I recall hearing when I first came to the University of Chicago in 1969 the expression “Nirvana Fallacy,” used to describe the belief then dominant in the economics profession that market failures could and should be rectified by government intervention, assumed to be apolitical and effectively costless. The belief was unsound; government failure is commonplace, partly because of politics, partly because of the intrinsic difficulty of many of the tasks that are given to government to perform.
The opponents of the Nirvana Fallacy did not deny the existence of market failures; they just wanted the costs to be balanced against the cost of government intervention. But as the years went by there was a growing tendency among conservatives to regard markets as Nirvana—as self-regulating—and thus to deny the need for government regulation. Alan Greenspan, when he was chairman of the Federal Reserve Board, was a spokesman for this position. It became particularly influential during the administration of the second President Bush, with seriously adverse consequences. The deregulation of the banking industry, which had begun under President Carter and been completed during Clinton’s second term, coupled with extraordinarily lax regulation of the nonbank banks (such as Goldman Sachs, Merrill Lynch, and Lehman Brothers) by the Securities and Exchange Commission (which had the principal regulatory authority over the nonbank banks) under the last chairman appointed by Bush, lax regulation of insurance companies (such as AIG) by state insurance commissioners, lax regulation of Fannie Mae and Freddie Mac by the Federal Housing Finance Agency, and lax enforcement by the Federal Reserve Board and the other bank regulatory agencies of the remaining regulations of commercial banks, were major causes (along with the lax monetary policy of the Federal Reserve in the early 2000s and misleading statements by successive Fed chairmen) of the financial crisis of September 2008 and the ensuing economic downturn—the most serious since the Great Depression.
Most economists did not understand the inherent instability of financial markets (which derives from the basic financial model of borrowing short term and lending long term, which can induce runs, especially when, as in the case of the nonbank banks, the short-term capital—often overnight—is not insured), the vulnerability of housing markets (in which the banking industry was heavily involved) to bubbles, or the potential macroeconomic consequences of a failure of those markets, which made deregulation a riskier policy than in industries such as air and surface transportation, electrical distribution, natural-gas production, oil pipelines, and communications. Because of the potential for catastrophic market failure, regulation should have been much tighter than it was.
Of course more than mistakes by economists were involved; the pressure of the banking industry for deregulation and light enforcement of the remaining regulations was intense, because the bankers wanted to be allowed to take more risk so that the expected return would be greater. Whether there would have been more resistance if the economics profession had opposed the industry is an academic question.
Regulation had got a worse name than it deserved because of a tendency to conflate it with other, more questionable government activities—the actual operation of economic enterprises (the Post Office, air traffic control, toll roads, TVA), all of which would be more efficiently operated as private firms, and a variety of unjustifiable subsidies, such as the provision of medical insurance to affluent old people, or the deductibility from federal income tax of interest on home mortgages. Government-run businesses and most government subsidies displace more efficient private activity, but regulation is essential and cannot be outsourced. Not that there isn’t excessive regulation; but some—notably of financial markets—is indispensable.
Another potential confusion is between comprehensive economic regulation of specific industries and the regulation of safety and health and of workplace discrimination, cutting across industries. Public utility and common carrier regulation, illustrated by the regulation of telephone companies and railroads before the deregulation movement, was notably inefficient, tending to protect not consumers but instead sellers, by shoring up the sellers’ cartels or monopoly. Banking regulation was of that character before the deregulation movement—limitations on the grant of banking charters, on branch banking, and on the payment of interest on demand deposits were examples of regulatory policies that reduced competition in banking. This was not an entirely undesirable effect because the more competitive banking is, the riskier it is—and the risks are macroeconomic (in contrast, if the airline industry, say, went bankrupt, the consequences for the rest of the economy would be trivial). But the traditional regulation of banking was too restrictive and was rightly dismantled—only the deregulation of banking (and related financial institutions) went too far.
The deregulation movement that focused on comprehensive regulation of specific industries coincided with a movement in the opposite direction—toward greater regulation—with regard to safety, health, pollution, and discrimination. Many of these regulations have no economic justification; they are paternalistic, as in the case of seatbelt laws—or if justified, are justified only because of the existence of other unjustified government interventions, such as subsidies for the medical expenses of people injured because they don’t fasten their seatbelts.
But the fact that there is a great deal of unsound or questionable regulation is not a good argument for leaving all economic activity to the Darwinian processes of the market. Competition forces businesses to ignore external costs and benefits (that is, costs and benefits not borne by the creator of them). If either sort of externality is great enough, there is a strong case for regulation, provided the benefits of regulation can be shown to be highly likely to exceed the costs.