Monday, January 2, 2012

Discretion in the Imperfections

John Cochrane has an interesting post that begins by saying:
I am often asked, "doesn't the financial crisis mean we need more regulation?" It's one of those maddening questions, because the answer is "that's the wrong question," which gets you nowhere.

For regulation is not "more" or "less," something you just pour into a cup until you've had enough like a good beer. Regulation is most of all "smart" or "dumb." Dumb regulations produce the opposite of their intended effects, have all sorts of unintended consequences, or get used for fully intended but pernicious consequences like driving out competition. Smart regulations don't.
Cochrane goes on to describe the differences between regulation by law, rules and discretion, which is an interesting discussion that shines light on how financial regulations differ. One point that Cochrane acknowledges (but does not develop in his post) is the inevitable role of discretion in regulation.

For example, take Cochrane's example of a clear-cut law: obeying the posted maximum speed limit. The law is clear cut, but enforcement of the law is not. To the extent that enforcement is (as Cochrane puts it) "imperfect," regulation of speed limits must rely on discretion.
  • On one level, a solitary police officer is often not able to enforce strictly the posted speed limit. Faced with two speed demons at the same time, the officer must use discretion about who to pull over (and he may favor pulling over the red car or the car that appears to be going faster). This often happens in the state of Illinois on Lake Shore Drive, for example.
  • On a higher level, even the police chief must use discretion about enforcing posted speed limits. Police departments must optimize the patrol of traffic crimes relative to other types of crime. Absolute and strict enforcement of one type of law is often unattainable (and usually not optimal). Hence, the remaining tool of the police chief is to delegate the discretionary enforcement of the law to officers on duty.

Cochrane's point is that regulation by discretion can go wrong because it is often too vague. I think this point is right, but unfortunately, some amount of discretion is inevitable because resources to enforce and define the law are scarce.

As a side note, another quote from Cochrane's post deserves mention.

This is really the basic problem with the Dodd-Frank approach to financial regulation. The Financial Stability Council can simply "determine" you pose a "systemic risk," and that's it. (Yes, there is an appeal process, but without an objective standard, it's hard to see how anyone will beat a "determination.") The Fed can then tell you how to run your business, in any way that it deems appropriate. Imagine what chaos would result if "speeding" were defined simply by the cop's authority to "determine" that your speed poses a "risk to the traffic system."

With regard to the regulation of traffic offenses, we actually don't need to imagine this. The State of Montana used a standard for speeding called "reasonable and prudent" on its Interstate highways from December 1995 through May 1999. Speaking from experience, driving was slightly more chaotic than when there was a posted speed limit, but this marginal increase in chaos from November 1995 to December 1995 driving in Montana pales in comparison to the difference between Montana and Chicago driving.

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