Appalachian State Almost Never Beats Michigan, and Government Regulation Almost Never Works
If you are good, 49 percent of your decisions will be wrong. Even if you are great, something just short of a majority will be losers.
—Nick Kokonas on trading, Life, on the Line
On September 1, 2007, Division 1-AA Appalachian State beat the fifth-ranked Michigan Wolverines football team 34–32 in Ann Arbor. The result stunned not just the college football world but everyone with even a passing interest in sports.
ESPN’s Pat Forde wrote, “These are the kinds of things that don’t normally happen in college football, where the chasm between the have and have-not is wider than in any other sport.”1 Indeed, since the partition of college football’s Division 1 in the late 1970s, never had a 1-AA team beaten a 1-A team that was ranked in the top twenty-five, let alone one that was ranked in the top five.2 Michigan is a football factory. It has produced some of the NFL’s best players, including the New England Patriots quarterback Tom Brady, number-one NFL draft pick Jake Long, and future Hall of Fame defensive back Charles Woodson. Appalachian State can claim only a handful of NFL players—eight as of 20133—none of them stars.
Yes, every once in a while, Appalachian State beats Michigan—but it’s pretty darn rare. On the day that Appalachian State “shocked the world,” Louisville and Boise State beat their 1-AA opponents 73–10 and 56–7, respectively, while the Florida Gators smashed Western Kentucky 49–3.4 And there’s a lesson here about government regulation of business. The conceit of regulation is that bureaucrats of below-average talent have the knowledge, insight, and skill to oversee the talented and to catch their errors before they do themselves. In other words, government regulation assumes that Appalachian State is going to beat Michigan every time.
The mismatches that define the early weeks of each college football season are like the mismatches that define regulation. The best high school football players aspire to play for teams such as the Texas Longhorns and Miami Hurricanes, and the best financial, medical, and business minds migrate toward J. P. Morgan, Merck, and Coca-Cola. Those with talent generally seek employment with other talented people, where the work is stimulating and the compensation high. It is unlikely that the best and brightest will settle for a federal regulatory agency and its relatively low pay. A great analytical mind will probably go to Goldman Sachs rather than Goldman Sachs’s regulator, the Securities and Exchange Commission. So “victories” for lightly talented regulators—catching problems ahead of the experts in the private sector—are about as rare as Appalachian State victories over Michigan.
The problem of mismatched talent is aggravated by perverse incentives. The more capable regulators can be tempted to go easy on the businesses they oversee in the hope of eventual employment with them, where the pay is better. This is part of what the Nobel laureate economist George Stigler called “regulatory capture”—regulated interests’ exercising decisive influence over their regulators. Apart from regulatory capture, regulation doesn’t work because of the talent mismatch and the inability of even the best businesses and investors to see reliably into the future.
John Allison retired as CEO of BB&T Bank in 2009 after transforming a small bank with four billion dollars in assets into a global financial institution with $152 billion in assets. In The Financial Crisis and the Free Market Cure (2013), Allison observes, “Financial services is a very highly regulated industry, probably the most regulated industry in the world.”5 Yet the oversight of the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Federal Reserve, the SEC, and other agencies did not prevent the banking industry from plunging into crisis in 2008. As consumers backed by generous bank loans rushed into housing, writes the Wall Street Journal’s Gregory Zuckerman, “Rather than rein it all in, regulators gave the market encouragement, thrilled that a record 69 percent of Americans owned their own homes, up from 64 percent a decade earlier.”6
Known as the “Maestro” in the early 2000s because of his allegedly skilled chairmanship of the Federal Reserve, Alan Greenspan told a convention of community bankers in 2004 that “a national severe price distortion [in housing] seems most unlikely.”7 In June 2007, Greenspan’s successor at the Fed, Ben Bernanke, asserted, “We will follow developments in the subprime market closely. However, at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system.”8
While the Federal Reserve is responsible for regulating banks and keeping an eye on their health, its blindness to the looming problems inside those same banks did not surprise Allison, who recalls, “In my career, the Fed has a 100 percent error rate in predicting and reacting to important economic turns.”9 Indeed—how surprising is it that the salary-men at the Fed fail to detect a crisis before the multi-million dollar earners in the banking industry do?
It may be obvious that regulators are not up to their task, but working for the government means never having to say you’re sorry. “One of the most remarkable things about Washington,” observes American Enterprise Institute senior fellow Peter Wallison, “is the fact that poor performance by regulators is regularly rewarded with more funds and broader powers, both conferred by a grateful (and apparently forgetful) Congress.”10
The market sees to it that poorly run businesses are starved of capital so that they cannot waste any more of it. Government, by contrast, devotes more human and financial resources to what isn’t working. It’s as if Western Kentucky, after that thrashing by Florida, poured millions of dollars into its football facilities on the assumption that a better weight room might produce a different result next time. There might be some improvement, but the Gators are still going to have their way with the Hilltoppers 99 percent of the time. Government regulators almost always arrive late to the scene of the accident regardless of how many billions of tax dollars Congress appropriates to them. As they say in sports, you can’t coach speed or height.
Human beings—even the smartest and most experienced—are seriously limited in their ability to see the future. Even the best stock, bond, and commodity traders lose money on slightly less than half of their trades. If the best, most handsomely compensated market traders are wrong about the future 49 percent of the time, the low-paid bureaucrats regulating them haven’t a chance. What Samuel Johnson said about second marriages applies to regulation: it represents the triumph of hope over experience.
So does the failure of government financial regulation leave us exposed to the wolves of Wall Street? No. There are effective regulators in the marketplace, but they don’t work for the federal government. One of them is the hedge fund manager John Paulson.
Paulson famously earned billions in 2007 and 2008 for betting against the home mortgages that banks were so feverishly issuing to voracious borrowers. He is hailed as a genius now, but Paulson was not always so highly regarded. Although white-shoe investment banks like Morgan Stanley and Goldman Sachs were happy to earn commissions on his trades, Paulson was, according to those who handled his trading account at Goldman, “a third-rate hedge fund guy who didn’t know what he was talking about.”11 A trader at Morgan Stanley who executed the trades by which Paulson intended to profit from a housing correction thought, “This guy is nuts.”12 The people who handled his trades thought the insurance against mortgage defaults he was buying was the equivalent of earthquake insurance that would never be paid out.13
The payoff can be enormous when so many on Wall Street, or on Main Street, do not agree with you. Paulson saw what others did not: the mortgage market was headed for a correction. And if you’re as smart about the markets as he is, you don’t squander your talent as a salaried government regulator. You stay in the market yourself and make billions. Yet Paulson’s trades, and his eventual success, served banks and other financial institutions more effectively than the regulators who show up after the damage is done. The profits he made from buying insurance on mortgages were a signal to banks that they were far too exposed to housing and the underlying debt that propped it up. They didn’t take him seriously at first when some banks went under or were bailed out. But nothing grabs the attention of others like success, and Paulson’s billions surely saved banks from much bigger mistakes. Even better, Paulson “regulated” away many greater errors by savers and investors, without whom there are no mortgages. Paulson’s foresight provided those savers and investors with explicit market signals telling them to cease committing capital to housing.
Credit default swaps (CDSs) achieved much the same result. Without getting into a highly technical explanation of CDSs, it’s enough to say here that they are merely a market measure of the creditworthiness of financial institutions and businesses. The large market for credit default swaps indicated what this chapter has made plain, that investors knew well that they couldn’t rely on regulators to ensure the financial health of the banks they vainly presumed to oversee. CDSs were the logical market response. They are market regulation personified.
Along the same lines, the ratings agencies of the private sector are in the business of appraising the quality of all manner of bonds. But as “Vinny” in Michael Lewis’s 2010 book The Big Short observes, “The ratings agency people were all like government employees.”14 The people employed to rate the quality of mortgages that gave so much life to the housing market were almost totally unable to comprehend the markets they were supposed to analyze. As Robert Bartley explained in The Seven Fat Years, no rational person would “believe that an individual bond rater could outguess the collective decisions of the market; if he could, he’d be rich and not have to work in such a stodgy place.”15
Those who should know better finger CDSs as the “cause” of the 2008 financial crisis. Such an obtuse suggestion is the equivalent of a Michigan fan blaming the scoreboard for the Wolverines’ loss to Appalachian State in 2007. Back in the real world, CDSs then and now are simply the market’s view at any given moment of the ability of businesses to pay their debts. Because bureaucrats and ratings agencies are so poor at foretelling problems in the financial sector, markets have created instruments to do what regulators cannot.
Our financial regulatory system asks the impossible of those who administer it. Rarely do regulators detect banking problems before those in the business do. So markets devise financial instruments that reflect the informed wisdom of the marketplace. The idea that these instruments caused a “financial crisis” is the height of naiveté, as we’ll see in a later chapter. The troubles of 2008 in the heavily regulated banking industry provide more evidence that all the money and resources put into federal oversight are wasted. We’re asking people of average talent to forecast the future more accurately than the most gifted financial minds can do.
* * *
Finance may be too complicated for regulation, but what about consumer products, or the drug industry?
It would be hard to find a better-known consumer product in the world than Coca-Cola. But not everyone would “like to buy the world a Coke.” Critics warn of the “Coca-Colonization” of the world,16 fearing that the powerful brand is a tool for imposing American cultural norms on other parts of the world. They can relax. The history of Coca-Cola shows how quickly a great brand can get into serious trouble.
On April 23, 1985, Coca-Cola rolled out “New Coke.” The company’s legendary CEO Roberto Goizueta billed it as “smoother, rounder yet bolder.” Coke’s historically loyal customers didn’t agree with him, however. Soon enough stories fizzled up about cases of the original drink selling for thirty dollars, and a Hollywood producer was said to have put a hundred cases in a wine cellar for safe keeping.17
What was arguably the world’s most powerful brand was brought to its knees by a customer base that didn’t like New Coke. Within two months, New Coke was being pulled from the shelves. “We did not understand the deep emotions of so many of our customers for Coca-Cola,” explained the company’s president, Donald Keough.18 So much for the irresistible market power of the corporate colonizer. “Coca-Cola Classic” was sheepishly restored to an angry, and relieved, public.
In 1957 Ford Motor Company announced to America, “The Edsel is Coming!”19 It is said that the Edsel came with new gadgetry that helped define the future of the automobile, but the buying public was not impressed with the car’s looks, and it got a reputation for shoddy workmanship. The Edsel became a cautionary tale about corporate hubris. It’s another example of how customers themselves regulate companies with their wallets.
The actors Kevin Costner, Sylvester Stallone, and Ben Affleck all have Academy Awards for Best Picture on their resumés (Dances With Wolves, Rocky, and Argo), but when they were bad, audiences let them know it. No one stood in line for The Postman, Tango & Cash, or Gigli. Customer preference is an effective and costless regulator.
Without government’s watchful regulatory eye, wouldn’t pharmaceutical firms sicken, maim, or kill their customers? And yet here too, upon examination, the case for regulation doesn’t hold up. You have the same talent mismatch that undermines financial regulation. There’s a great deal of money to be made in the pharmaceutical industry, so the talent is concentrated on the business side of the regulatory fence.
But the case for pharmaceutical regulation is most seriously challenged by a simple question: How many successful, multi-billion-dollar businesses got that way by killing or maiming their customers? Even if the employees of pharmaceutical firms were completely indifferent to the safety of their products, their companies would not stay in business for long. Successful businesses reach large markets through positive word of mouth. Without the Food and Drug Administration, the incentives for Merck, Pfizer, Eli Lilly, and others to produce life-enhancing drugs with limited side effects would be just as strong as it is with federal regulation if not more.
If Pfizer sold a faulty drug in a world without the FDA, the failure—which could lead to bankruptcy—would be its own. Regulation, on the other hand, has the potential to create a false sense of security. If the federal government puts its stamp of approval on something, maybe it’s safe. Or maybe it’s honest (remember Madoff Securities in 2008?). As always we have the less talented overseeing the more talented. Regulation to some degree relieves us of responsibility for our own lives, and as the Madoff debacle reminds us, the consequences can be disastrous.
Apart from pharmaceutical firms’ overwhelming self-interest in the safety and efficacy of their products, the market supplies other “regulators” that make the FDA superfluous. Many drugs require a doctor’s prescription, and it’s a fair bet that most people have more faith in their doctor’s judgment about a particular drug than in that of the salaried bureaucrats at the FDA. The next level of regulation inherent in the market is pharmacies, which have a powerful incentive to ensure that the medicines they sell to their customers are safe and effective.
Federal drug regulation is as costly as it is unnecessary. The heaviest cost is the cures that reach the market too late or not at all because the FDA looms as a barrier. You won’t hear about it from the drug companies themselves, which are loath to speak ill of the regulatory masters who can make their job even more difficult and expensive. Another reason for their silence is that the FDA protects the established pharmaceutical firms from competition. If you doubt it, you need only discover a cure for cancer. Unless you’re willing to sell your discovery to one of the big drug companies, the odds of your ever bringing it to the market are quite slim.
The problems with our system of drug regulation were dramatized in the film Dallas Buyers Club, set in 1985, when an AIDS diagnosis was tantamount to a death sentence. At the time, the FDA was supervising trials of the drug AZT—which the film argues did more harm than good—but was blocking imports and trials of other potential cures. “Regulated to death” is perhaps an apt description of what happens when governments expropriate the role of the marketplace in the area of health.
* * *
Surely air travel is a field in which the risks are so serious that public safety demands robust government regulation. After all, when a commercial aircraft goes down, hardly anyone walks away. But it was none other than the arch-liberal Senator Edward M. Kennedy, in a televised debate with Eastern Airlines’ president, Frank Borman, who asserted on March 1, 1978, that “the problems of our economy have occurred, not as an outgrowth of laissez-faire, unbridled competition. They have occurred under the guidance of federal agencies, and under the umbrella of federal regulations.”20 Kennedy argued, correctly, for more airline competition, while Borman defended “the orderly regulated marketplace.”21 The Kennedy-Borman debate revealed that regulations often exist to protect markets for established businesses. No supporter of big business, Kennedy was arguing for the competition that airline deregulation would bring—competition that would make air travel more accessible to the common man.
Most people don’t realize that big carriers such as American Airlines were largely a creation of the federal government. As T. A. Heppenheimer reported in his 1995 book, Turbulent Skies, the federal government took “the lead in promoting the growth of this nation’s airlines,” and its reason for doing so was to help the U.S. Postal Service move mail more quickly around the country.22 Given the federal government’s role in creating the industry, it is no surprise that the same government heavily planned fares and routes. It is also unsurprising that U.S. airlines have suffered substantial losses and bankruptcies over the many decades of commercial flight. Airline executives have been heard to joke that they wish someone had shot down the Wright Brothers so that air travel had never been discovered. But we didn’t need the government to invent commercial air travel for us. And if we had left it up to the market, how much more advanced, comfortable, and punctual would the airlines be today?
The idea that there would be more plane crashes without the Federal Aviation Administration is hard to take seriously. In a wholly unregulated market, an airline with a poor reputation for safety would be out of business quickly. In the age of terrorism, airlines competing for passengers would have all the incentives they need to make sure no one boarded with a bomb, and they’d probably assure their passengers’ safety a lot more graciously and efficiently than the TSA does.
Ted Kennedy ultimately got his way, and airline routes and fares were eventually deregulated. But as the federal government’s still prominent presence at airport gates and in control towers attests, Uncle Sam’s involvement is heavy enough to ensure that the wonder of air travel is a nuisance many would prefer to avoid.
* * *
As we’ve seen, one of the problems with regulation is the mismatch in talent between regulators and the regulated, but regulation creates another problem related to talent. Big profits generate the big pay packages that attract the most talented people to an industry. Government regulation squeezes profits in the target industry, encouraging the best people to work elsewhere. The biggest problem in the heavily regulated financial, transportation, and pharmaceutical sectors is that there are not enough billionaires in each.
It’s a truism in the banking sector that “for a well-run bank, any capital requirement is too much, and for a poorly run bank, no capital requirement is high enough.” But since all banks are required to maintain certain capital cushions, the well-run banks are penalized with lower profits than they would have otherwise.
Banks need a capital cushion for times when depositors rush in to get their cash. Those cushions deter bank runs. But if cash on hand is what consumers want so they can sleep at night, then banks will honor their customers’ wishes with or without regulations requiring them to keep cash on hand. Warren Brookes wrote long ago, “Businesses, like people, seldom if ever fail solely because of a lack of money.”23 A well-run financial institution would never fail because of a lack of cash because it would never lack the collateral necessary to borrow money at times of high customer withdrawal.
In short, capital requirements foisted on banks are worse than superfluous. They harm the healthiest institutions (and, by extension, well-qualified borrowers), and by reducing profits they make it harder for those banks to attract the people who would run them best. The reward for this is more frequent bank failures, which are, unfortunately, covered by the taxpayers. The “seen” here is highly paid bankers who are sometimes foolishly bailed out, but the “unseen” may well be the loss of more talented bankers who would be less likely to fail in the first place.
We should expect lower-quality executives to migrate to heavily regulated industries such as airlines and Big Pharma. The contrast with Silicon Valley is stark. James Ostrowski pointed out some years ago, “What is perhaps the country’s most important industry—the computer industry—is almost entirely unregulated, governed only by the Darwinian laws of laissez-faire economics.”24 Is it any surprise then that Silicon Valley is littered with billionaires?
In markets where people are free, and even encouraged to fail, they are equally free to earn as much money as the free markets will allow. In unregulated Silicon Valley, no one props up failures, and the many successes are not forced to subsidize the mistakes of the failures. Instead, bankrupt ideas are replaced by better ones in a frenzy of fortune-making. Imagine if there were an FDA-style regulatory agency that had to approve the entrance of new social networks? Friendster and MySpace might be subsidized at the expense of Facebook. Without such regulation, an entrepreneur with a better sense of the market might one day topple Facebook.
As we marvel at the success that freedom from regulation, low barriers to entry, and unlimited profits have brought to Silicon Valley, we have to wonder what the airline and pharmaceutical industries would be like in a similar environment. Better yet, what would Steve Jobs, Jeff Bezos, or Sergey Brin have accomplished with an airline or a drug company? What comfortable, efficient, and affordable travel, what cures might we enjoy today? What is the “unseen” that regulation has deprived us of?
As Warren Brookes observed, it’s generally not lack of money that causes businesses to fail. “They fail,” he said, “because of lack of ability, judgment, wisdom, ideas, organization, and leadership. When these qualities are present, money is seldom a problem.”25 And government regulation helps to ensure that industries most in need of that kind of leadership are least likely to attract it.
The damage that government regulation does to the American economy is all the more appalling when you consider how expensive it is for businesses to comply with the mandates of their regulatory masters. Wayne Crews, a vice president of the Competitive Enterprise Institute, estimates that the annual cost of regulatory compliance is two trillion dollars.26 And Crews would almost certainly agree that the number underestimates the actual economic costs involved. Economic growth is about production first and foremost, and regulation cripples our ability to produce.
Since the government can shut a company down or indict its management on a moment’s notice, businesses must expend great sums at the expense of profits and growth in order to stay on their regulators’ good side. Though BB&T was quite well capitalized amid the 2008 financial meltdown, regulators made it clear to John Allison that if he refused to accept bailout money that the bank did not need, BB&T would soon receive attention from “very concerned” regulators with the power to shut it down.27
Regulators are worse than worthless in banking and finance. They’re wholly superfluous in other areas of commerce such as drinks, cars, and entertainment. When it comes to our healthcare regulation, there’s probably a death toll. And because regulation saps the profits that attract the skilled, the costs to the economy as a whole are incalculably large.
Our best estimates of the expense of regulation capture only a fraction of the actual costs. Regulations are an expensive, growth-sapping burden that leave us with reduced innovation. The regulatory state has convinced its citizens that it is the only thing standing between them and the law of the jungle. The truth, as we have seen, is quite the opposite. It’s time to scrap the whole misbegotten system, in which the blind lead the sighted and the mediocre drive out the talented.