One of the reasons given for the current financial crisis is deregulation, which permitted greedy Wall-Street-types to earn huge incomes by taking excessive risk. We can expect to see an increase in regulation in the near future. Treasury Secretary Geithner is calling for increased regulation in the financial sector.
While I will not argue that some changes in regulation may be needed, I fear that the changes that will be implemented will not lead to a better financial system. Why? For several reasons. First, when the consensus of policymakers is that we are in a crisis, the likelihood of passage of poorly conceived and poorly thought out laws and regulations is high. At least some of the deregulation movement in the past developed because deficiencies in the regulations that existed at the time had become apparent. Second, regulation tends to be reactive--reacting to the perceived shortcomings of the situation without knowing the effects of the regulations when the economic environment is different. This reflects the general concern economists have for the unintended consequences of government actions. Third, between government officials and the press, one could think that regulators will be wise, impartial, selfless public officials, and they can oversee the selfish, risky actions of the people working in finance. But all are human beings. All lack omniscence; all lack perfect foresight.
Economists who work in the economics of regulation long ago gave up the idea that regulation was done in the public interest. Instead, it is recognized that regulators are impacted by interest groups. Further, interest groups include, but are not limited to, those in the industry that is regulated. As we examine the current situation and the politicians who are key figures of key committees in the House and the Senate, can we not expect that those interest groups that Barney Frank and Christopher Dodd pay attention to will have more influence in the outcome of legislation than other groups? (I use the two men only as an example and am not accusing them of nefarious behavior. This is how our system of representative government works.)