The Nirvana Fallacy

President Obama has announced his "sweeping overhaul of the financial regulatory system."

We can debate endlessly whether the Constitution authorizes any president to "overhaul" the financial system. But I want to focus on a different matter: whether any president, with all his advisers, is capable of overseeing something as complex as the financial system.

My answer is no, and it is ominous that a bright guy like Obama doesn't know this. He thinks he must regulate the system because it is so complicated and important. In fact, those are the reasons why he cannot regulate it, and should not try.

As F.A. Hayek said in accepting the 1974 Nobel Prize in economics, "[W]ith essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones." So when regulators set out to redesign an economy, they display not wisdom but a "pretence of knowledge".

Yet Obama is so confident.

"[W]e will ... coordinate and share information, to identify gaps in regulation, ... solve problems in oversight before they can become crises ... that will allow us to protect the economy."

What Obama cannot tell us is why these are anything more than words. We've heard them before. Why should we be comforted?

Regulators are human beings with the same shortcomings as everyone else. Even if we assume they have the best motives, on what basis do we believe they could possibly know what they need to know to manage a financial industry that is complex beyond conception -- and changing every day in response to new conditions?

Obama speaks as though these facts don't exist. He goes so far as to say, "[W]e're proposing a set of reforms to require regulators to look ... -- for the first time -- at the stability of the financial system as a whole."

That is precisely what no one can do. The financial system isn't a machine. It's people -- a huge number of them -- engaging in countless transactions often on the basis of hunches that are not quantitative and never written down. How is a regulator to keep tabs on -- much less manage -- that?

It cannot be done. If he tries, he'll end up stifling competition, innovation and life-enhancing economic growth.

Contrary to the foes of free markets, the choice is not between regulated and unregulated markets. As the French economist Frederic Bastiat long ago pointed out, the free market is regulated by its own logic. If we have simple, easily understood rules against fraud, then people acting in their self-interest, without privileges or bailouts, generate market forces that create order and make our lives better. The key is market discipline, which government reduces whenever it intervenes.

Is the market perfect? Of course not. The market is people. But the same kind of people will run the regulatory bureaucracy -- except they play with other people's money and have brute power in their hands. Here is where Obama's planners commit what economist Harold Demsetz calls "the Nirvana fallacy". They compare the real-world marketplace to an idealized regulatory apparatus run by omniscient bureaucrats.

But the latter is not available, so the comparison is pointless. We must choose between two systems, both run by fallible people. The decentralized, competitive market full of free people is hands-down preferable to a centralized body of clueless bureaucrats who can hold a gun to our heads.

Obama says the free market is "not a free license to ignore the consequences of our actions." He's right but doesn't understand why. A genuine free market allows risk takers to fail and suffer "the consequences." Only government can grant "license" to ignore consequences. Government caused the financial morass by doing just that -- pushing banks to weaken mortgage lending standards, pressuring Freddie and Fannie to buy up dodgy mortgages and sell them as safe securities, bailing out big banks when they got into trouble and insuring bank deposits -- thereby encouraging us not to care if banks are reckless.

Government failed, not the market. Obama's answer? Just like George W. Bush's: more government.

Give me a break.