Madoff: An Argument For or Against Regulation?

Minyanville attacks deregulation vis-a-vis Bernie Madoff in the article "Deregulation to Blame for Madoff Fiasco". Now while chock full of rather illogical statements which might be better left ignored, a dissection of this article does highlight some misconceptions in regards to regulated vs. unregulated markets.

Madoff senior was charged with a single count of securities fraud. He was released from prison a few hours later after posting $10 million bail. If convicted, Madoff faces 20 years in prison and a fine of $5 million. His list of victims includes Steven Spielberg, New York Mets owner Fred Wilpon, and the European bank HSBC

The question arises: How did this happen?

The answer is quite simple: Madoff’s investment firm was allowed to operate for 2 years without regulation from the SEC.

Well here's at least a very basic error. Madoff's swindle spanned far more than two years. If this is a mis-type, and they meant to say 20 years, then the statement is false as there was SEC oversight, with an investigation in 1992 to prove it. Madoff was even advising the SEC...

Odd, isn’t it? Diamond miners in the Congo are subjected to body-cavity searches to prevent them from secreting tiny gems - but savvy, ambitious men like Madoff are allowed to wander around unsupervised, carrying diamonds the size of fists. And we pretend to be shocked when some of the loot goes missing.

Ok now the fun part. This makes no sense. Mining companies are not regulated to body-cavity search their "diamond miners". Any such agreement is rather the result of a contract or other form of agreement between employer and employee. All rules don't flow from regulation. And a lack of regulation doesn't mean a lack of rules. Rules can be privately negotiated between willing parties, and are every day. 

Here’s a thunderbolt: There’s no such thing as a “free-market economy.” What does the “free” part of it mean? I have found no convincing explanation.

Wasn't sure to even include this one, admittedly. While indeed there is currently no country which can provide an example of a 100% free-market economy, most economics books nevertheless can explain what a free market economy means, this should be obvious to most and for perhaps another post. Anyhow, some businesses operate in effectively free market environments. Moving on.

Every financial system requires rules and regulations to function. The PR coup of the “free-market economists” is that they managed to convince the American public that only little people need rules.

This quote further exposes the misunderstanding whereby deregulation means the absence of rules. 

It makes the common, false, assumption that little guys are helped in a highly regulated environment. In actuality, large companies can easily cover the costs of regulation while smaller ones face higher barriers to entry due to them. They also benefit when little innovation takes place, as their are little challenges to their business positions. 

A site such as Minyanville should also consider how much harder it would be to get their online business running if they had to comply with, say, more onerous online financial commentary regulations. Anyone who has ever considered a small business in the finance space should realize that there are already massive regulatory barriers.

Further along in the piece, the author then goes on to say that while the SEC missed Madoff, it was due to too few officers. This kind of argument allows for any failure of regulation to then imply the need for more regulation rather than to see it as a sign that crooks exist in all environments.

I predict, as the case goes to trial, that coverage will focus on Madoff’s personality flaws, the warning signs, and his dramatic fall from grace. 

But that’s trivial. What’s important, and worth discussing, is that Americans are so deathly afraid of “regulation” that we meekly allow ourselves to be swindled. 

Now, the WSJ does a far better job at explaining this last post and at delivering an overall rebuttal to this Minyanville post, than I can do here. (Madoff and Markets)

Nevertheless, the main takeway hopefully from this post is that this Minyanville article exposed a common misconception among many who argue against free market principles- that rules don't exist in a free market. It also exposed a general misunderstanding of what a regulated vs. unregulated market are, which I have seen to be rampant when talking with people or reading online. 

Rules still exist in an unregulated market, its just that there is a difference is in who gets the opportunity to negotiate them (individuals on their own vs. bureaucrats forcing them on everyone). There is also thus a difference in the resulting opportunities for diversity and sophistication of economic activities. Hopefully doesn't have to be repeated here, but the ability to zig and zag with new ideas is a foundation of US success in many industries, including the financial industry. Its no surprise that financial innovations such as Venture Capital (as distinct from merely wealthy families funding companies) were invented in the US, and along with sophisticated capital markets, allowed global companies to leap to multinational status faster than anywhere else. Recent example- Google.

Finally, in regards to the Madoff case, nobody was forced to invest with him, just like how there are $10,000 pairs of Michael Jackson underwear on Ebay (I'm admittedly assuming) yet nobody is forced to buy them. He also was able to avoid a lot of currently standing regulation as it was. Smart crooks like him can likely jump around some a few more. There will always be clever crooks. And... some of the most clever crooks actually use regulations to their advantage. Take a peek at the wealthy monopolistic tycoons in heavily regulated, poor countries and you'll see that regulation by no means reduces economic crime (it even sanctions it in many cases). 

We should be willing to take the responsibility to do our own homework when presented with opportunities, in return for a country where we have the right (and of equal importance where other people have their own right) to choose the rules of our own economic engagement. 

(Vincent @ The Stalwart)

Comments

[Alan]

It's not just a matter of not enough regulations. The SEC was warned about Madoff in around 1999 but it chose not to investigate. This is the main problem.

You can have as much regulations as you want but if you don't enforce them, then they are useless.

[Johnny Abacus]

While indeed there is currently no country which can provide an example of a 100% free-market economy, most economics books nevertheless can explain what a free market economy means, this should be obvious to most and for perhaps another post.

From what I understand, most black market economies (the drug trade especially) operate in an almost textbook fashion. The same goes for the Even Online economy (report here: http://myeve.eve-online.com/devblog.asp?a=blog&bid=518)

[Vincent (The Stalwart)]

Interesting point. Nevertheless, they aren't free market environments. Black market economies are based on regulation making some sort of commerce illegal. Free market doesn't mean lawlessness. I can't use violence for example to negotiate a price in a free market economy, though in a black market economy I can because it exists outside the law. Free markets reside within a legal system. But I still think your point is interesting in that in many ways a black market economy does resemble a free market one.

[johnny abacus]

Nevertheless, they aren't free market environments. Black market economies are based on regulation making some sort of commerce illegal. Free market doesn't mean lawlessness. I can't use violence for example to negotiate a price in a free market economy, though in a black market economy I can because it exists outside the law. Free markets reside within a legal system. But I still think your point is interesting in that in many ways a black market economy does resemble a free market one.

I'm afraid you are mistaken. The free market, in the "no true scotsman" sense of the term, is entirely free from external regulation. The regulation one does see in the market is internal to it and largely driven by reputation effects.

The example you gave is a perfect illustration of the internal mechanisms of a free market - almost no supplier in the drug trade initiate violence against customers except in the case of breech of contract; this is largely due to the preference of customers for suppliers who treat them well.

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