give us want we want at the time, and so we are satisfied at each juncture. If we add in the assumption that people make decisions based on short-term expectations (some modified version of a preference for present consumption), we have a reasonable theory as to why the phenomenon persists.


Given the opportunity to choose a different overall strategy from a neutral perspective,  something akin to Rawls' "viel of ignorance," we would, hopefully, chose a regulatory structure that maximizes our preferences over the long run. But assuming that human decision making is dominated by short term expectations, we will continue to prefer extremes and our representatives will continue to take extreme actions.


And so goes the hapless and headless story of the free world.

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Charles Davi is a capital and derivatives markets lawyer in New York City. He received his J.D. from New York University School of Law and B.A. in Computer Science from Hunter College.

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