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The "Watchful Eye" Fallacy

When it comes to regulation, hope springs eternal in Washington, D.C. No matter how many codes and decrees fill the law libraries, lawmakers seem to believe that just a few hundred thousand more pages of regulation will set the country right.

Unfortunately, this confidence in regulation is based on a logical error. I call it the “Watchful Eye” fallacy, employing the new president’s phrase. In his inaugural address on January 20, 2009, Barack Obama said, “Nor is the question before us whether the market is a force for good or ill. Its power to generate wealth and expand freedom is unmatched, but this crisis has reminded us that without a watchful eye, the market can spin out of control.”

At first glance, this seems a plausible view. No one can deny that some of the people involved in market activities—investors, brokers, bankers, salesmen—are inept, shortsighted, or untrustworthy. Because of their human failings, harmful outcomes are possible. For example, thoughtless investors can be carried away by the idea that some particular activity is the wave of the future. When the speculative bubble pops, the contraction in economic activity is felt on Main Street. Or, to take another example, a dishonest salesman might peddle shares in an unsound company, leaving investors with losses when the fraud is discovered. To prevent such unfortunate episodes, says Obama, the market needs to be supervised and regulated by the watchful eye of government.

The fallacy in this view lies in the assumption that government regulators can rise above the human limitations that apply to everyone else. It assumes that while the businessman can be shortsighted, the senator will be farsighted, or that while the banker may be inattentive, the deputy undersecretary will not be.

The Same Human Stuff

The idea that government officials are more capable might be plausible if these officials came from a distinct social caste. If they were raised from birth by strict nannies, and taught exceptional academic and moral standards in special schools, there might be a case for claiming they are better than the rest of us. But government officials do not have a distinctive upbringing. The businessman we mistrusted because of his shady dealings in real estate can become a senator. The banker who was shortsighted in managing investments becomes an undersecretary of the Treasury. Does holding the new post suddenly make him wiser?

Because they are made of the same human stuff, it is unreasonable to expect government officials to correct errors being made in the marketplace. A look at the market failures Obama alluded to in his speech bears this out. Take the speculative bubble in housing. Did senators see the danger before the rest of us and pass laws to limit the purchase of real estate? Of course not. They participated in the housing boom along with everyone else.

Another example was the subprime lending boom. Did legislators forbid banks to lend to homebuyers with poor credit? To the contrary: it was the political class that passed the Community Reinvestment Act in 1977, legislation that, in the end, all but forced banks to lend to borrowers with poor credit ratings. Did these lawmakers forbid Fannie Mae and Freddie Mac to buy up the subprime loans? No, they encouraged and protected these institutions even as analysts warned they were dangerously overextended.

Ignoring the Smell Test

Maybe government officials aren’t clever enough to buck unhealthy investment trends that fool the rest of us, but at least they can catch fraudulent operators, right? Not necessarily. After all, those who engage in deceptive practices look like respectable managers and trustworthy investment advisers. That’s why they fool ordinary investors. Why should we expect government officials to be unusually acute, seeking out fires where no one else even saw smoke?

Indeed, even when bureaucrats are given smoke to smell, it appears they are reluctant to suspect fire. The notorious case of investment fraudster Bernie Madoff is instructive. A few insiders in the investment community knew something was fishy about his company. One, Harry Markopolos, spotted the fraud in 1999 and sent the Securities and Exchange Commission a detailed report listing 29 reasons why, as he entitled his report, “The World’s Largest Hedge Fund is a Fraud.” The SEC looked into the matter and found nothing wrong. After the scandal broke in 2008, the embarrassed chairman of the SEC, Christopher Cox, bemoaned the “multiple failures” of his staff that caused the agency to miss the fraud.

The idea that government regulation makes the market safe and fair is an illusion, a fallacy rooted in the belief that government is a God-like body casting a watchful eye over the doings of the human race. Government, alas, is staffed by mere mortals, ordinary men and women who exhibit the same lack of perception that enfeebles all human institutions.

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