Better regulation, not more

Michael Alan Hamlin

Posted on January 22, 2009

The collapse of the subprime mortgage market, triggering the global financial crisis and the collapse of the American investment banking sector; subsequent and related investment scandals, prominent among them the $50 billion Ponzi scheme run by Bernard L. Madoff ; and earlier business scandals beginning with the dramatic collapse of Enron in 2004 have understandably resulted in calls for increased regulation. But those calls are a kneejerk reaction that will likely hobble economic recovery rather than ensure better, more honest business and financial management.

No doubt, regulators were clearly asleep at the wheel for much of the first decade of the 20th century. Enron took advantage of deregulated energy markets meant to lower the cost of electricity with the opposite result – while losing billions of dollars; in fact, close to the amount Madoff lost for his mindlessly trusting investors. Convoluted subprime derivatives sold over and over at escalating commission rates was an exercise in exquisite and irresponsible irrationality.

But it is easy to forget why deregulation should be more attractive to economic managers than it is to business managers. Regulation has typically been used as a tool to limit opportunity and protect established firms at the expense of innovation and price-reducing competition. In the United States, the breakup of AT&T and subsequent liberalization of the telecoms industry, for example, saw an end to decades of reliable but slowly evolving telecommunications services. The competitive environment that resulted provided lower communications costs and new innovations enabling consumers to communicate more easily, cheaply, and frequently.

Liberalization of the telecom sector in the Philippines might have made this country the text capital of the world – a title of dubious and probably worthless financial merit outside the telecom industry – but it also made the Philippines an attractive investment for business process outsourcing (BPO) services providers. According to the Business Processing Association of the Philippines (BPA/P), BPO generated almost $7 billion last year. By 2010, revenues are projected to reach $12 billion, and the industry will account for close to one million high-paying jobs.

BPO is an example of how deregulation works. And it not only works, it works by mistake. When former president Fidel V. Ramos led deregulation of the telecom industry few anticipated that it would set the stage for the explosive growth of the BPO industry.

Innovations in service, better service, more investment, and better-paying jobs are all great reasons to foster deregulated environments, even though there will always be risks. But there are other practical reasons as well. For one, regulated environments don’t offer any guarantee against financial crisis as a result of mismanagement.

While the US derivatives sector is only loosely regulated, that’s not true for investment banking or consumer banking. Madoff was investigated repeatedly by the Securities and Exchange Commission (SEC). In each case, until Madoff himself admitted that he was a sham, the SEC took no action against the now infamous fund manager, typically taking Madoff’s explanations for his mind-bending returns at face value, according to news reports.

Madoff’s case and others don’t demonstrate that deregulated industries and markets are time bombs ticking away. Instead, they demonstrate that better regulation, not more regulation, is required. If SEC investigators had done their jobs properly, Madoff would have been shut down long before he lost $50 billion of his investors’ money.

Legislators and government officials in largely protected markets like the Philippines can cite the subprime and investment debacles as examples that demonstrate why deregulation doesn’t work the way it’s supposed to, and rationalize continued protection of established practices and industries (and by extension, firms). For a developing economy like the Philippines, that’s a dangerous argument to make. Weak institutions virtually ensure that a regulated environment becomes a rich breeding ground for opportunity – only the wrong kind.

Corruption indices compiled by Transparency International and the World Bank show that the Philippines’ clearly serious problem with corruption is growing worse. While corruption involves both the private and public sector, in a liberalized environment, the leverage for corruption is weakened. In a highly regulated and corrupt environment, increasingly limited financial opportunities are monopolized by recognized players. In a highly deregulated environment, opportunity is expanded with the result that recognized players are marginalized by professional competitors.

Will there be tradeoffs to a liberalized environment? Yes. But which tradeoff makes most sense?

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