Rules to prevent financial fraud or toxic dumping or faulty medical devices — these don’t destroy the free market.  They make the free market work better. — President Obama, State of the Union Address, 1/24/12

Over the past year, discussion over regulations has frequently been distortedly one-sided, as if their only possible effect on the economy and markets is to cause damage. The Obama administration itself has often failed to add balance to this conversation, so it was heartening to see the president lay out a more comprehensive assessment in his State of the Union address.

In the address, President Obama focused most on the financial crisis and regulations. He, appropriately, stated that the roots of the economic collapse and ongoing economic troubles included regulatory inadequacy:  “In 2008, the house of cards collapsed.  We learned that mortgages had been sold to people who couldn’t afford or understand them.  Banks had made huge bets and bonuses with other people’s money.  Regulators had looked the other way, or didn’t have the authority to stop the bad behavior.”

So the effective implementation of strong financial regulations can not only provide needed protections to individual borrowers and savers, they can also abet financial stability, in all these ways making the free market “work better.”

A fuller version of the President’s claim would also include the following reasons why regulations can help the free market work better and help the economy.

• Even outside of the financial sector, weak or absent regulations can be a direct threat to the economy and employment. Inadequate regulation contributed to the BP oil spill and its substantial economic costs. Inadequate regulation can also undercut the faith of consumers in an industry’s products because when dangerous products are being produced the public is naturally less likely to buy them. This story recently applied to the food industry. In the wake of too many product horror stories and weak regulation, the food industry supported stronger regulations in the form of the Food Safety Modernization Act of 2010.
• Regulations can have broad economic benefits that may not be apparent at first blush. Clean air regulations, for instance, significantly improve the health of workers and children, resulting in lower health care costs and more productive workers.
• Regulations often spur technological innovations that boost productivity. Michael Porter of Harvard Business School—a self-described Republican and an eminent specialist on how companies and nations compete—has hypothesized that properly designed environmental regulations can lead to so much innovation that they completely offset the costs of compliance.
• Regulations ensure that firms do not act in ways that place unacceptable costs on those outside the firm, or on the society as a whole; these “externalities” are themselves a form of “market failure.” For example, economists would say that much of the externality (or external costs) of air pollution has been overcome with regulations designed to correct this market failure (a term which refers to any market result that does not result in optimal results for society).  Once, manufacturers could pollute the air at will. With regulations, laws now require manufacturers to reduce pollutants and to incorporate into their production processes the costs of disposing of waste. This has benefited both the public at large as well as the private sector (companies benefit, for instance, when their workers are not breathing polluted air caused by other firms).
• The direct cost of complying with regulations translates into increased employment. For example, an environmental regulation will mean more jobs for those engaged in pollution abatement. Further, it is possible that regulations may produce more labor-intensive production processes.  Compliance can particularly benefit job creation when labor markets are slack, and companies generally have substantial surplus cash, as is now the case; companies do not have to divert such spending from other investments, and plenty of workers are available to meet any increases in demand.

This isn’t to suggest that the only potential effect of any regulation is to improve free markets, but it is to suggest that the relationship between regulations and the market is a complicated one, and frequently positive. For those interested in more detail, please see this report from a year ago on the role of regulations and the economy.