Commentary

Strangulation by Regulation

This article appeared in the National Review on May 1, 2000.

Is America really “the land of the free,” as Francis Scott Key put it? It’s true that Americans (excepting many college students) can say and write almost anything, anywhere, and at any time with impunity. It’s also true that Americans can practice and express their religious beliefs (or lack thereof) pretty much as they wish.

But markets are another story. A prescient Mr. Key would have written “the land of the free and the home of regulated markets.” The hand of the regulator lies heavy on the land, shaping what is offered and paid in almost every market, from automobiles to utilities to fast food. Thinking of a market that is untouched by regulation is a lot harder than hitting the high note in “The Star-Spangled Banner.”

Why are America’s markets so heavily regulated? Regulation usually rides in the Trojan horse of “market failure”-the perception that a particular market does not (or will not) operate efficiently without government intervention. Yet regulation persists in spite of evidence that it does not enhance efficiency. Why? Like most political acts, regulation is really about redistribution.

What can be done to quell the redistributive urge that drives government intervention in markets? Would it be enough to replace offending officeholders with right-thinking ones? Perhaps their time in office should be limited so that they cannot become beholden to narrow interests. Or perhaps they can be sheltered from hard decisions by establishing independent commissions to deal with politically sensitive economic issues, as in closing military bases.

Truth is, none of those actions would remedy the interventionist urge, which derives its legitimacy from views commonly held by elite opinion makers and the voting public-namely, that when constituents want government to intervene in markets, elected officials should grant their request. Thus, the long-term remedy for interventionism is education. The better everyone understands how markets work, and how regulation harms the nation as a whole even though regulation may help those who advocate it, the less likely it is that the public-and public officials-will embrace regulation as the answer to every perceived market failure.

Market failure: the excuse for regulation

An efficient market benefits everyone who chooses to transact business in it. The seller covers his costs (including a profit sufficient to keep him in business). The buyers willingly part with money for goods or services that they value at least as much as the other goods or services they could have bought with the same money.

Under what conditions do markets fail to produce efficient outcomes, and how do regulators presume to make them efficient? One form of so-called market failure arises when property rights are not defined or the cost of defending them is high. For example, a firm can pour industrial waste into a river, without paying a fee to do so, because no one owns the river. Similarly, automobile exhaust may be emitted into the air without charge because no one owns the air. Thus, environmental regulation ostensibly forces polluters to make the payments they would have to make if someone owned the water and air into which they dump their wastes.

Then there’s the fear that markets won’t provide crucial information. How can depositors monitor whether banks invest in high-quality loans? How can investors obtain information about the corporations in which they invest? How can consumers know whether life-insurance companies can pay future claims? What foods are safe? Which workplace practices are hazardous?

Getting answers to such questions is presumed to be difficult. And firms that attempt to fill the information gap may not be able to collect fees from everyone who uses the information. (Once information has been sold, the seller has no practical means of controlling its dissemination.) Thus, government tries to compensate for imperfect information by regulating banks, securities exchanges, insurance companies, the professions, working conditions, and food products-to give only a few examples.

Finally, there are the “monopolies,” firms that face insufficient competition either because the relevant market isn’t big enough to support two firms or because the firms have engaged in collusive behavior. The absence of competition allows monopolies to maximize profits by pricing their products above cost and restricting output. Ostensibly, that is why governments regulate railroads, trucking companies, telecommunications firms, pipeline companies, and electric, water, and gas utilities.

Follow the money

Forty years of scholarly research shows that markets have been regulated unnecessarily, if not cynically. Regulation usually benefits a privileged group (often the regulated), makes everyone else worse off than they would have been without regulation, or does both.

Airline regulation, for example, restricted entry into the airline business, which led to higher airfares. Similarly, the regulation of petroleum production by the Texas Railroad Commission reduced petroleum supplies, which made petroleum products more costly than they would have been.

There are more insidious examples of regulation. The 1927 Radio Act, for example, gave the federal government authority over the electromagnetic spectrum (EMS). Why? Purportedly, the signals of stations would interfere with one another if the government didn’t manage the EMS. But recent scholarship points to a quid pro quo: Politicians gained some degree of control over a medium that influenced political outcomes; incumbent broadcasters received handsome profits because government control of the EMS restricted entry into broadcasting.

Supposedly, banks are regulated and bank deposits are insured to correct defects in the market for information about the quality of banks’ investments. But, again, recent scholarship indicates that the threat of runs on banks induces banks to make sounder investments. And healthy banks can form private associations to insure one another against runs that are motivated by fear, not facts. Even in the Depression, most banks closed by runs were insolvent and should have been closed. Instead of making banks sounder, regulation (especially restrictions on branch banking) and deposit insurance simply allowed smaller (and usually weaker) banks to survive against their larger and more efficient competitors.

Surely, it is argued, regulation is necessary to ensure the health and safety of workers and the wholesomeness of food products. But research has found that workers recognize risks when they see them; thus, employers must pay higher wages to attract workers who are willing to accept greater risks. And the burgeoning organic-foods industry testifies to the power of market forces to yield safer and healthier products, for which those who desire such attributes are willing to pay.

Of course, market solutions to perceived health and safety problems do not satisfy those who dream of living in a zero-risk world. They demand that the rest of us pay for their dream through higher taxes, higher prices, and fewer jobs.

The same mentality underlies environmental regulation: All environmental benefits are infinitely valuable and must be secured at any price; pollution of any sort is infinitely bad and must be eliminated at any price. Such rhetoric makes for good political theater and poor public policy. Congress cannot even discuss the notion of acceptable levels of pollution. Instead it passes vague laws that proclaim zero tolerance for pollution and delegates the hard choices to the Environmental Protection Agency.

As with airline, banking, and telecommunication regulations, the rhetoric surrounding environmental regulations obscures their protectionist effects. Environmental regulations often give existing firms a competitive advantage by setting higher standards for new facilities, forcing prospective competitors to invest in expensive antipollution technology in order to compete with established companies. If legislators and regulators were interested only in pollution control, they wouldn’t favor old polluters over new ones.

What about so-called natural monopolies? Some of the delivery infrastructure of electrical, telecommunications, railroad, and pipeline systems may have economies of scale that make competition less than perfect, but not impossible. (Recently, for example, even the People’s Republic of Montgomery County, Maryland, adjoining Washington, granted a franchise to a second cable company to compete with the incumbent-an impossibility if cable really were a natural monopoly.) In fact, many scholars have concluded that natural-monopoly regulation came about because incumbents demanded regulation to create market stability-there was “too much” competition-and accepted rate regulation as the quid pro quo. It is not clear that consumers have benefited from this. Some scholars have concluded that regulated prices differ little from the prices that profit-maximizing monopolists would charge in the absence of regulation.

The enemy is us

So much for the rhetoric of regulation. The reality, again, is that regulation-like most political acts-is for the purpose of redistribution. Politicians are entrepreneurs who supply redistribution in return for votes and organizational resources that aid their campaigns.

But blaming regulation on politicians is like blaming addiction on drug dealers. Suppliers don’t supply unless there is demand. Where does the demand for redistribution come from? From most Americans. (Libertarians are the exception that proves the rule.)

To be sure, public-opinion polls find that a majority of Americans oppose governmental programs that directly redistribute income. (Here it helps to believe the fiction that there is a Social Security trust fund.) Nevertheless, Ameri cans also demand government intervention in particular markets at particular times for particular reasons, often because those markets directly affect their incomes or lives. Being principled in their opposition to government intervention, many of those same Americans also oppose government intervention on behalf of other Americans.

Examples are plentiful. Auto dealers, in order to protect their investment from Internet competition, have lobbied their state legislatures to strengthen laws that prevent consumers from purchasing cars from anyone other than dealers. Those same dealers, of course, oppose environmental and work-safety regulations as infringements on their property rights. Farmers want the unrestricted right to export their products to other countries-a good pro-market position-but they also want government restrictions on output so that they can sell their products for higher prices. Those who already own homes in desirable neighborhoods vociferously support zoning restrictions to keep others from building homes in those same neighborhoods, which not coincidentally adds to the resale value of existing homes.

Thus, most constituents at one time or another ask politicians for economic favors, often in the guise of beneficial regulations. Legislators will grant those favors as long as they gain more electoral support from the recipients of those favors than they lose from those who pay for them in the form of higher taxes, higher prices, and less freedom. How long can this last? Not indefinitely. But it will go on as long as favors for specific constituencies and interest groups do not create costs for the general public that are intolerable.

Why has there been some deregulation?

If economic favoritism is politically rational, what explains episodes of deregulation? Sometimes, deregulation comes about when firms in a regulated market become less profitable as economic substitutes arise. The regulated firms then demand deregulationthat they can compete-or else regulation of the substitutes. For example, in the 1920s railroads demanded the regulation of trucking, to stem the flow of business from railroads to trucking. But the regulation of trucking failed to stem the decline of railroads, and by the 1970s railroads were near bankruptcy and calling for deregulation.

There is a noteworthy recent example of regulated firms’ seeking-and getting-the regulation of other firms. Under the terms of the 1998 tobacco settlement, the big four tobacco companies are to pay the states $ 206 billion over 25 years, as “reimbursement” for smoking-related Medicaid costs claimed by the states. The 19 smaller companies don’t have to make payments-unless their market share increases because they offer lower prices. If the small companies’ right to compete on the basis of price had not been limited, the government-organized tobacco cartel would have collapsed, and the states would have faced a prolonged battle in court over claims that are demonstrably unfounded. Tobacco will be regulated as long as three conditions persist: there is no good substitute for it, it generates great profits for the large companies, and smokers are a despised minority of voters.

On the other hand, a politician who is willing and able to exert leadership can beat down economic favoritism, at least temporarily. A classic example is found in the reform of the tax code in 1986. Sen. Robert Packwood-who had presidential ambitions-locked the doors of the bill-markup session and eliminated an astonishing number of tax deductions and credits in return for lower marginal rates across the board. Since then, of course, we have reverted to normal politics: All kinds of privileges, exemptions, and loopholes have found their way back into the tax code.

Are there no lasting antidotes to the politics of economic favoritism? I will consider three: electoral reform, process reform, and education.

Is there hope in electoral reform?

Would it help to elect more pro-free-market politicians to Congress? Not unless they were elected in overwhelming numbers because of a sea change in voters’ attitudes toward economic favoritism. At the margin, however, if a particular member of Congress disdains regulation or other economic favors that would benefit his congressional district or state, that district or state will not receive new economic favors, but its citizens will nevertheless pay higher taxes and prices for the favors bestowed on other districts and states. Any member of Congress who wants to be reelected (oddly enough, most do) soon will realize that a principled stand against economic favoritism will cost him the votes and financial support necessary for reelection. A legislator who promised to vote against economic favors and then did so could not count on reelection unless his constituents could be bound to a pledge to reelect him if he stuck to his promise.

What about electing legislators who promise to limit their time in office and therefore their need to garner electoral support through economic favoritism? Sadly, that wouldn’t change the result. Those legislators who develop a taste for reelection would find that they must deliver economic favors to ensure their reelection. Those legislators who fail to deliver economic favors would be thrown out of office-like it or not-by constituents who resent paying for everyone else’s economic favors but receiving none of their own.

What if term limits were imposed constitutionally? That would not eliminate the underlying problem of constituent self-interest. Instead of renominating the usual suspects, party organizations would seek-and find-candidates who would strive faithfully to deliver economic favors, if elected. Voters would then redevelop the strong allegiances to parties that they had in the days when New England was a Republican redoubt and the South was solidly Democratic. Would that be progress?

Is process reform the answer?

Members of Congress do know that economic favoritism is a prisoner’s dilemma that can be eliminated only by institutions that prevent legislators from granting constituents their requests for favors. And when the stakes have been high enough, members of Congress have been able to cooperate in an effort to revoke economic favors. One example-often held out as a model-is the Base Realignment and Closure process.

Congress delegated to a base-closure commission the politically difficult task of identifying military facilities that could be closed at little risk to military preparedness. The apparent success of this process depended on two ingenious provisions of the authorizing statute. First, the commission’s lists of facilities to be closed had to be accepted or rejected in toto by the administration and Congress. In other words, the bad medicine had to be swallowed whole or not swallowed at all-in public view. Second, Congress could reject a list only if Congress passed a resolution of disapproval within 45 days after receiving the list from the administration. Because each list affected only a small minority of congressional districts and states, Congress never rejected a list.

If that sounds too good to be true, it is. The base-closure process is not a model that can be applied to many (or even a few) congressional deliberations. In fact, it may have been one of a kind. There have been other so-called independent commissions, but Congress has never given any of them the power that it gave the base-closure commission. Under most circumstances, Congress will not cede such power, because to do so would eliminate the stuff of congressional life: logrolling.

Furthermore, the base-closure process worked only as long as all parties to the deal recognized the necessity of base closings and didn’t meddle in the process. The deal fell apart after 1995 because base closures proposed for Texas and California threatened President Clinton’s ability to carry those states in the 1996 election. Although Clinton approved the 1995 base-closure list and sent it to Congress, which let it take effect, he then invented ways to circumvent the closings in California and Texas. Not surprisingly, Congress has since refused to reauthorize the process.

If economic favoritism can’t be averted, perhaps Congress could at least find a less costly way of distributing largesse to its intended beneficiaries. For instance, instead of regulating markets, why not give sacks of money to the politically favored-but let economists design the giveaway schemes?

It has been tried. The Federal Agricultural Improvement and Reform Act of 1996 ended the market-distorting system of price supports and acreage controls that had augmented farmers’ incomes for 60 years. The act replaced price supports and acreage controls with direct subsidies, to be distributed on a fixed, seven-year schedule. Farmers would get their money, but market forces would decide how much food was produced and at what price.

Farmers were happy with the new program in 1996 and 1997 because their new subsidies were greater than the price-support payments they would have received under the old system. But when farm prices plummeted in 1998, Congress reneged on the payment schedule and gave farmers about $ 6 billion more-further proof, if any were needed, that Congress cannot make long-term commitments to stay out of taxpayers’ wallets.

The good news, in this case, is that Congress gave farmers their extra $ 6 billion as a lump-sum payment rather than revive price supports. And the visibility of direct subsidies makes it likely that there will be a good debate in 2002, when the subsidies come up for renewal.

The bad news, of course, is that Congress has cooperated only to the extent of finding a more efficient way of delivering an economic favor. Instead of regulating agricultural output and prices, Congress simply hands money to farmers. But given political realities, this may be the best we can get.

A final process reform favored by many in the policy-analysis business is the creation of an independent agency staffed by economists that would issue reports about the costs and benefits of economic regulation. Such analysis, currently performed mostly by think tanks and academics, might have more clout if it were an official, independent part of the political process.

As a policy analyst myself, I am sympathetic to the argument; but if we look to history for evidence in support of an official role for policy analysis, honesty demands reduced expectations. Robert McNamara, Alain C. Enthoven, and the other “whiz kids” of the early 1960s institutionalized the role of economic analysis in the Defense Department as a clever way to say “no” to the demands of the services. But it was effective only so long as it had presidential support. The Systems Analysis Office was never more powerful than when it was run by Enthoven in the 1960s. When Richard Nixon became president and installed Melvin Laird as secretary of defense, the balance of power in program selection shifted from the whiz kids to the services. Never again would analysts dominate the services. Iconoclastic analysis of the sort provided by the whiz kids is effective only if the party in power wants it to be effective.

Education: the only hope?

The education of future policymakers may lead to more rational regulation, if not less regulation. The legal profession supplies the judges who interpret laws and regulations, as well as a healthy fraction of legislators, regulators, and their staffs. As a result of the rise of the law-and-economics movement at the University of Chicago, the tenured faculties of all elite law schools now include card-carrying economists. One cannot graduate from a top law school without having been exposed to lessons in how markets work, how fragile their efficiency characteristics are, and how efforts to regulate them often have perverse results.

But the last, best hope for deregulation rests with future generations of voters. Voters get the legislators and laws they demand. It is easy for voters to demand regulation-or to acquiesce in it-because most voters do not understand its negative effects. Today’s students, of course, are tomorrow’s voters. The more that students are exposed to the truth about the benefits of free markets and the costs of regulation, the less likely it is that they will vote for politicians who favor regulation.

Yes, the task of such an educational effort is the daunting one of taking citizens back to a view of the proper role of the state that was not popular for most of the 20th century. Many believe that the movie cannot run backwards. We have no choice, however, but to try. Exposure to economics, particularly in high school, is now totally inadequate and should be expanded. If a majority of citizens believes that it is okay to demand economic favors from the government, politicians will accommodate those demands. And no institutional magic bullets will stop them.

Peter Van Doren is a senior fellow at the Cato Institute and editor of Regulation magazine.