Regulation is a social substitute for trust.
That's not a moral statement, just a factual one.
Sometimes it's obvious. We submit to the regulation of traffic laws because we can't trust everyone will simultaneously interpret the rules of the road similarly. And, when stoplights fail, we trust the regulation of traffic cops, whose very jobs are the result of a citizenry's decision to be regulated.
Another regulatory no-brainer would seem to be the "commons," i.e. a situation where, at the margin, it's in everyone's personal best interest to behave selfishly. Except that, when everyone does so, everyone turns out the loser. (In game theory, the "prisoner's dilemma" spells this out).
We can't trust everyone (or even most people) to do what's socially good, so we submit to regulation.
So it is we end up with regulated airspace and water tables (though there are still crazies who insist they should be able to fly anything anywhere anytime, and drill any water drillable beneath their half acre of Arizona; plus, we still over-fish).
Closely related are natural monopolies, e.g. utilities (except, bafflingly to me, water companies in the UK). These businesses, left unregulated, will drift, often quickly, to monopolies. Much of regulatory debate is how to balance society's interest vs. the normal trappings of markets. (Can we trust Microsoft to innovate? Airlines to share route rights? Telecom companies to share scale economies?).
The right degree of regulation for natural monopolies would be an easy matter for industrial economists, if only political ideologues nattering about free markets vs. socialism would leave them alone.
Much less is clear when it comes to naturally competitive markets in which people and companies behave in an untrustworthy manner toward customers, shareholders, employees and society. Here the issues become more clearly trust-related.
Can we trust the stockbroker's motives when he recommends a stock? The food company's label of 'organic?' Can we trust that the insurance company will be there when it's claim time? Can we trust that a corporate email sent in confidence will be treated as such? That a doctor's prescription is not unduly influenced by a pharmaceutical company?
Here are a few social policy rules of thumb for thinking about the relationship between trust and regulation.
1. Trust--where possible--is preferable to regulation. It avoids moral hazard; it is cheaper; and it is inherently specific to the situation at hand.
2. Industry associations have a potentially powerful role to play. Too often they see their role as defenders of their constituents against regulation, rather than the far more constructive and long-term perspective of evolving powerful self-regulation. For a specific example (financial planning), see my post here. Or, simply look at the regulatory nightmare the pharmaceutical industry has become for failure to self-regulate.
3. Certain industrial economics criteria cry out for regulation. If no one--investor, regulator, customer--has an integrated interest across a sector of business, then the situation is rife for abuse. The securitized mortgage industry had no one to play this role.
4. All else equal, short-term perspectives destroy trust and invite regulation.
5. Transparency may be the least costly form of regulation. It works best when obvious ("Smoking causes cancer; these assets were marked to market").
6. If an industry is fond of saying things like "caveat emptor," or "hey it's not illegal," or "we're only giving the consumer what they want," look out. This is defensive language, typically used against stakeholder complaints--Big Tobacco, Big Food, and, I suspect, melanin producers in China.
7. Personally, I think business-school faculty have a huge responsibility. In an increasingly hyper-linked world, the competition-centric ideology taught as "strategy" is increasingly dysfunctional. It destroys trust by teaching that the natural state of business is to compete against our suppliers and customers, rather than to collaborate with and serve them.
By destroying trust, this ideology invites regulation. Which, as stated in point one above, is the less preferable option.
Business, heal thyself.
Follow Charles H. Green on Twitter: www.twitter.com/charleshgreen
This would lead to a healthy and "smaller is beautiful business model" ie, a small butcher shop that has a small chance of making a large number of people sick from E. coli would have no need for a full time federal inspector on premises (paid for by the butcher) than Monfort or IBP that has the potential to infect millions of people with infected meat. Or perhaps a mandatory 90 day shut down, a full meat recall and full disinfection of the plant (with lab testing) would also work.
The problem with industrialization is that huge quanities of "cheap" product is deemed the greatest good, and quality and lasting good goes out the window, we need to demand better form our suppliers of everything, from food to cars to computers that will work for many years, no matter if they are obsolete before we buy them.
This leads to a situation where the healthy skepticism that would be an integral part of every management decision goes down the river. Because of all the babble about competition and how it's so healthy and always healthy and never destroys value, people forget that returns come at a risk and that you need to be the one who knows the risk of the business you run better than everybody else.
The shortsightedness even destroys the insights of the free-market economists themselves. Trust is no longer possible or rational because you need to assume that nobody knows what they're doing. Even to the point of acting against their own best self-interest.
Frightening. But one insight helps: it can be made clear that people who claim to be able to act strategically (based on the ignorance of others) in such a 'market' fool themselves. It is close to impossible to come up with a well-defined measure of performance that would attribute 'success' to any kind of action or strategy in such a debased environment. It's very hard to separate it from random profits. Too hard. Foolish competitors make everybody's life unnecessarily difficult.
Sad news: why is this news, given that it's not news, but was known for ages?