Regulatory Arbitrage and Mom and Dad

As I was just walking to the library I had the quick thought that I could analogize part of what happened in this financial crisis through the dynamics of a typical family. Bear with me here (and also note that since my family is something I am particularly familiar with I will use my family as the example, which is sure to be funny). Of course the story is a stylized one and bears only a loose relationship to reality.

So I’m the oldest of 7, which means that my family is fairly large. So let’s adopt this conceptual schema: Imagine us children as citizens/market participants and our parents as government. During the early years, government passes prohibition on candies and other sweet things to protect the public health and maintain an orderly populace. But as in any market, prohibition of a substance like candy isn’t always effective: in this case, the market for candy becomes a black market, with candy being obtained from illicit sources (Sunday School, neighborhood friends, etc). Government sees the candy ban hasn’t resulted in the desired outcome and implements further regulation, specifically regulations detailing how external interactions may happen so as to preserve the benefit of external contacts without allowing the trade in black market candy.

Of course, this isn’t effective because kids are sneaky and good at getting what they want. Government eventually adopts a rather nasty and prickly web of regulations that ends up being functionally unenforceable because of their size and complexity while the market develops cavities. Also, since everyone’s strung out on sugar all the time, public order suffers. Private cartels (shifting alliances of siblings) emerge to internally regulate the access and trade in illicit candy, creating a situation where fights break out over the control and allocations of a scarce resource. Eventually, government had no alternative to imposing martial law and borrowing against the future because a dental bailout of the market was urgently necessary.

What are the lessons to be learned here? Well, first, it’s that markets innovate and arbitrage around undesired regulations. If you have difficulty understanding what I mean by that, it may help to think about regulations as goods in a market: people desire good regulations and flock to the best suppliers. Second, it’s that government is bad about thinking in incentive-compatible terms. Solutions like bans rarely work and end up being prohibitively costly to enforce. Other solutions that might be more incentive compatible are ignored because of the incentive structures government faces, that is to say, government likes to maintain the illusion that it is really in control and refuses to lose face through the perception that laxer regulatory structures imply a loss of control and legitimacy. Of course, governments that look past that illusion are usually the ones that do the best.

Instead of banning candy, government could have tied comsumption to the performance of some other activity, like doing homework or chores (of course, this doesn’t work in markets where participants think they can arbitrage around doing homework or chores). But an outcome where government can monitor consumption is preferable to a situation where it can’t since crises are more predictable instead of less and also because you leverage some control over the incentive structures that market participants face, so markets don’t reach dangerous and unsustainable levels.

Think about the war on drugs or the financial meltdown in this way. It’s clear to me that the politicized debates over regulations typically miss the point: the debate is not over more vs. less regulation but about what is good regulation.

Any thoughts?

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2 thoughts on “Regulatory Arbitrage and Mom and Dad

  1. Heather Joy says:

    I’ve been making this same point ever since they raised the price of my favorite candy bar to a hundred grand.

    • mom says:

      I throughly enjoyed the ramblings of your mind and found them to be not only so close to reality but you finally trying to figure how ‘governments’ work.

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