The SEC versus Police

My post yesterday argued for eliminating the Securities and Exchange Commission.  I wrote:

Eliminating the SEC would make investors bear full responsibility for monitoring corporate behavior.   This occurs to a substantial degree already, since the SEC cannot effectively monitor all the firms subject to its regulations.  But eliminating the SEC would spur additional private monitoring and strengthen investor incentives to engage in due diligence.

Greg Mankiw has responded with skepticism, arguing that my logic also suggests eliminating police.  Greg wrote:

Eliminating the police would make people bear full responsibility for protecting their own safety. This occurs to a substantial degree already, since the police cannot effectively monitor everyone who might commit a crime. But eliminating the police would spur additional private monitoring and strengthen individual incentives to engage in due diligence.

Greg is right that the structure of my argument applies to government efforts to prevent ordinary crime as much as to government efforts to prevent white collar crime like CEO fraud or embezzlement.  Thus, consistency might seem to suggest drawing the same conclusion about both types of government policies.

Many libertarians respond by opposing both government attempts to deter white collar crime and government efforts to deter ordinary crime.  And they use the kinds of arguments that I suggested for white collar crime and that Greg has mimicked and applied to ordinary crime.

I have two responses.  To begin, the libertarian position on government and ordinary crime is not as bizarre as most people assume.   The scope for private crime deterrence is substantial (locks, alarm systems, guard dogs, guns, private security personnel, gated communities, and so on).  The evidence on whether police deter crime is mixed at best.  And some current police activities increase rather than decrease crime (prohibitions against vice). 

That having been said, I am not convinced that eliminating police is the right policy.  But that does not change my view on the SEC because ordinary crime and white collar crime differ in at least one key respect. 

In the case of ordinary crime, the victim has not entered into a relationship with the perpetrator of the crime.  In the case of white collar crime, the victims are the shareholders, and they willingly purchased the stock of the company in question.   That is, shareholders entered into a contract with the corporate executives; the shareholders gave the corporation money in exchange for shares, and the executives agreed, at least implicitly, to maximize the value of those shares.

Thus when CEO’s commit fraud or embezzlement, the shareholders have grounds for complaint, but they are not victims in the same sense as victims of a mugging or a robbery.  Shareholders have more than ample opportunity to design CEO contracts that make fraud difficult and that punish CEO’s for transgressions (loss of pension, stock options, etc).  Shareholders can hire private auditors to watch over CEOs. 

Under this “contractual” approach to disciplining CEOs, government still plays a role in limiting CEO misconduct by providing courts that resolve contractual disputes between shareholders and CEOs.  But they do not criminalize CEO misconduct, and they do not independently pursue white collar “crime.”

Reasonable people can debate whether the private, contractual approach to disciplining CEO misconduct will be sufficient without the threat of criminal penalties.  But at a minimum, the moral claim of a murder victim is different than that of someone who bought Enron stock.  The later knowingly assumed the risk; the former (usually) did not.

My bottom line, therefore, is that all government attempts to criminalize private actions have a range of costs and possibly some benefits.  The balance differs dramatically depending on the private action in question. 

At one end of the spectrum, criminalizing murder is almost certainly the right approach, but even this has drawbacks (the direct costs of police, prosecutors and prisons, plus any crowding out of private efforts to avoid getting murdered in the first place).   

At the other end of the spectrum, criminalizing victimless crimes like drug use, prostitution, or gambling has at best modest benefits in reducing an undesirable activity, and it generates substantial costs.

So the question of what to criminalize should take into account a range of issues, including whether the “victims” knowingly assumed the risks in question, whether criminalization itself has substantial costs, and whether private actions can reasonably address at least most of the negatives associated with the action in question.  My assessment is that for ordinary crime, the case for criminalization is probably convincing.  For white collar crime, the costs of criminalization likely outweight the benefits.

Comments

[KipEsquire]

Your thesis still falls flat for a very simple reason: "fraud" is not synonymous with "breach of contract."

Your answer to the problem of securities fraud is simply to assume it away. Not especially persuasive.

[Richard Phillips]

It seems to me that criminalization has nothing to do with the victim knowing the risks or not. For example, almost everyone is constantly and knowingly assuming several violence-related risks (e.g., by walking on a street and being subject to an armed robbery).

Contractual punishment is clearly not enough to discipline CEOs. Without criminal sanctions, dishonest executives could always hide money in some fiscal paradise and flee.

[Jason]

I recommend Bryan Calpan's two-cents over at EconLog.

[Joshua Lyle]

Re: KipEsquire
I don't think I'd contract services from an "Esquire" that can't envision putting provisions in a contract for dealing with the eventuality of fraud. There are many privately provided means, including insurance, escrow accounts, and arbitration.
Re: Richard Philips
The possibility of retirement in fiscal paradise already exists; the mere existence of criminal punishments has not prevented it, as extradition treaties are not universal.

[elliottg]

Contract enforcement is frictionless and instantaneou in your utopia.

[Richard Phillips]

Re: Joshua Lyle

It's true that the possibility already exists, but as criminals they wouldn't be freely allowed to leave the country. You cannot introduce this punishment in a contract. Contractual monetary sanctions mean nothing if they can hide some money and go spend it somewhere else. Criminalization introduces a much higher cost for dishonesty.

[Joshua Lyle]

Re: elliottg
I'm not sure what the formula is for the friction of contract enforcement, but to my knowledge private arbitration tends to be much less costly than going through the courts. Check out the arrangement used by the Visa Group.
Re: Richard Phillips
I'm not sure what you mean by criminals not being allowed out of the country. I mean, I could go shoot someone today and my passport would not be magically invalidated, although it would likely be revoked or seized upon my arrest. An arbitrator could insist on the surrender of a passport.
Also, contractual costs for fraud can be set very high. What if 95% of an executive's compensation was held in escrow until five years after the termination of his or her contract? In most cases, that's certainly enough money to send a guy to a fiscal paradise and hire a bounty hunter or assassin.

[Lonny Paul]

The most disturbing fact is that so many of today's largest companies find that their CEOs, Board Members and other top staff are and have committed fraud, embezzlement and committed other high crimes - and are generally still covered by their contract. Why?

Shouldn't the SEC push for transparency allow shareholders to know if a corporate executive is committing acts which are against the companies ethics, policies or have had any impact financially on the company (whether it is 'put back' or not)?

Many sitting CEOs have been caught with their hands in the cookie jar - but as long as they hit their goals they are 'golden.'

[Bpmhalrqxz]

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