The behavioral problems of regulators

We often hear about how weak-minded and emotional consumers and investors need regulation to protect them from themselves and from businesses that prey on them. This is particularly significant for financial regulation -- indeed, an important basis of such regulation is that people tend to be irrational when it comes to handling money and investments.  And of course we’re hearing this a lot in the wake of the problems with subprime.

I’ve been a skeptic of behavioral economics justifications for regulation in general and financial regulation in particular. See my Fraud on a Noisy Market. One basis of my skepticism is that the same theories that call for consumer protection also apply to the regulators themselves.

David Hirshleifer has a wonderful and accessible short paper outlining these concerns, Psychological Bias as a Driver of Financial Regulation. Here’s the abstract:

I propose here the psychological attraction theory of financial regulation - that regulation is the result of psychological biases on the part of political participants - voters, politicians, bureaucrats, and media commentators; and of regulatory ideologies that exploit these biases. Some key elements of the psychological attraction approach are: salience and vividness, omission bias, scapegoating and xenophobia, fairness and reciprocity norms, overconfidence, and mood effects. This approach further emphasizes emergent effects that arise from the interactions of individuals with psychological biases. For example, availability cascades and ideological replicators have powerful effects on regulatory outcomes.

And here’s the engaging first paragraph:

At a delightful dinner not long ago, a former president of the American Finance Association mentioned to me that as a behavioral financial economist, I should be a keen advocate of regulation to protect investors from themselves. He was quite surprised by my reaction, that the behavioral approach in some ways strengthens the case for laissez faire, and raises some new doubts about the value of regulation, because much regulation is driven by psychological bias—on the part of the proponents, not necessarily the regulated. As several authors have argued . . . . individuals have stronger incentives to overcome their biases when investing their own money than when making political choices that affect other people’s money.

My main quibble with the paper is that Hirshleifer omitted what I think is the best paper on this subject: Choi & Pritchard, Behavioral Economics and the SEC, 56 STAN. L. REV. 1(2003).

Comments

[Michael Webster]

Do you have any particular or specialized view on franchise disclosure regulation?