What self-regulation remains in the finance industry could soon come to an end with a U.S. government overhaul of the rules. But let’s hope not. Self-regulation often works better than lawmakers’ dictums. And it doesn’t cost taxpayers a dime.
Self-regulation sounds nice, you might say, but what incentive do greedy businesses have to create rules controlling their own behavior?
Plenty, actually. Even the most unethical and avaricious actors often benefit from regulating themselves. History’s most notorious criminals–early 18th-century Caribbean pirates–relied entirely on self-regulation for their business–and they were violent thieves. The reason for this is simple: Privately created regulations often enhance productivity rather than stifling it, and tend to be good for the bottom line.
To maximize profits, pirates, for example, required rules and regulations to constrain their criminal inclinations among one another. They needed to prevent violence among one another, prohibit inter-pirate theft, and regulate activities–such as gambling, drinking and fraternizing with the fairer sex–that were likely to instigate conflicts. Pirates couldn’t rely on government to create such rules and regulations for them; they were outlaws and therefore had to regulate themselves.
The system of self-regulation pirates devised for this purpose was impressive. Besides regulating the activities mentioned above, pirates regulated smoking and collective decision making, and even provided social insurance for injured sailors. Not too shabby for a pack of sea scoundrels.
Pirates’ self-regulation worked surprisingly well. Through it, pirates managed to secure “honor among thieves.” It worked because pirates–rather than somebody else–created the rules. Pirates had “local knowledge” of their particular circumstances and how various rules were likely to affect life aboard their ships.
They knew, for example, that prohibiting smoking in the hold was important because the crew stored its gunpowder there, and that an accident could send the whole lot of sea scoundrels (prematurely) to hell. By the same token, they knew that prohibiting smoking altogether would lead to cranky pirates and cost the crew more than it was worth. Armed with local knowledge and blunderbusses, pirates created productivity-enhancing regulations and, just as importantly, avoided those that were counterproductive.
Legitimate modern firms also have more local knowledge about what kinds of regulations they require, and what kinds of regulations are unnecessary and might stifle productivity, than outsiders do. But government often ignores this fact and acts as if bureaucrats have better information about what firms need than the firms themselves do.
When this happens, regulations may not only fail to have the desired effect, they may also backfire and have exactly the opposite effect. That’s what the Americans with Disabilities Act did when government introduced it in 1990: In an effort to boost employment for Americans with disabilities, the federal regulation forbade employers from firing an employee because he or she had a disability.
As a 2001 study by MIT economists Daron Acemoglu and Joshua Angrist showed, by making it harder to fire a disabled worker for reasons totally unrelated to his or her disability, the ADA caused employers to hire fewer workers with disabilities, reducing, rather than increasing, disabled Americans’ employment.
Self-regulation is far from perfect. Private-sector decision makers make mistakes–sometimes big ones. But so do public-sector decision makers. The former, at least, have strong incentives to get regulations right and avoid regulatory backfires: Regulatory mistakes hurt the bottom line.
Public-sector decision makers, on the other hand, don’t have such strong incentives to avoid mistakes. Unlike their private-sector counterparts, public-sector decision makers don’t pay for regulatory oversights or backfires through reduced profits. Thus, in addition to having a weaker ability to get regulations right because of a lack of local knowledge, public-sector decision makers have a weaker interest to do so as well.
When it comes to regulatory regimes, it’s better to follow the example set by pirates than it is to follow the advice of politicians. As a friend of mine who advocates more government regulation recently said to me, “Expecting greedy businesses to regulate their business is like expecting thieves to regulate their theft.” Exactly.
Peter T. Leeson is a visiting professor of economics at the Becker Center on Chicago Price Theory at the University of Chicago and author of The Invisible Hook: The Hidden Economics of Pirates.