“If we persist with a legalistic rule setting process, the opportunists will thrive. We will settle into a fatalistic acceptance of systemic financial crises, flash crashes, and ever more exotic forms of opportunism.”
Here’s my summary, but by all means read the original (21 pages double-spaced with wide margins, so it’s a quick read):
* Rules. A productive economy needs rules and social norms to coordinate individual activities. These range from innocuous things like driving on the same side of the road to more complex issues like airline safety and financial regulation.
* Rules aren’t “one and done.” As the world changes, the rules need to change with it. Advances in technology and globalization have made this more difficult in two ways. One is that the pace of innovation requires more rapid change. The other is that the scale is so large that traditional social mechanisms for controlling behavior don’t work as well — and changing more formal systems is harder to do.
* Detailed rule-based systems are prone to manipulation and opportunism. He seems to have financial regulation in general in mind, but focuses on OSHA, which sets mind-bogglingly detailed regulations for all kinds of things. The idea is not that the regulations are so detailed, which they are, but that no such system can ever keep up. The smart operators will always find a way around them, and have legal protection in doing it (we followed the rules).
* Principle-based systems work better in some settings. His example is the FAA, which “approaches its task of ensuring flight safety with rules that specify required outcomes but that are not overly precise about the methods by which these outcomes are to be achieved,” … Examines have “a large measure of flexibility” but “are held responsible for their decisions.” “There is no codified process a manufacturer can follow and be guaranteed that a new plane will be declared airworthy. There is no way for them to hide behind a defense that they checked all the boxes.”
I’m not sure what the FAA analog of financial regulation would look like, but it’s an interesting line of thought. When I get a chance, I’ll ask him about it.
Posted by Dave Backus