Securities Regulation Daily Commissioner Peirce uses prominent economists' insights to explore limitations of regulation as a problem-solving mechanism
Friday, May 17, 2019

Commissioner Peirce uses prominent economists' insights to explore limitations of regulation as a problem-solving mechanism

By Joanne Cursinella, J.D.

SEC Commissioner Hester M. Peirce employed the work of two prominent economists to discuss the limits of policymaking tools to solve complex social or market problems and what the Commission can learn from the economists' insights for its rulemaking.

At the “Smart Regulation and the Future of Financial Services-Public Policy Conference” held this month at George Mason University, SEC Commissioner Hester M. Peirce reflected on what two economists, American economist Harold Demsetz and Hungarian economist and political theorist Anthony de Jasay, had to teach about policymaking. Peirce said they teach the importance of being brutally realistic about what can be achieved through government policy, particularly given the people and tools at hand to create and implement that policy, and that these considerations should be taken into account in SEC rulemaking.

Demsetz and the nirvana approach. According to Peirce, Demsetz, who made significant scholarly contributions in several areas, including property rights, price theory, and the theory of the firm, discussed complicated issues with a clarity that made them accessible even to a non-mathematician, and she said that he often took contrarian positions in his work. For example, in conceding another's argument that conditions of perfect competition would not lead to optimal allocation of resources because of the costs, and optimal allocation would only possible if “the government or some other agency not governed by profit-and-loss criteria” financed the research, Demsetz countered with a comparative institution approach, which seeks to discover “which alternative real institutional arrangement seems best able to cope with the economic problem.”

Demsetz suggested that the nirvana approach, one that presents a choice “between an ideal norm and an existing ‘imperfect’ institutional arrangement,” rests on underlying fallacies: the grass is always greener fallacy, the fallacy of the free lunch, and the people could be different fallacy, Peirce pointed out. As to the human factor, bringing a policy solution from conception to successful implementation involves more than just dropping it into an agency black box and watching a perfectly functioning program emerge on the other end, Peirce added.

The nirvanas that American policymakers pursue still reflect Demsetz's criticism of the way we think and talk about policy options, Peirce said. She added that politicians, and more troublingly, policymakers suggest that possessing pure intentions and putting the right government employees to work obviate the need to interrogate assumptions about how policy will work in practice.

But Peirce found “glimmers of hope” that Demsetz's lessons are being absorbed, pointing to a recent SEC rule proposal that would exempt certain companies from the requirement to obtain an auditor attestation of their internal controls. The proposal recognizes that—for a subset of companies that are small and have low revenues—investors might rationally decide to retain the risk and spare the expense of paying an auditor, she said.

Jasay expands Demsetz's argument. While perhaps lesser-known in the U.S., Jasay's work provides insights that sharpen Demsetz's argument, Peirce claimed.Jasay studied economics and wrote about it until his death in January 2019.Jasay was not wedded to any particular school of thought, Peirce said, and he believed that macroeconomics was rooted in micro principles.Peirce pointed out that like Demsetz, Jasay did not favor idealizing government solutions intended to respond to social or economic inefficiencies; in fact, government solutions are imperfect because government itself has a motive to pursue its own ends, namely, increasing its discretionary power.

In fact, a central theme in Jasay's work is that it is “monumental folly” to ignore the state's interest in any analysis worthy of consideration, Peirce said. This forces his readers to confront difficult questions about what the state can be expected to do, and particularly whether it can be expected to respond well to the conflicting demands of competing interest groups, Peirce added. But Jasay does see a way for conflicting preferences of people in society to be organically reconciled in the power of private arrangements, Peirce pointed out.

According to Peirce, Jasay's argument about the state's pursuit of its own interests nicely complements, yet complicates, Demsetz's description of the nirvana approach and the related fallacies. Demsetz points out how proposed government solutions must be evaluated in the cold, harsh light of reality, rather than assuming that government involvement will eliminate inefficiencies or that flawed human beings will overcome their flaws when they work for the state, Peirce pointed out. Jasay's analysis suggests that government solutions may fail because the state is pursuing its own ends, she said, which may not involve solving the problem used to justify the policy. Jasay insists that liberty considerations be part of the analysis.

Application to SEC rulemaking.According to Peirce, “We can be better policymakers if we do not sweep reality, including the reality of our own limitations, under the carpet.” Demsetz and Jasay, with their “eyes-wide-open view of private- and state-based solutions,”can help regulators in making better policy choices. Sometimes the best choice will be to leave a problem to the market to solve. In other instances, the best choice will be a government solution that draws on market forces and takes into account government incentives and human tendencies, she said.

Peirce claimed that these insights should inform the economic analysis that is part of every SEC rulemaking. Peirce said she always calls for an analysis to start with an identification of the problem. Next, the analysis should describe a baseline against which each alternative solution will be compared. Then it should assess reasonable potential solutions, including market-based solutions, with an honest look at the costs and benefits of each. The analysis must include a realistic assessment of how any regulatory mandate would work in practice and what its unintended consequences would be, incorporating metrics to evaluate success, she said. Finally, policymakers should be humble in their policymaking role and wary of their own motives, she concluded.

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