When people advocate government intervention, they rarely, maybe never, tell us how the incentives will be set up so that government will do the right thing. Think about how asymmetric the argument is. Incentives in the private sector are such that someone will do something in his interest that hurts others in society, but he doesn’t take account of that hurt in his decision. Or, someone could take action that would benefit others a great deal but it isn’t in his interest to take the action. Notice the use of reasoning about incentives to show why the market fails. Therefore, continues the argument, we should have government intervene. Did you catch the non sequitur?

When a particular signal works well for good intermediaries (ones that make a legitimate profit by choosing investments wisely), there is an incentive for bad intermediaries (who choose investments less wisely) to mimic the signals provided by good intermediaries. Falkenstein claims that there is no equilibrium in which good intermediaries are well received and bad intermediaries are not. When times are good, the incentives are great for bad intermediaries to develop the ability to mimic good intermediaries. Only when there is a crash do the bad intermediaries get exposed and wiped out. Right after a crash, people distrust all sorts of signals, including those that had been used by good intermediaries. So after a crash, even good intermediaries have difficulty establishing credibility. By the time they come up with credible signals, bad intermediaries are ready to mimic those signals.

That’s why drugstores budget for shrinkage rather than locking everything away, putting it behind the counter, or searching the patrons as they leave. It’s why businesses do not actually attempt to make sure that every expense is 100% justified. In fact, systems often need this kind of loss to reduce friction in the system; I’ve heard a plausible case made, for example, that without Medicaid fraud, virtually no one on Medicaid would be able to secure primary care outside of a hospital clinic. The reimbursement rates are simply too low.