The Empty Case for More Regulation

The Madoff scandal shows why bigger government isn't the answer.

If there is anything we have learned from the crisis in the financial sector, it's the urgent need for more regulation. Had federal regulators been more vigilant or wielded greater powers, all this suffering and heartache might have been averted. That's the story we've been told, and it must bring a rare smile to the face of Bernard Madoff.

Madoff was the manager of a Wall Street investment fund that he allegedly confessed to his sons was "one big lie" and "a giant Ponzi scheme." But "giant" fails to capture the scale of his fraud, which may have lost $50 billion, more than the entire gross domestic product of most of the countries on Earth.

Also striking is that his alleged victims were not rubes and simpletons but individuals of exceptional wealth and financial acumen—including various tycoons, as well as managers for banks, pension funds, and hedge funds. Even Madoff's own son, who worked for his father's firm, invested millions of dollars of his own money in the supposedly phony fund.

A Ponzi scheme, as it happens, is not a scam of dizzying complexity. It's the oldest scam in the book. You take money from new investors to pay off previous investors, and you keep doing it until the new infusions can't keep up with the withdrawals. It's about as simple as financial trickery gets.

So if regulators had been paying attention, they would have detected what was going on, right? After all, as one expert noted, Madoff was conspicuously unable to attract a lot of big institutions. "There's no Harvard management, there's no Yale, there's no Penn … no State of Texas or Virginia retirement system," James Hedges IV of LJH Global Investments told Fortune magazine.

Why not? "Because when you get to page two of your 30-page due diligence questionnaire," said Hedges, "you've already tripped eight alarms and said, 'I'm out of here.'"

So you would think all this would have caught the eye of any regulators who were half-awake. But regulators, it turns out, were not oblivious to what was going on. Nor were they lacking in means to rein Madoff in.

In fact, as The Wall Street Journal reported the other day, the Securities and Exchange Commission had been suspicious of his methods for a long time. It had even heard in 2005 from a competing investment executive who drafted a 21-page report arguing that Madoff was running a Ponzi scheme.

The government had actually investigated him—not once or twice, but "at least eight times in 16 years," according to the Journal. Yet it "never came close to uncovering" the operation, which may have begun as early as the 1970s.

So what makes anyone think that future bureaucrats, no matter how vast their authority, will be able to do better? Advocates of stricter regulation often talk as though the choice for protecting investors is between imperfect market mechanisms and foolproof government regulations. In fact, governments, like every other institution, are staffed by fallible individuals who can be fooled as easily as anyone else.

The call for more federal control overlooks inconvenient facts. The first is that con artists will often outfox regulators, if only because they have far more to gain from carrying off a fraud than civil servants have to gain from stopping it. If the SEC couldn't catch the brazen Madoff in eight tries, what suggests we should place greater faith in the ability of other agencies trying to monitor a vast network of financial companies?

Banks have been decimated by their purchase of mortgage-backed debt that has gone bad. But banks operate in one of the most heavily regulated sectors of the economy. The call for more intervention assumes that if one aspirin won't cure a case of pneumonia, two will.

And if America's weird aversion to regulation is the problem, how come banks in government-addicted Europe are in the same hole? "By some measures, in fact, European banks exposed themselves to even higher levels of risky debt than American banks did," the International Herald Tribune reported in October.

Federally imposed rules are no match for a mass outbreak of reckless abandon, and they're no substitute for individual prudence. A new burst of regulation would eventually confirm those truths, but the mess we're in should be lesson enough.

COPYRIGHT 2009 CREATORS SYNDICATE, INC.