A sceptic’s guide to regulation

Regulation is not about the public interest at all, but is a process, by which interest groups seek to promote their private interest … Over time regulatory agencies come to be dominated by the industries regulated.” Richard Posner

Laws, like sausages, cease to inspire respect in proportion as we know how they are made. Anonymous – often falsely attributed to Otto Von Bismarck.

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Introduction

The Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into federal law by President Barack Obama on July 21 2010. It should be understood as a government response to the Global Financial Crisis that kicked off in 2008 and the shenanigans on Wall Street. At 2,319 pages, the finance bill is massive. This is an example of word inflation. The 1913 act that created the Federal Reserve in 1913 had just 31 pages. The Glass-Steagall Act, which in 1933 separated investment banking from commercial banking, was just six pages longer. Even the recent Sarbanes-Oxley Act, which was written in the wake of the accounting scandals of the noughties, was a mere 66 pages long. Dodd–Frank is complex and full of provisions that will require further interpretation. It is going to keep lawyers exceptionally busy for years, to come. It is hardly surprising that it has been dubbed the “Lawyers’ and Consultants’ Full Employment Act of 2010.” It may well end up creating more jobs than Obama’s 2009 stimulus package.

In the wake of the GFC one of the principal culprits is said to have been the massive deregulation that took place in the 1980. Are the critics right? Is the solution to bring back more and stricter regulations? In this post I am going to look at some of the constraints faced by regulations and regulators.

Last week I was looking at the kind of biases identified by Daniel Kahneman. But regulators are not immune from their own biases; regulators are human too. In a paper entitled Are regulators rational? Slavisa Tasic looked at the psychology of regulators. He identified five mistakes that government regulators often make:

Action bias This is the tendency to overreact in the face of risks and uncertainties. There is a feeling that something has to be done. Talking about this question, Matt Ridley made a comparison with the Dangerous Dogs Act 1991, which was brought in after a number of cases in which dogs injured or killed people in the United Kingdom. It is now seen as an overreaction to tabloid outrage and a transient public mood. I don’t know about this particular legislation, but I don’t like this kind of knee-jerk policy-making. We have to ask if the abovementioned Dodd–Frank act will actually make things better, or even create greater problems down the line. To quote Ridley:

It takes unusual courage for a regulator to stand up and say “something must not be done,” lest “something” makes the problem worse.”

Motivated reasoning Motivated reasoning refers to the unconscious tendency of people to fit their processing of information to conclusions that suit some end or goal. This leads them to only see the facts that confirm what they already believe, while ignoring contrary evidence. According to this theory it is not a cynical power grab as regulators genuinely believe that more stringent regulation is in the public interest.

The focusing illusion The focusing illusion, which was mentioned by Kahneman, is a bias that appears when people consider the impact of one factor on the overall situation and overestimate its importance. This ties in with Frederic Bastiat’s idea of the seen and the unseen. Bureaucrats tend to judge policies by focusing on obvious benefits, but they fail to see the unseen costs. With the so-called “availability heuristic”, we assign extra importance to prominent events or those that we most easily recall in any given moment. We saw this phenomenon in action after 9/11 when there was greatly increased fear about terrorist activity. As I mentioned in my post about airport security the draconian airport security regulations have pushed more travellers onto the road. There is no doubt that flying has become safer, but at the cost of more deaths on the roads. The too-big-to-fail policy for banks is one where we can see one tangible benefit but not the considerable drawbacks.  The fact that taxpayers have to pay has been the source of public outrage, but what about efficiency losses from supporting inefficient banks, the blunting of the mechanism of creative destruction and the very real danger for the future with the creation of moral hazard? I will be looking at this later in the post.

The affect heuristic This is present whenever policies are judged, by voters and regulators alike, on their emotional appeal rather than on the rational analysis of consequences. When you have an emotive issue good intentions will trump the evidence of real effects, trade-offs and unintended consequences of a policy.

Illusions of competence The natural human tendency to overestimate our capabilities is also prevalent in regulators. Do we really have sufficient knowledge to intervene effectively?

Apart from these psychological aspects, we also have politico-economic factors. Here are three important ones:

Regulatory capture This theory of regulatory capture was first put forward by academics like George Stigler and Richard Posner from the University of Chicago. It occurs when groups or individuals lobby for their desired policy outcomes. They have a lot invested in the outcome, whereas members of the public, each with only a tiny individual stake, tend to ignore it altogether. In the Public Choice theory of economics they talk about concentrated benefits and dispersed costs. The smaller the group and the higher the per capita stake, the more likely it is that the group will be successful in organizing and effectively influencing the regulations that are finally brought in.

However, regulatory operates on more than one level. We have a phenomenon known as “cognitive regulatory capture”. The regulators who engaged in recent financial sector bailouts were not necessarily doing it out of corrupt motives, or because they had a direct material stake. Rather, as they come from the same professional or social circles, they cognitively internalise the objectives of the interest group.

Simon Johnson has chronicled Wall Street’s capture of Washington:

One channel of influence was, of course, the flow of individuals between Wall Street and Washington. Robert Rubin, once the co-chairman of Goldman Sachs, served in Washington as Treasury secretary under Clinton, and later became chairman of Citigroup’s executive committee. Henry Paulson, CEO of Goldman Sachs during the long boom, became Treasury secretary under George W. Bush. John Snow, Paulson’s predecessor, left to become chairman of Cerberus Capital Management, a large private-equity firm that also counts Dan Quayle among its executives. Alan Greenspan, after leaving the Federal Reserve, became a consultant to Pimco, perhaps the biggest player in international bond markets. These personal connections were multiplied many times over at the lower levels of the past three presidential administrations, strengthening the ties between Washington and Wall Street. It has become something of a tradition for Goldman Sachs employees to go into public service after they leave the firm. The flow of Goldman alumni—including Jon Corzine, now the governor of New Jersey, along with Rubin and Paulson—not only placed people with Wall Street’s worldview in the halls of power; it also helped create an image of Goldman (inside the Beltway, at least) as an institution that was itself almost a form of public service.

This is crony capitalism.

The Pelzman effect The Peltzman effect owes its name to the economist Sam Pelzman, who observed that people tend to adjust their behaviour in response to perceived level of risk, behaving less cautiously where they feel more protected and more cautiously where they feel a higher level of risk. It has its origins in road safety research, but has now migrated to many other fields. In the former we can see that the introduction of seat belts could lead to increased risky behaviour. As I pointed out, it has many other applications. So free condom distribution programs may fail to reduce HIV prevalence as predicted because risky sexual behaviour increases. American football and rugby illustrate this problem perfectly; the former is more dangerous than the latter because as they are protected, the players are able to hit harder.

I think that each case is different. And I am certainly not advocating that these preventative measures are bad. What I do want to show you is why interventions can sometimes fail to achieve the expected level of benefits. Even so, the risk compensation effect may be small compared to the fundamental benefits of these regulations, resulting in an overall safety benefit. Unless the behavioural change is so large that it negates all of the positive overall effect, the regulation may well be worthwhile.

Moral hazard is one practical example of how a feeling of greater safety can alter our behaviour. The concept of moral hazard is that people with insurance may take greater risks than they would do without it because they know they are protected. I really do think that the idea that they were too big to fail influenced a lot of the bankers’ behaviour.

Baptists and Bootleggers This concept was first described by the economist Bruce Yandle. Preachers campaign to make alcohol illegal while the bootlegger also wants it to stay illegal because it provides him with a business opportunity. The Baptists provide the cover for the bootleggers to make money. Politics does indeed make strange bedfellows! Companies often like to be regulated, because it enables them to see off weaker competition. One thing is the high-minded purposes behind the law, but how it works out in reality is a different question. A highly regulated industry can make it hard for new competitors to enter; the existence of numerous government regulations tends to give competitive advantages to big business, as there are important economies of scale in complying with these regulations.  This allows for a concentration that favours the big players. Big business also likes to present its green credentials. They see opportunities for taxpayer-funded subsidies, and to get consumers to pay more as in the case of energy-efficient washing machines.

Conclusion

What I havetried to show is that regulation is more complicated than we want to admit. The English economist Ronald Coase coined the term the Nirvana Fallacy, the tendency to compare real-world market distortions with ideal government solutions. We need to be aware of the limitations we face. Of course, we need regulation, but it will have to be more intelligent. I don’t think the Dodd-Frank is the way forward. We need to simplify regulation. Unfortunately, I fear we are going in the other direction.

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