What Can Regulators Regulate?

In an important article titled, "What Can Regulators Regulate? The Case of Electricity" written in 1962, George Stigler and Claire Friedland observe,

The literature of public regulation is so vast that it must touch on everything, but it touches seldom and lightly on the most basic question one can ask about regulation: Does it make a difference in the behavior of an industry?

As the House Committee on Oversight and Government Reform hearings begin, the washingtonpost.com reports that

Internal Freddie Mac documents show that senior executives at the company were warned years ago that they were offering mortgages that could pose dangers to the firm, hurt borrowers and generate more risky loans throughout the industry.

The documents also suggest that the GSE's executives knew their firms were falling behind private sector firms in product innovation and market share. Parenthetically, this suggests that the GSE's were not the culprit of the housing bubble, its bursting, or the ensuing financial crisis, but rather a somewhat late player. Fannie's CEO, Daniel Mudd expressed concern in 2005 that

A business presentation in 2005 expressed concern that unless it didn't [push into new markets], Fannie could be relegated to a "niche" player in the industry. Mudd later reported in a presentation that Fannie moved into this market "to maintain relevance" with big customers who wanted to do more business with Fannie, including Countrywide, Lehman Brothers, IndyMac and Washington Mutual.

In a wonderful Cato Policy Report touching on the social value of free markets and the impact of regulation, titled, "Are We Ailing from Too Much Deregulation," David R. Henderson notes that the GSE's were important players in the mortgage industry

Of the more than $15 trillion in mortgages in existence in early 2008, about one third were owned by, or were securitized by, Fannie Mae, Freddie Mac, Ginnie Mae, the Federal Housing and Veterans Administration and other government agencies [GSE's] that subsidize mortgages.

Despite falling behind private financial companies, the GSE's knew their importance in the industry. The washingtonpost.com reports that

The documents suggest than Fannie and Freddie knew they were playing a role in shaping the market for some types of risky mortgages. An e-mail to Mudd in September 2007 from a top deputy reported that banks were modeling their subprime mortgages to what Fannie was buying.

When Representative Darrell Issa (R-Calif.) who said (washingtonpost.com) that the executives at the GSE's need to take responsibility for their actions and the companies failure, and other members of Congress who have said similar things should remember with some humility their institution's failures to oversee their creations. Regulators, both those at the Office of Federal Housing Enterprise Oversight (OFHEO), and in Congress were unable to successfully regulate Fannie Mae and Freddie Mac. Particularly egregious were members of Congress who blocked regulatory reform.

Why did regulation fail? Henderson suggested two reasons: regulators have little incentives to regulate well, and regulatory agencies are often captured by the industry they regulate. Slate's Jack Safer beautifully illustrates political capture by Fannie and Freddie in, "Fannie Mae and the Vast Bipartisan Conspiracy." Let me suggest a third reason regulators, congressional or otherwise, fail: they do not have the knowledge needed to control a spontaneously and organically growing market, nobody does.