The Limits of Rules

From Frederic Sautet at The Austrian Economists,

Bernard Madoff’s alleged $50 billion fraud is another interesting example of the limits of governments to enforce their own rules. …The more rules governments must enforce, the less they will be able to do so adequately. Instead, one should rely on the incentives people have to successfully enforce the arrangements they themselves establish or on the reputation of others to enforce those arrangements. As the WSJ puts it:

The fact is that the only people who seem to have taken concrete action to protect investors from Mr. Madoff are private research shops like Aksia LLC. Its analysts did the real work of figuring out that Mr. Madoff’s claimed investment strategy couldn’t be happening at the volumes he claimed to be trading. Likewise, it was the short sellers who first blew the whistle on Enron, while the SEC was clueless and the firm’s auditors were asleep.

There’s a lesson here for investors and Congress. Instead of shoveling more money and power to the regulators who already had plenty of both, let’s take care not to overregulate the people who actually warned about Mr. Madoff’s miracle returns. Law enforcement is useful in punishing wrongdoers after the fact, which will deter some crooks. But expecting the SEC to prevent a determined and crafty con man from separating investors from their money is no more sensible than putting your life savings with a Bernard Madoff.

Rules aren’t always bad. Rules are often very efficient and sensible, as in much of the criminal law. They can also make sense in some civil situations. Generally, when a rule simplifies things, it’s a good rule. But if the rule–or set of rules–becomes too unweildy or complex, then the rules themselves work counter to their intent.

Richard Epstein makes the point in Simple Rules for a Complex World,

[U]nder the dominant constraint of scarcity, insist that every new legal wrinkle pay its way by some improvement in the allocation of social resources. All too often, today’s law does just the opposite: it makes more complex rules that hamper the productive efficiency of the society they regulate.

The SEC has a lot of rules and a lot of agents and a lot of money to employ both. Madoff was big, in plain sight, and the subject of many complaints. The SEC missed him because they were too focused on all the minutae of complex, inscrutable, profligate regulations. They simply missed the forest for the trees.

Note that the point isn’t that there shouldn’t be any rules, it’s that the rules should be simple, clear, and enforceable. You don’t need new rules to prosecute fraud, you just to attend to the prosecution. This is as true in the Madoff scandal as it is of the collapse credit default swaps. We don’t need more regulation; we need better, simpler and leaner regulation.

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One thought on “The Limits of Rules

  1. Where practical, rules (and guidelines, and laws, etc) should indeed be comprehensible to those of us with “average” intelligence and education.

    Alas, with laws, this is not always practical. With rules, it may be a bit easier. WIth guidelines, it should be the norm – but seldom is.

    In all cases, there should be some leeway. And some measure of thought. I often think, in this connection, of a parolee who was found by police holding a pistol. Being thus in violation of parole, he was automatically arrested when his parole office noticed, and processed to be returned to prison. Until the story appeared in the newspaper: seems while employed as a clerk in a convenience store, he had wrested the gun from a robber and held him at gunpoint for the police. A simple, clear, law – violate parole and go back to serve out your sentence – that should not have been applied but was.

    After public response, “prosecutorial discretion” was finally exercised and the “violation” dropped. But, where was this “discretion” prior to outside influence?

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