Back in 2004, the first line of defense against regulation was to argue that consumers and markets could be protected by self-regulation. But without a willing enforcer or timely enforcement, even well-meaning companies got sucked into a race to the bottom.
Lesson 1 from the subprime fiasco: Industry self-regulation almost never works.
The second line of defense is to argue that in a competitive market, disclosure and transparency are the keys. But anyone who has gone through a house closing and signed "disclosure" documents knows that this process is inevitably hijacked.
Lesson 2: Disclosure alone won't deter bad behavior.
Another common defense against regulation is that, if you properly align incentives, markets can discipline themselves. But in real life, it turned out the vigilance of gatekeepers was easily subverted by fees which, however exorbitant, were a pittance compared to the potential profits to be made from hoodwinking homeowners and investors.
Lesson 3: Market discipline can be easily corrupted.
One of the most common arguments against regulation is that most parties involved are sophisticated players who can look out for themselves. In the real world, however, the people who run German savings, Florida savings banks and some of the world's largest mutual funds did not understand the risks behind complex, asset-backed securities.
Lesson 4: Even sophisticated buyers and sellers cannot always protect themselves, let alone the safety and soundness of the system.
Opponents of regulation are right about one thing: In the long run, markets correct for their own excesses. But it is also true that the people who get hurt during that corrective process are not necessarily the people who caused the problem.
Deregulation zealots and free-market purists may not value fairness or stability, but the rest of us do. One hopes the Fed recalls those lessons the next time it is tempted to worship before the altar of financial deregulation
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