Regulation and Fraud

A few days ago I had an interesting discussion with a friend about regulation. He argued that regulation tends to make individuals more likely to fall prey to scams. One of his arguments in particular made me pause to think a little more deeply about regulation and fraud:

...It is not the freedom of the market that allows more people to be easily sucked into these scams, it is the lack of freedom in the market. Corruption does not come from freedom or the market, corruption comes from those who can use regulation and regulatory endorsement in place of reputation.

To be clear, my friend was defining regulation as something distinct from the legal consequences to individuals who are found guilty of fraud (i.e. he wasn't advocating a lack of laws against fraud, instead he was arguing against regulatory structure). He went on to argue that reputation is a strong enough force that we don't need regulation. Indeed, he argued that regulation encouraged fraud because fraudsters exploit regulatory loopholes or abuse the regulatory system to develop a false reputation. 

While I agree that individuals may exploit poor regulation to the detriment of others, this argument seems to imply that if we were to get rid of all regulation (i.e. eliminate all government intervention in the market), that our markets would thrive.  I would have to disagree with that notion. 

While I agree that reputation can go a long way, I have a hard time seeing reputation as sufficient for our complex markets. I would argue that as members of society we have a very hard time critically evaluating the reliability of an individual's reputation. Most fraudsters exploit their victims' tendency to trust the fraudster. The level of trust that fraudsters can get from their victims is evident in the way that many victims of ponzi schemes continue to defend the fraudster who scammed them even when major regulatory bodies are threatening action the fraudster. 

Fraudsters who run investment scams (e.g. ponzi or pyramid schemes) usually develop a positive reputation by following through with their promises to pay unsustainable returns. In the case of Madoff where his promised returns were not particularly spectacular in the short term, he was able to develop a strong reputation for consistency and following through on his promised returns. I would argue that his business reputation was a much larger factor than his political/regulatory reputation in attracting investors, although I don't dispute that the latter was likely a factor. I guess what I am trying to say is that most fraudsters are successful at conning people without having to exploit any regulatory loopholes.

Further, a few points about the free market: First, I have yet to meet a free market economist who would argue that the market could function with absolutely no government intervention. The government needs to ensure some basic rights and provide some basic structure in order for markets to function properly. Second, the free market maximizes societal welfare IN AGGREGATE, but not necessarily at the individual level. In most cases the free market also maximizes individual welfare, but that is not always the case. Given those two points, the question is not whether we should regulate, but how much.

I think we can all agree that over-regulation has major societal costs.  I also believe that politicians have a tendency to engage in knee-jerk regulation, which can often be difficult to scale back ex post.  Still, a free market needs some basic level of regulation in order to provide structure.  One area where I believe regulation is very important is the realm of financial reporting. Free markets cannot function well without free flowing information. Without some regulation over financial reporting, it would be incredibly difficult to compare company performance. If we were to remove all regulation over financial reporting, it would likely be very difficult for individual investors to assess relative investment quality. In that case, most individual investors would probably pull their capital out of the market, leaving only the capital provided by institutional investors. Because the supply of capital would be greatly reduced, it would increase the cost of capital to corporations--which would have an adverse impact on aggregate welfare. 

Having said all that, I'm still not sure how to determine the optimal level of regulation.  Because both the costs and benefits of regulation can be subjective and difficult to measure, I'm not sure that we can easily determine the optimal level of regulation.  Thoughts?