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The Case For Government Regulation

[Update: Watch CSPAN Book TV of Spitzer at MIT on 4/26/11 lecture on his book “Government’s place in the market“.

Spitzer presents 3 principles as the justification for government intervention in the marketplace, very similar to those he spoke of at Harvard: ) 1 enforce standards for market integrity; 2) incorporate externalities; and 3) protect core values. Noting that regulation can never been the only tool, he closes by recommending shareholder power.]

Last night, I watched (and strongly recommend) C-SPAN’s tape of former NY Governor Eliot Spitzer’s address at Harvard, “On Government and the Market Economy” (Spitzer’s suggested title, which I like better than CSPAN’s, was: “From Ayn Rand to Ken Feinberg: How Quickly the Paradigm Shifts“).

Spitzer spoke about 3 things:

1) parameters and principles to justify government intervention in the market;

2) the current financial crisis, major flaws in the Wall Street bailout, and the need for specific reforms, particularly to promote jobs; and

3) flaws and needed reforms in corporate governance.

I will focus here only on the first, the justification for government regulation.

Given that I’ve spent my career in government on regulatory policy, and recently have been writing about our new Governor’s environmental policy, I thought it might be a good opportunity to lay out Spitzer’s justification for government intervention. His arguments have direct relevance not only to current policy debates over financial markets and regulation, but for drug safety, consumer protection, and environmental protection regulation as well, which are driven by the same market forces. The transparency, integrity, and market failure issues are broadly relevant to even the field of science, which relies on complete disclosure of data. Spitzer illustrated this with a disturbing drug safety case, where the pharmaceutical industry failed to disclose adverse health effects data from clinical trials.

I also can’t avoid taking this opportunity to note the huge intellectual and ideological contrasts between Spitzer (a former NY Governor and 2 term Attorney General) and the NJ Governor elect, a former US Attorney. Hands down, Christie is far outmatched by Spitzer – it’s like the NY Giants versus the local high school team. If you don’t want to take my word for it, just consider the simple contrast that Spitzer has spent his career prosecuting big time Wall Street fraud, while Christie has focused on small time local government crooks. Or watch the C-SPAN show (link above) and decide for yourself.

Whether you agree with Spitzer or not on policy, you must agree that he is both far more articulate and intellectually powerful than Christie, who comes off as a lightweight by comparison.

Spitzer managed to be substantive and accessible, without being theoretical, pedantic or lawyerly. While he focused on policy, he didn’t hesitate to talk about the political aspects, including calling out those personally responsible for policy and market failures, as well as the flawed and failed theory and public policy that caused the current financial collapse.

His inside story about a personal threat from lawyers from Merrill Lynch was chilling. A ML lawyer tried to intimidate Spitzer and back him off his prosecution with the mob-like threat: “Be careful, we have powerful friends“. (I wonder, were they the ones who arranged for Spitzer’s prostitution wire taps et al?)

Spitzer began by noting the collapse of financial institutions, which he attributed to failures of government regulation and markets. He stressed the need for analysis and dialogue of the causes of these failure, and for reform. But, in a somewhat elitist fashion, he found the voices of those he called “the angry populists” as unhelpful as the ideological libertarian followers of Ayn Rand who caused the problem.

He traced the recent policy history, and noted the vast shift in the intellectual paradigm from Reagan free market libertarianism to a far more interventionist approach, which he illustrated by a government bureaucrat, Ken Feinberg, controlling Wall Street CEO compensation. He used this observation to note how quickly the paradigm had shifted, given the financial collapse.

He then laid out 4 parameters that justified government intervention in the economic marketplace:

1. Only government can enforce rules related to integrity and transparency in the marketplace.

Spitzer rehashed his successful criminal investigations of Wall Street fraud and corruption. He outlined gross conflicts of interests and lack of transparency that corrupt market transactions. Basically, when faced with the choice of integrity or profits, or integrity and market share, Wall Street chose profits. The market drove those rational decisions, which destroyed the integrity of the market, and created systemic risks, which in turn ultimately led to market failure and financial collapse. Individual firms could not be honest, because that would put them at a competitive disadvantage. They needed system-wide rules. Competition and the drive for profits and market share led firms to lie.

Transparency, honesty, and integrity are preconditions of functioning markets. Contrary to libertarian and free market ideologists, the market can not police itself. Only government can police the market.

2. Only government can prevent exercise of monopoly power and ensure effective competition through anti-trust law enforcement.

Markets tend toward monopoly. Monopoly is inefficient, blocks technological innovation, reduces productivity, and deprive consumers of the benefits of vibrant competition.

3. Only government can intervene to change the way the market behaves and mitigate externalities.

Externalities are costs (or benefits) that are not accounted for in a market transaction (i.e the price of a good or service). Spitzer spoke of a classic example of air pollution from mid-western coal power plants. To meet local air quality standards in Ohio, those plants built tall smokestacks that shifted pollution costs from Ohio to NY state. This externalized the costs or electric power. As NY Attorney General, Spitzer sued these plants under the Clean Air Act. Only government can mitigate externalities, which are pervasive in the environmental policy arena.

(Note: although Spitzer didn’t specifically mention them, there are at least two additional solid justifications for government intervention. The first is what economists call “public goods“, like clean air or clean water. The second is what is called “inter-generational equity” or considerations of the future. Residents of the future can’t participate in current market transactions.)

The aggregate of excess debt is an externality. Too much debt is a threat, or systemic risk. Government has to intervene.

4. Only government can protect core social values from the ravages of the marketplace

Spitzer called this the most elastic of the justifications, but the most important. He used discrimination and minimum wage as examples.

Free market theorists’ arguments that discrimination is inefficient and therefore will be eliminated by competitive markets is just wrong. Social factors over-rode market rationality, so discrimination persisted. Only government intervention via laws was effective. Similarly, we have made a societal value judgment in minimum wage, There is no market justification for social policy. Ayn Rand and the libertarian free market fundamentalists are wrong. The angry populists are equally wrong. Government must be active in protecting ┬áconsensus core social values.

On the whole, I found Spitzer’s policy diagnosis right on the mark and his aggressive prescription refreshing, especially compared to the weak kneed response of the Obama Administration, which is captured by Wall Street.

The only thing I was turned off by was his politics, which amounted to an elite dismissal of the “angry populists”, who I think are an important allie and required to create the bottom up movement like political pressure to force a policy solution.

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