David Brooks had a great column about the problematic relevance of behavior economics to the question of regulation:
If you start thinking about our faulty perceptions, the first thing you realize is that markets are not perfectly efficient, people are not always good guardians of their own self-interest and there might be limited circumstances when government could usefully slant the decision-making architecture (see “Nudge” by Thaler and Cass Sunstein for proposals). But the second thing you realize is that government officials are probably going to be even worse perceivers of reality than private business types. Their information feedback mechanism is more limited, and, being deeply politicized, they’re even more likely to filter inconvenient facts.
I think that makes more sense if you just change the last sentence to say “their information feedback mechanism is more limited so they’re even more likely to filter inconvenient facts.” But I think this is an important point — in just the areas where we’d most like effective regulation, we’re sort of unlikely to get it. If traders are likely to overestimate the effectiveness of their risk models, then regulators are prone to those exact same errors. Where does this leave us?
Brooks, I think, thinks it leaves us just as skeptical of regulation as we were before we took the behavioral turn. I think it arguably leaves us somewhere else. It leaves us with an appreciation of crude measures rather than hubristic efforts to get the regulations precisely right. Until the 1980s, banks couldn’t operate across state lines at all. This didn’t make any real sense. Some states (California, New York, Texas) are much bigger than others either in terms of land area or population or both. And of course New York City is much more integrated with parts of New Jersey (and even some parts of Connecticut) than it is with, say, Buffalo. So whatever the “right” rule was here, this clearly wasn’t it. At the same time, this rule, for all its arbitrariness, has the virtues of being clear and largely self-implementing. It doesn’t depend on anyone’s discretion being used wisely or honestly, and it doesn’t depend on anyone’s calculations being right. And it had the effect of limiting the size of banks so that you never had a really enormous bank failure.
Now that’s not to say we should go back to the ban on interstate banking (I honestly have no idea), but I think it shows the general shape of what we should be looking at. The best you can hope from a regulatory regime is that it will be a satisficing solution wherein some fairly crude rule will improve on the outcomes generated by the unfettered market. When that’s not the case, we may as well let the market go unfettered even though that, too, will be somewhat sub-optimal. But at the same time when we’re looking at a regulatory regime that seems to be working okay, and the regulated parties start saying we need tweaks x and y and z and oh there’s no danger there we should be very suspicious. We shouldn’t count on being to fine-tune our results to perfection, we should either lean in with a heavy hand or else stay away.