We don’t think about it, but financial regulation is a way of redistributing costs, and doing so allows more people to participate in our economy.
In Adam Smith’s The Wealth of Nations, he talked about sheep markets. Each person buying a sheep could decide for themselves the quality of the sheep being purchased, and with that the honesty and integrity of the person selling the sheep. One of the costs of any financial transaction is evaluating the honesty and integrity of the other party in the transaction; when we put our money in a bank or brokerage, how do we know they won’t take the money and spend it? In the financial world, this is called counterparty risk, the risk that the other party in the transaction won’t live up to its obligations.
In theory each of us could make a determination on counterparty risk by ourselves. We could talk to other depositors of the bank to see if they trust the bank, or perhaps tour the bank’s vault to make sure our money was there. But doing our own evaluation costs money and many people lack the financial sophistication to truly evaluate a bank’s stability. Instead, we outsource this task to the federal government – we trust that the government has checked the bank’s finances and operations and so it is safe to deposit our money. The federal government then redistributes the cost of insuring the integrity of banks and brokerages to everybody.
This role for the government grew out of the Depression. In the nineteen twenties it was on each depositor or investor to decide for themselves whether or not banks and investment houses were stealing from their depositors. It turned out a good number of them were. When Americans found out, they lost faith in all banks, even the honest ones. This started a run on banks and pushed us into the spiral that became the Depression. It was only when the government stepped in and assumed the role of guarantor of our financial system that people began trusting banks and Wall Street again.
The government’s role takes a beating in our modern political world, and it’s easy to forget how much we rely on the government’s assurances every day. Can you imagine depositing your paycheck in a bank if the government didn’t guarantee the sanctity of your deposit? Would you buy stock of a company that has its headquarters a thousand miles away if the Securities and Exchange Commission didn’t enforce disclosure and accounting standards? It’s not an exaggeration to say that our national economy can’t work without a strong national government.