Libertarians struggle with the question of how and when any government or private regulation is proper. In the wake of the subprime mortgage market collapse and in view of the existing problems with the patent system in the United States, I have come to a few more general conclusions.
The most useful role for regulators is to ensure that the consumers whose transactions constitute the smallest units of demand within a market are required to internalize at least part of both the positive and the negative externalities (i.e., social costs and benefits not otherwise priced into the bilateral transaction) of subsequent comparable transactions. This will require at least the cooperation of the individual or firm that is counterparty to the smallest unit of demand.
In the housing market, a bubble developed because at each stage in the cycle from homebuyer to bank, to larger institutional investors, and back to buyer, no accounting was made for how an increase in home prices was going to increase the price and decrease the volume of transactions in other goods. In other words, the opportunity costs of increasing prices in homes was not sufficiently internalized by homebuyers in the subprime mortgage market. This problem could have been avoided by requiring homebuyers to buy insurance covering the risk of declines in home price due to off-site factors. (Thanks, Lee Fennell.)
Taxes are probably the most impactful way that government regulators have ensured that the negative externalities of an individual engaging in particular activities are internalized by the same individuals in some measure. (Thanks, Pigou.) In the sense I'm thinking about them, taxes are like an insurance premium we pay to the government to ensure that somebody is worrying about (and will bail us out from) major catastrophes that are too large in scale or too long in time horizon for the market to accurately price into transactions with consumers. Please note that this does not mean that I am in favor of raising taxes! A corollary is that the role of government may be rationally more limited in places and times when private institutions are able to more accurately price low-probability and long-time horizon (i.e., major) catastrophes. Requiring insurance and reinsurance against catastrophes is probably healthier for everyone than building labyrinthine bureaucracies (like FEMA) that aren't going to do much work on preventing disasters, and won't be much help when they inevitably occur.
Here's one piece of evidence to support this theory. Warren Buffett and Charlie Munger have almost made a religion out of including negative feedback in every financial statement, probably even in every transaction. The result? Longer time horizons and more accurate pricing (through negative feedback) have permitted them to run what is perhaps the most efficient conglomerate in the history of humanity.
How is it organized? I don’t think in history of world has anything Berkshire’s size organized in so decentralized a fashion. Net amount of bureaucracy is tiny, costs are low, autonomy in subsidiaries is vast, no common culture shuffling people around. How far can this go? This system has gone farther than any other system. Low cost, not a lot of envy effects – where everyone compares everything. People in subsidiaries have a feeling – whereby there is less fealty to headquarters. If you want an imperial headquarters which exacts a big overhead charge on the provinces – they will resent it. Net number of intra-subsidiary transfers is tiny. It has worked well. It can go a lot farther. No one else has been here before.
Berkshire-Hathaway is one of the first private regulators to make negative feedback a priority, and look at what they have accomplished. What would the world look like if we redesigned legal and social norms to encourage negative feedback (i.e., accountability). And Berkshire-Hathaway did it without any government telling them that they had to. They were seed crystals in this sense.
Update: The characteristic slope of the Taylor Rule for monetary policy (which requires that the magnitude of changes in target rates always exceed the magnitude of changes measured in inflation) could be viewed as an embodiment of the negative feedback principle. A control theorist might say that the Taylor Rule leads to more stable economic cycles by requiring a decrease in money supply in response to increases in inflation. Assuming the measurements were accurate, in the limit in which the lag in time between the decrease in money supply and the increase in inflation approches zero (i.e., assuming adjustments could be made instantaneously) the money supply rate and the rate of inflation should be equal.
Thus, the best known approach to matching the money supply rate to the real rate of inflation is not unlike the approach followed by Buffett and Munger in their attempts to match the price of Berkshire-Hathaway stock to their estimates of its intrinsic value: negative feedback works.