incomplete guide to free market regulation

I’ve spent the past week or so struggling with how best to write a post on the proper role of regulation in market design. This a difficult topic to synthesize, since each market poses a different set of challenges for regulators; and I do not intend to catalog every regulation that exists and explain why I believe it to be useful or destructive.

That said, the current financial crisis has incited a chorus of criticism of the deregulation movement of the past thirty years. This deregulation has transformed numerous industries: air, bus, shipping, telecommunications, and, yes, finance. Now that there's been a financial meltdown, in the mind's of many, deregulation has been completely invalidated (of course, most of these folks felt this way five years ago).

I'm less than impressed by this mode of argument, as I believe that deregulation is necessary in many instances to reduce distortions in the market. But unlike some caricatures of the free-market position, I don't advocate deregulation to the point of anarchy. I'd like to remove many regulations, keep many others, and selectively add a few as well.

Regulation is tricky business, and I am interested in arriving at a principled differentiation between regulation as appropriate market design versus regulation as nefarious market meddling. I’ve emailed a few highly-regarded bloggers, but in lieu of an appropriate response by these bloggers, I thought I would take a shot.

It’s appropriate to begin with a discussion of what I mean by market design versus market meddling. Market design is the set of formal and informal rules that shape and limit participation in the market: market design rules separate a market from anarchy. Market productivity is indeed enhanced by rules to govern market behavior. Thefts indeed reduce market exchange. Beyond security, consumer confidence is essential: forgeries will quickly empty a market place. The purpose of market design is to maximize voluntary exchange between willing parties.

Here's my (incomplete) theoretical check list for a free market:

* No single buyer/seller should exert significant influence over prices or output (e.g., monopoly, collusion, unions)
* No asymmetric/incomplete information: participants must be straightforward in what they are buying/selling (e.g., used car market)
* No unpriced externalities (e.g., cost of toxic chemicals released into local lake)
* No threats to property (e.g., theft)
* No restrictions on who can buy/sell goods (e.g., licensing)
* No restrictions on prices at which goods can be bought/sold (e.g., minimum wage)
* No restrictions on the quality of the goods exchange (e.g., FDA approval)

Many will point out that by this check list, no market is completely free. This is truism akin to the observable fact that no human being is truly free. Still, just as I'd prefer to be "more free" even if I'm not completely free, I'd prefer to participate in markets that are "more free."

Indeed many of these concerns will be mitigated by the market participants themselves. Two-faced scumbags will be left without a trading partner, while fair-dealing will be rewarded with more business. You probably don't inspect the newspaper you buy in the morning before you hand over your money. But there is no law against selling newspapers with pages missing.

Still, few markets of import are self-regulating in all aspects. Formal legal laws and informal rules are necessary to advance the free-market agenda listed above. This post has served to reestablish the principles of the free market, which has been perverted by critics of the deregulation movement in their zeal to win the political blame game currently taking place.

The next post will be a bit more practical in looking at the issues of regulation, including regulatory arbitrage and capture, specifically in the context of our faltering financial system. It's easy to say we need the "right" regulation (which obviously was lacking). It's even relatively easy to state the principles by which this regulation should abide. It's much harder to explain which, if any, rule-making institution (e.g, Congress?) is likely to produce regulation that improves the sustainability and productivity of the market.

But let's try.