Oh, it'll take a little time
Might take a little crime
To come undone now
--Duran Duran

A recent Fortune article that profiles banking entrepreneur Peter Fitzgerald (Birger, 2009) offers industry-specific examples of how regulation can restrain standard of living over time. Standard of living advances through innovation that improves productivity. Regulation can impair innovation through the following mechanisms:

Distorting signals of value. When purchasing goods or services from sellers, buyers indicate their value preferences through their willingness to part with scarce monetary resources in the exchange. Sellers use this signal as confirmation that they are on the right track. Producers are thus motivated to do more of the same.

Regulation distorts this signal. In the banking industry, for example, government sponsored insurance has decreased consumer due diligence when making banking purchases. Less informed buyer choices have supported inefficient operators, many of which lie at the center of our current systemic problems. As noted by Mr Fitzgerald, "The reason we got into this situation is in part that people didn't care what their bank's balance sheet looked like because their accounts were FDIC-insured." This, of course, is the moral hazard principle in motion.

Raising barriers to entry. Research suggests that major innovation often springs from new entrants to an industry rather than from existing firms (e.g., Christensen, 1997). Because they are less restrained by historical commitments that shackle incumbent operators, new enterprises tend to be more creative in producing output that meets consumer needs.

Regulation raises industry entry barriers. Costs of regulatory compliance, such as the myriad reporting systems required for financial services firms such as Morgan Stanley (MS), may be considerable. High costs discourage would-be entrants.

Regulation also prevents weak incumbents from failing, which reduces potential for enterprising firms to acquire market share from less efficient competitors. It should be obvious by now that our current regulatory scheme makes it very difficult for institutions such as Bank of America (BAC) or Citigroup (C) to fail regardless of the degree of managerial imprudence. Regulatory protection of incumbent franchises is likely to turn away many enterprising entrants.

Regulating markets is often deemed necessary to protect individuals from big bad corporations. Ironically, it is regulation itself that can perpetuate corporate bigness and badness.

References

Birger, J. 2009. A banker of the old school. Fortune, 159(11): 60-64.

Christensen, C. 1997. The innovator's dilemma. Cambridge, MA: Harvard Business School Press.