Paradoxically, over-regulation brings about under-regulation. Let’s take regulations that govern the trading of securities. The government is supposed to prevent fraud in all business contracts. Its standard mode of prevention is to prosecute and punish people who commit this crime. That deters others from doing the same thing. To prosecute and punish, government has to specify what constitutes fraud. Some types of fraud are easy to specify, but securities fraud is not.

Securities fraud is hard to specify for a lot of reasons. One is that a lot of institutional layers and middlemen generally exist between buyers and sellers. The securities market is more opaque than many other markets. So we tend to regulate what we’re able to regulate, things like insider trading. Insider trading isn’t even fraud, strictly speaking. It is, however, a type of unfairness that we have fastened on in our regulatory regime for securities. The elements of proof for insider trading are fairly clear-cut, so prosecutors are on familiar ground when they bring a case of that type.

Along comes Bernie Madoff, who gives all of us an example of true fraud. Everyone has heard of a Ponzi scheme, and everyone has a general idea how it works. When we observe a skillful, sophisticated practitioner of Ponzi schemes, we know what to do. We prosecute and put the person in jail. We are all angry that Madoff made off with so much money. Widows suffered. Bernie Madoff will die in the prison infirmary.

Now consider credit default swaps. People in the financial industry call these CDSs. Or consider collateralized debt obligations. These are CDOs. Or how about mortgage backed securities, or MBSs for short? We could regulate all of these instruments, and in fact we have tried to regulate them. But how do you separate legitimate trading in these securities from fraudulent activities? How do you distinguish right from wrong in these markets?

I’d argue that fraud is fraud, and that it’s not so difficult to recognize it when you see it. As a well quoted judge said about obscenity, “I know it when I see it.” When you have a regulatory regime that depends on an over-detailed specification of the crime, however, you run into trouble fast. Regulators in the 1960s wanted to say that depiction of female genitals was obscene and not to be permitted. What about Renaissance painters who depicted nude female bodies? Were they all pornographers, and will we destroy all the books that contain images of these paintings? Of course not. Does that mean we can’t regulate obscenity? Of course we can regulate it, but we want to think about how we do it.

The same goes for securities fraud. It’s doubtful that a detailed specification of what counts as fraud in the market for mortgage backed securities would be that effective. You want to craft laws that prevent fraud, no matter what instruments are traded. You want to craft laws that take into account the kinds of difficulties that arise when you regulate obscenity. Lenny Bruce used words in his performances on stage that landed him in jail. Today we regard his prosecution and punishment as absurd. You can say that community standards have changed, or you could say the laws governing obscenity were wrong. Even if both factors are at play, good obscenity laws would not have sent Lenny Bruce to jail.

We want good laws to prevent securities fraud. We want people who commit fraud to be punished for it, and we want people who conduct their business affairs honestly to be free to continue their pursuits for everyone’s benefit. If people who commit fraud go unpunished, that produces both anger and disillusionment. That makes people say, “I play by the rules. Why shouldn’t they? Even more, why should my money go to pay off people who gambled and lost, and gambled dishonestly at that?”

During the recent financial crisis, analysts frequently commented that the people who did this didn’t break any laws. They may have played fast and loose, but we can’t punish them because under our statutes, they didn’t commit a prosecutable offense. Still, fraud is fraud, and we all know it when we see it. If you rely overmuch on detailed regulations, you are going to get into trouble. You will be forced to burn books of Renaissance paintings in order to keep Hustler out of your child’s private stash.

We already know how to prevent fraud, but we have to act quickly and decisively to prevent it when it appears. By 2008, people in the banking industry could rightly claim, “Everyone is doing it.” That is actually a powerful claim, if you believe that scapegoating is not a legitimate legal strategy. Scapegoating singles people out to make an example of them. Scapegoating piles another unfairness on top of the original crime. To avoid scapegoating, prosecutors have to go after criminals early, before the crime becomes organized and established as a widespread and therefore legitimate activity. If criminal behavior does become established, prosecutors don’t have any good choices.

We know now that Wall Street firms committed fraud. I commented to people after reading The Big Short by Michael Lewis, no matter how bad you think the financial dealings that led to the crisis were, it was worse. It was a lot worse. The fraud was so massive by the time the bubble burst in 2008, no regulatory regime or legal proceeding would have done much to end it by then. The only way to end it was what actually happened: a complete collapse of the bubble. The institutional fraud ended at the same time.

A proper end to these comments would be to suggest some well crafted regulations to prevent securities fraud. I’ll demur on that. It’s a hard job, best undertaken by people who know more about banking than I do. Certainly banks themselves do not like to endure what they endured during the recent collapse. We can also be confident that bubbles will occur from time to time no matter what regulatory actions we undertake. Whatever the future brings, though, we know one more thing with certainty. If people who commit fraud not only escape punishment, but receive compensation from the public treasury, the people who paid that compensation will want to know how that could happen.