Regulating Financial Markets: Protecting Us from Ourselves and Others

The current global financial and economic crisis highlights the ongoing tug-of-war between those who pull toward free markets and those who pull toward strict regulation of markets—between those who pull toward libertarianism and those who pull toward paternalism. Rising stock markets and economic prosperity empower those who favor free markets and libertarianism; stock market crashes and economic recessions empower those who favor strict regulation and paternalism. This article discusses the current crisis against the backdrop of earlier crises and focuses on margin regulations, which limit leverage; suitability regulations, which require providers of financial products to act in the interests of their clients; blue-sky laws, which prohibit securities deemed unfair or unduly risky; and mandatory-disclosure regulations, which require providers of financial products to disclose pertinent information even if potential buyers do not ask for it. The current global financial and economic crisis highlights the ongoing tug-of-war between those who pull toward free markets and those who pull toward strict regulation of markets—between those who pull toward libertarianism and those who pull toward paternalism. Motivated by ideology or self-interest, members of each group try to enlist legislators and the general public in their cause. Historical accidents, such as stock market crashes and economic recessions, attract members to one group or the other, boosting its power and tugging the rope left or right. New self-interest groups form once new regulations are enacted, new historical accidents occur, and the tug-of-war continues. This sequence of events played out when the Securities Act of 1933, the Securities Exchange Act of 1934, and the Glass-Steagall Act of 1933 were enacted during the Great Depression; when the Gramm–Leach–Bliley Act was signed into law during the boom of 1999, repealing portions of the Glass–Steagall Act; when the Sarbanes–Oxley Act was enacted after the 2000 crash; and, most recently, when financial institutions were bailed out and their regulation was tightened in the current crisis. We must come to grips with the crisis and reconsider the balance we should strike in this tug-of-war. This article discusses the current crisis against the backdrop of earlier crises and focuses on margin regulations, which limit leverage; suitability regulations, which require providers of financial products to act in the interests of their clients; blue-sky laws, which prohibit securities deemed unfair or unduly risky; and mandatory-disclosure regulations, which require providers of financial products to disclose pertinent information even if potential buyers do not ask for it. In 1999, Senator Phil Gramm spearheaded the Gramm–Leach–Bliley Act, which eased regulation and repealed barriers erected by the Glass–Steagall Act of 1933 to reduce the risk of economic catastrophes by separating commercial banks from investment banks. Senator Gramm was a Republican, but support for the Gramm–Leach–Bliley Act extended beyond his party. The act was signed into law by President Clinton, a Democrat. We should not be surprised to learn that the Gramm–Leach–Bliley Act was enacted in 1999, which was during the top end of a financial and economic boom. Financial and economic booms shift the tug-of-war power from those who pull toward paternalism and heavy regulation to those who pull toward libertarianism and free or lightly regulated markets. Now, in 2009, a year at the bottom end of a financial and economic bust, power is shifting to those who pull toward paternalism and heavy regulation. History tells us that we tend to overreact by urging legislators and government executives to pull too far toward paternalism when we are fearful and too far toward libertarianism when we are exuberant. There is danger in pulling too far toward one end or the other, but there is also danger in not pulling far enough. The pull toward libertarianism and light regulation stoked the stock bubble of the 1990s and the real estate bubble that followed it. Often citing U.S. Supreme Court Justice Louis Brandeis’s 1914 proclamation that the sunlight of disclosure is the best disinfectant, some urge us to stop pulling toward paternalism once we have reached mandatory transparent disclosure to investors and in financial institutions and markets. But today, almost a century after Brandeis’s declaration, we know that our hospitals need more than sunshine as a disinfectant and that diseases can spread rapidly even when relatively few forgo immunization. Mandatory disclosure might keep most of us economically healthy most of the time, but we need the economic equivalent of mandatory immunization to prevent the carelessness of some from infecting us all.