Which regulations on business should we keep? Should we keep any?

Nothing drives businesspeople crazy more than regulations.  Not even taxes.  No executive waxes poetic about the joys of operating under the regulatory thumb. Rather, they argue they could do so much more if there weren’t so many regulations.  And they are correct.  But unfortunately, without regulations, consumers, workers, and business owners would be worse off.

There are many reasons to regulate economic activity. The government creates regulations to protect health and safety and ensure the workings of the marketplace.  Many of these have to do with social concerns such as safe food handling, workplace safety, and truth-in-lending or product descriptions. 

There are also regulations that fix market problems, where competition and information are limited or where pricing fails to reflect impact on those not involved in the transaction. Pollution control is the most obvious example of this. 

Consider smoke, whether it is produced by a utility in West Virginia or the person sitting next to you enjoying a cigar in a restaurant.  The smoke knows no boundaries, but it does create harm. Indeed, much of the air pollution Philadelphia suffered came from plants located outside the region. 

When those not involved in economic activity bear the cost or receive the benefits of an activity, you have what economists call externalities.  The market doesn’t correctly price the value of the product, which is where the government comes in. 

One of the major roles of government is to regulate externalities. So we have environmental laws whereby you cannot simply pollute the air or water or land — or smoke in a restaurant.

There are also regulations that limit firms from taking risks that could cause harm. The banking industry is a classic example of one that, if left unregulated, could, and has, caused significant economic problems.  The Federal Reserve was created to stabilize the financial sector because bank panics used to be a major factor in recessions. 

Given that we need regulations, the issue becomes how much regulation is required?

The problem with regulation is that we don’t know who will be the next bad actor or what will be the next bad action. Thus, regulations have to throw a wide net, applying to a broad set of actions, some of which are not yet even known. 

Since regulations are supposed to be forward-looking and conditions change, they have to be broadly structured and need to expand with the emerging complexities.  Consequently, an element of judgment in the enforcement of the rules also is required. 

But sometimes, the regulator’s judgment leads to major problems. Take the housing bubble/financial crisis. It was risky to qualify borrowers for mortgages based on the teaser rate rather than the non-teaser rate, but banks did that. And the regulators allowed it.    

What would have happened if regulators stopped the practice?  There would have been significantly fewer home purchases and less speculative construction, and many of the risky financial products would have been eliminated. The massive costs of the housing bubble would have been reduced, possibly dramatically.

But if regulators had stopped that practice, bankers, borrowers, and the Wall Street financial wizards would have screamed that there was too much regulation, and that it was killing the housing market and growth.

And that raises the key problem for regulation:  You cannot prove a negative.

If much of the housing bubble’s costs had been prevented, we couldn’t point to the huge costs of under-regulation to prove the benefits of regulatory restraints.  It's hard to argue what would have happened if it didn’t happen.

We under-regulated the mortgage market, and the result was an economic disaster.  The alternative would have been to “over-regulate” the industry, restrain the housing market and economic growth, and prevent the bubble from getting so large.  But to this day, individuals, businesspeople, and politicians would still be moaning about too much regulation. Looking back, which would you have preferred?

Put very simply, we don’t know when to under-regulate and when to over-regulate. We don’t know when regulations are working correctly because we don’t know the negative impacts from not regulating the action. And it’s not that we need better regulation, not more regulation.  All that means is we have more enforcement, which is the same as more regulation. 

We have to choose our poison: Too much or too little regulation, and, unfortunately, sometimes it's good to do one and sometimes the other.  

Undoubtedly, there are way too many regulations. But there is one huge problem with regulatory reform: Even if we know that half the regulatory rules should be junked, we simply don’t know which half.  

jnaroff@phillynews.com