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The Vicious Cycle of Regulation April 22, 2009

Posted by federalist in Markets, Regulation.

Fraud can occur in both regulated and unregulated markets, due to failures of both regulators and participants.  Chidem Kurdas analyzes the failure of Manhattan Capital and argues that regulatory responses can produce a vicious cycle.

The conventional response of boosting government watchdogs magnifies the impact of their mistakes while reducing both the watchdogs’ and the public’s incentive to learn.  It creates a vicious spiral of more regulation, regulatory failure, and even more regulation.

In contrast, non-regulatory responses to a market failure are patently virtuous in comparison.  As Carl Close summarizes:

[T]here’s often a big difference in the consequences of their respective mistakes, Kurdas argues. When investors fail, everyone tends to learn from their mistakes; but when regulators fail, new regulations are proposed, and investors are not given stronger incentives to learn.



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