The $50-billion investment scam allegedly pulled off by Wall Street insider Bernard Madoff has ignited predictable calls for more regulation.

The “massive fraud … was made possible in part because the regulators who were assigned to oversee Wall Street dropped the ball,” said President-elect Obama.

“This scandal underscores the need for a 21st century regulatory approach,” writes Arthur Levitt Jr., former chairman of the Securities and Exchange Commission (SEC), in The Wall Street Journal.

Notice the disconnect. Regulation failed, so we need more regulation. I see it differently. Regulation failed, so let’s try free markets. That would be a change.

Regulation did indeed fail. “An executive in the securities industry, Harry Markopolos, contacted the SEC’s Boston office in May 1999, urging regulators to investigate Mr. Madoff. Mr. Markopolos continued to pursue his accusations over the past nine years,” The Wall Street Journal reported.

Of course, when a regulatory agency fails, the usual response is to make it bigger, not abolish it. Economist Robert Murphy notes, “In the private sector, when a firm fails, it ceases operations. The opposite happens in government. There is literally nothing a government agency could do that would make the talking heads on the Sunday shows ask, ‘Should we just abolish this agency? Is it doing more harm than good?’”

Most people won’t like the suggestion that we dump regulation for free markets. We can’t let markets run themselves, they’ll say. Someone has to protect the unsuspecting from conmen. The Madoff case shows why this view is wrong. We’ve always been told that regulation of financial markets protects the least knowledgeable investors. Sophisticated people know what they are doing and can fend for themselves.

But Madoff’s alleged Ponzi scheme is fascinating precisely because it caught some very knowledgeable people. They knew Madoff. Everyone trusted him, including the regulators.

That’s one reason those savvy investors gave him their money. But there is surely another reason. Since the 1930s, investors have been led to believe the regulatory system watches out for dishonest investment schemes. That creates a false sense of security – and sets people up to be conned.

Advocates of regulation attribute almost magical powers to regulators, but clever cheats can get around any system. They always have. It’s their chosen profession, and the regulators can’t look everywhere. Regulation advocates also assume that bureaucrats are disinterested and incorruptible, but we know this is not always true. People who work in government are like anyone else. There will always be a percentage of individuals who can be tempted by corrupt opportunities. The logic of regulation would require that super bureaucrats be appointed to watch over the regulatory agencies.

But who will watch over them?

This is why regulation is counterproductive and a poor substitute for investor vigilance. The more rigorous the regulatory effort appears, the more risky it is.

Regulation by market discipline is better, but in our state-dominated culture few people realize this. Arthur Levitt says, “The complexity of today’s products, markets and investment strategies calls for a laser-like focus [by the SEC] on risk assessment.”

But the opposite is true. Savvy investors would do their own risk assessment if they didn’t believe the government was doing it for them. And wouldn’t they do a better job, considering it was their own money at risk? Regulators risk nothing.

Of course many of us investors are unqualified to assess risk for ourselves. But we could pay specialists for the service, generating a competitive market for risk assessment – in contrast to the monopolistic SEC and other agencies.

That form of investor protection would be superior in every way to a system that gives a bureaucracy arbitrary power. After all, private risk assessors would have to justify their fees, which clients would pay voluntarily.

Current government regulation interferes with honest voluntary exchanges by imposing arbitrary terms and requiring tons of paperwork disclosing information no one wants anyway.

Fraud will always exist. Enforcement of anti-fraud laws is a useful deterrent, but in the end there’s no substitute for investor vigilance. Government regulations provide a false sense of security – and that’s worth less than no sense of security at all.

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