Monday, October 6, 2008

Government Failure: The Case of Wasteful Regulation

This is the first in a series of posts titled "Government Failure." The series will serve as a reminder that, even though markets sometimes fail, governments may fail much more frequently and intensely, and therefore should be called into action parsimoniously and in a thoughtful manner.

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Brazil, a country that I know well, is a regulatory nightmare. Red tape is everywhere. It has for example an extremely expensive system of multitiered accounting tribunals that are supposed to avoid misuse of public resources by government offices and corporations. Nonetheless, the country is riddled with government mismanagement and waste of public resources.

A parallel can be drawn with the mortgage industry in the US, one of the most regulated in the country. Yet, many now say that the industry failure was a result of lack of regulation and that the solution is even more regulation. Maybe they should take a look at the experience of overregulated countries like Brazil before jumping to conclusions.

A careful consideration of the reasons behind this financial crisis indicates that bad regulation and excessive government interference were the main culprits. The current regulatory framework should be replaced with a more efficient and less costly system that respects economic incentives and don't try to overachieve.

An example of the problems within the current framework is given in this interview with Warren Buffett (HT Cowen):

QUICK: If you imagine where things will go with Fannie and Freddie, and you think about the regulators, where were the regulators for what was happening, and can something like this be prevented from happening again?

Mr. BUFFETT: Well, it's really an incredible case study in regulation because something called OFHEO was set up in 1992 by Congress, and the sole job of OFHEO was to watch over Fannie and Freddie, someone to watch over them. And they were there to evaluate the soundness and the accounting and all of that. Two companies were all they had to regulate. OFHEO has over 200 employees now. They have a budget now that's $65 million a year, and all they have to do is look at two companies. I mean, you know, I look at more than two companies.

QUICK: Mm-hmm.

Mr. BUFFETT: And they sat there, made reports to the Congress, you can get them on the Internet, every year. And, in fact, they reported to Sarbanes and Oxley every year. And they went--wrote 100 page reports, and they said, 'We've looked at these people and their standards are fine and their directors are fine and everything was fine.' And then all of a sudden you had two of the greatest accounting misstatements in history. You had all kinds of management malfeasance, and it all came out. And, of course, the classic thing was that after it all came out, OFHEO wrote a 350--340 page report examining what went wrong, and they blamed the management, they blamed the directors, they blamed the audit committee. They didn't have a word in there about themselves, and they're the ones that 200 people were going to work every day with just two companies to think about. It just shows the problems of regulation.

QUICK: That sounds like an argument against regulation, though. Is that what you're saying?

Mr. BUFFETT: It's an argument explaining--it's an argument that managing complex financial institutions where the management wants to deceive you can be very, very difficult.

Change the names of people and offices in this story and it could easily have taken place in an overregulated economy of a less developed country.

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