A Flaw in George Soros' Case for Increased Government Regulation of the Financial System:

I am no expert on finance. Therefore, I cannot tell whether George Soros' proposals for increased regulation of the financial system have merit or not. Soros has probably forgotten more about finance than I ever knew to begin with. However, Soros' position has at least one serious weakness that is common to many arguments for increased government intervention in society: it fails to give adequate consideration to the shortcomings of the political process. Strangely, Soros admits that government is likely to do an even worse job in this area than he believes the private sector has; yet he still ends up supporting increased regulation.

Soros argues that speculative bubbles are a form of market failure that can cause great harm to the economy when the bubbles pop. He therefore concludes that we need government intervention to prevent bubbles from forming. However, he concedes that government regulators are unlikely to do any better at predicting dangerous bubbles than the market does:

[S]ince markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big. Alan Greenspan, the former chairman of the Federal Reserve, and others have expressly refused that responsibility. If markets cannot recognise bubbles, they argued, neither can regulators. They were right and yet the authorities must accept the assignment, even knowing that they are bound to be wrong. They will, however, have the benefit of feedback from the markets so they can and must continually re-calibrate to correct their mistakes. [Emphasis added]

If, as Soros believes, government regulators will be just as bad or worse at predicting bubbles than market participants, it's not clear why he expects government intervention in this area to improve things. "Feedback from markets" certainly doesn't create any comparative advantage for government regulators; after all, the private sector can use feedback from markets as well.

Soros' argument could still work if government financial regulation were costless. If that were so, the regulators might occasionally prevent a dangerous bubble from forming, while not causing any harm in the many cases where they are "bound to be wrong." However, as Soros himself points out, government financial regulation isn't costless because "While markets are imperfect, regulators are even more so. Not only are they human, they are also bureaucratic and subject to political influences." Unfortunately, he doesn't do enough to consider the likely impact of these "political influences." The rest of his argument for increased regulation proceeds as if government were a "benevolent despot," willing and able to implement the right kind of regulation so long as he gets the right advice from experts like Soros.

Common systematic shortcomings of government suggest that Soros' "political influences" might cause even more harm in the field of financial regulation than elsewhere. As I discussed in this post, government intervention typically suffers from three major shortcomings: inadequate knowledge on the part of government officials, widespread political ignorance among the electorate, and the power of interest groups who can "capture" the political process and use it to benefit themselves at the expense of the general public.

All three of these problems are likely to be especially severe in the field of financial regulation. Even those who worry less about political ignorance than I do would be hard-pressed to argue that the voters have a good understanding of complex finance policy issues. It's telling that some 25% of the public is so ignorant that they blame "the Jews" for the financial crisis. Such widespread ignorance suggests that voters will do a poor job of monitoring the performance of regulators, and also creates the danger that public ignorance will push the government to adopt severely flawed policies that seem attractive to voters with little understanding of the financial system.

It is also clear that there are interest groups in the finance industry who will lobby regulators to try to "capture" them and use government power to benefit themselves at the expense of the general public. Banks and large institutional investors are obvious examples. There are few other sectors of the economy with so many powerful, concentrated interest groups. The danger of special interest lobbying is, of course, exacerbated by widespread political ignorance. Ignorant voters can easily be fooled into believing that policies pushed by special interests will actually benefit the general public. This is especially likely in a crisis atmosphere like the present.

Finally, as Soros himself points out, government financial regulators suffer from inadequate knowledge and are likely to make mistakes as a result. The same complex nature of the financial system that ensures widespread public ignorance also makes it difficult for regulators to gather sufficient information to know when they should act. If regulators act on poor information, they might engage in interventions that create serious harm - as the Federal Reserve discovered on several occasions in its history, including the Great Depression.

Does all this necessarily prove that increased regulation of the financial system is undesirable? No, it doesn't. But it does suggest that justifying increased regulation requires a much stronger argument than that given by Soros. It isn't enough to prove that a market failure exists, even a very serious one. We also need proof that government regulators have the knowledge and incentives needed to improve on market outcomes without causing harm that outweighs any benefits they might create. Even if Soros is right about the alleged failures of the market, he hasn't shown that government intervention will be better. Indeed, for reasons he himself hints at, it might be much worse.

UPDATE: It's possible that Soros wants the new regulation to be conducted by experts insulated from the pressures of the democratic process. If so, that would partly (though by no means entirely) protect against the dangers of public ignorance and interest group lobbying. Unfortunately, the "rule of experts" solution to political ignorance has serious flaws of its own, which I discussed in detail here.