Financial regulators and the free market

Apr 28, 2012·Alasdair Macleod

Adam Smith’s great insight was that in a commercial transaction both parties benefit. Before his time, it was generally believed that in an exchange of goods, one party usually gained what the other lost.

The mistake was to misunderstand value: it is different to different people. A seller places greater value in the money than the product he sells for it, and the buyer places a greater value on the product than its cost, otherwise the deal would not happen.

Lovers of regulation do not seem to understand Adam Smith’s perception of enlightened self-interest. They believe unprincipled capitalists steal the widow’s mite. The prevalence of regulation, particularly in Europe, where everything must be regulated, is in this sense a complete denial of all economic progress since the days of mercantilism.

Regulation often defeats its objectives, a point which was made clear to me many years ago. I met the managing director of a spread-betting business at the time when there was a debate about whether or not spread-betting should be regulated as an investment activity. He welcomed regulation, because it would give his business added credibility, despite by definition being gambling. He was right: that is why everyone in the financial services business dealing with the public wants regulation. It enhances their credibility.

Unregulated, a business’s reputation is its most valuable asset. A regulated business does not have the same problem, so long as it obeys the regulations. Regulations replace the overriding need for a business to protect its reputation, and it is no longer solely concerned for its customers: the rule book has precedence. And the more regulation replaces reputation, the less important customers become. Nowhere is this more obvious than in financial services.

Back in the Eighties when single capacity was scrapped in London, and securities businesses were allowed to act as both brokers and market-makers, the conflict of interest was meant to be resolved by the interposition of a Chinese wall. We hardly ever hear the term nowadays, but this sham separation of broking from market-making demotes customers’ interests. Predictably, they have become cannon-fodder for the trading book, where the real profitability lies. And then there is the egregious example of MF Global, which it appears, has been permitted by the regulator to gamble and lose its customers segregated money.

The regulators assume the public are innocents in need of protection. They have set themselves up to be gamed by all manner of businesses intent on using and adapting the rules for their own benefits at the expense of their customers. These businesses lobby to change the rules over time to their own advantage and hide behind regulatory respectability, as clients of both MF Global and Bernie Madoff have found to their cost.

Where is the protection? Adam Smith must be turning in his grave.

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