Regulation Debate

Tyler Cowen responds to Paul Krugman's op-ed in today's New York Times. I don't know much about high-frequency trading, but I think that Cowen's point about financial regulation is important:

The more I read these debates, the more nervous I get about the idea of a financial products safety commission. Essentially, on innovation we're seeing a flipping of the burden of proof and I don't think it is possible to easily fine-tune that flipping in a way to capture good innovations and rule out bad ones. We should still follow the rule of regulating practices shown to be harmful or likely to be harmful.

I think this is absolutely true. In the wake of the financial crisis, there is growing skepticism about the power of markets to produce positive social outcomes. And the burden of proof has indeed shifted.

The standard economic assumption has always been that markets can produce poor outcomes when there are distortionary factors. But, as a rule, market-based economies offer more efficiency and adaptability than planned economies. This does not mean that markets are perfectly efficient. There are many examples of market failures resulting from misaligned incentives. And virtually all macroeconomists would agree that regulation is necessary to correct these problems.

But from a utilitarian perspective, there is a real danger in over-regulation. Regulators are often given enormous power to stifle innovations that have proven to be harmful to the public, or that seem likely to produce negative outcomes. However, if every innovation is suspect -- if the burden of proof is inverted -- then the general pace of innovation could slow dramatically. In the long-run, this could mean a lower standard of living for all Americans. We often forget how much our financial future depends on retirement accounts and pension funds.

Finding the proper balance between innovation and regulation is, of course, complex. Markets don't always work properly, but over-broad or poorly designed regulations can easily hurt consumers. In the coming years, there will be a tremendous need for creative investment and financial strategies that grow our economy. We should make sure that we're not squelching these innovations simply because they may seem "unnecessary."

In my view, the burden of proof should always rest with those who wish to impose new limitations on the activities of the market.

Update: A fairly recent column by Robert Shiller explaining the fundamental tension between regulation and innovation.