Reforming Regulation

November 25, 2014 • Cato Online Forum
By Susan E. Dudley

I would use the magic economic growth wand Cato has given me to reform the U.S. regulatory system.

In the 125 years since Congress created the first regulatory agency,1 the number of agencies and the scope and reach of the regulations they issue have increased dramatically. In 2014, there are over 70 federal regulatory agencies, employing over 300,000 people to write and implement regulation.2 Every year, they issue thousands of new regulations, which now occupy over 168,000 pages of regulatory code.

Without a counterfactual, it is impossible to know what a more restrained regulatory environment would have meant for economic growth and well‐​being in the U.S., though some estimates suggest the effects are very large.3 However, the World Bank observed more than a decade ago:

Although macro policies are unquestionably important, there is a growing consensus that the quality of business regulation and the institutions that enforce it are a major determinant of prosperity… Heavier regulation of business activity generally brings bad outcomes, while clearly defined and well‐​protected property rights enhance prosperity.4

New crises (real or perceived) inevitably lead to new legislation and new regulations. Regulations can provide a competitive advantage, so it is often in the self‐​interest of regulated parties to support them,5 (often hiding behind public interest arguments6) even while other interests oppose them. The resulting rent‐​seeking contests7 can destroy more economic value than even the most generous assessment of the benefits of a rule.8 The renewable fuel standards, for example, have been shown to raise consumer prices and harm the environment,9 but they remain because they benefit influential agricultural interests in key election states.10

Furthermore, since regulations often advantage market incumbents, once in place they gain a constituency and are almost impossible to dislodge. So we see a ratchet effect,11 where new regulations are piled on top of old with little attention paid to how they might affect complex market dynamics and even less effort applied to understanding their effects once in place.12

Given these pressures, reforming our regulatory system in a way that allows innovation to flourish and respects individual choices may seem daunting. However, we do have an historic model for successful regulatory reform. About 50 years ago, the U.S. regulatory system underwent an important transformation. Scholarship in the fields of economics, antitrust, and law generally supported the idea that “economic regulation” of private sector prices, product quality, entry, and exit tended to keep prices higher than necessary, to the benefit of regulated industries, and at the expense of consumers.13 Bipartisan efforts by policy entrepreneurs in the Ford, Carter, and Reagan Administrations, in Congress, the judiciary, and at think tanks eventually led to the abolition of whole agencies such as the Civil Aeronautics Board and the Interstate Commerce Commission, and the removal of economic regulation in several previously‐​regulated industries.14

This wave of deregulation is generally regarded as a success, having lowered consumer prices, increased choices, and aligned service quality with customer preferences. More competitive markets have generated real gains–and not just reallocated benefits–for consumers and society as a whole, and markets have evolved in beneficial ways that were not anticipated prior to deregulation.15

Unfortunately, we seem to have forgotten the lessons of the successful economic deregulation of the 1970s and 1980s. Economic forms of regulation are on the rise.16 The Affordable Care Act directs the Department of Health and Human Services to set price and quality standards, regulating what insurance plans must cover and what consumers must purchase. The Dodd‐​Frank Wall Street Reform and Consumer Protection Act granted newly‐​formed agencies broad discretion to regulate the characteristics and prices of financial products and even to assume control of and liquidate financial institutions. The Departments of Transportation and Energy are busy issuing mandatory energy efficiency levels for new cars and appliances,17 and assuring us that, though these restrict consumer choice, they will make individuals economically better off.18 And the president is urging the Federal Communications Commission to regulate broadband internet as a public utility,19 based on 19th century “common carrier” concepts.20

Since at least the 1970s, benefit‐​cost analysis (BCA) has been held out as a tool to ensure that new regulations provide social benefits that are greater than their costs. In theory, careful, objective BCA could ferret out rules that cost more than they are worth or that simply transfer wealth to favored interests, and focus regulators’ efforts instead on rules that maximize social welfare.

BCA has not been the silver bullet that some may have hoped, however. First, many statutes ignore or explicitly prohibit analysis of tradeoffs.21 Second, the Hayekian knowledge problem22 is enormous, as ex ante BCA necessarily rests on hypotheses of how the regulatory action will alter outcomes and what they will cost, and regulators rarely look back to test those hypotheses with real data.23 Third, agencies have strong incentives to demonstrate through analysis that their desired regulations will result in benefits that exceed costs. Regulatory impact analyses are often developed after decisions are made and used to justify rather than inform them.24 BCA is increasingly used to justify massive one‐​size‐​fits‐​all regulatory regimes based on regulators’ judgments about what individuals’ values, preferences, and behavior should be.

To address this problem, at a minimum, agencies should be required to present evidence that they have identified a material failure of competitive markets or public institutions that requires a federal regulatory solution, and provide an objective evaluation of alternatives (including the alternative of not regulating) and of the competitive and distributional impacts of different approaches.25

Also, since most legislative and executive branch reforms have focused on analyzing and improving new regulations, agencies seldom look back to evaluate whether existing regulations are having their intended effects. Initiatives to require ex post evaluation of regulations that are in effect have met with limited success26 largely because they did not change the underlying incentives. Variations on a regulatory budget (such as the one‐​in‐​one‐​out policy in the UK) could provide regulators incentives to evaluate and withdraw ineffective regulations.

However, it is important to recognize that regulators, like everyone else, are susceptible to what behavioral psychologists call “confirmation bias.”27 Regardless of what analytical requirements they face, their single‐​mission focus will lead them to discount data, research, values, and perspectives that do not corroborate their preferred regulatory action.28

Thus, more fundamental change is needed. Many of our regulations are still designed for the centuries‐​old concept of asymmetric information, where vulnerable consumers need protection from duplicitous salesmen. But the world has changed dramatically in recent years. New technologies and social media enable individuals to learn, not only from their own experiences, but from others’, and brand reputations thrive or fail based on customer reviews.

The most powerful technology for solving the Hayekian “knowledge problem” and effectively using the decentralized wisdom of crowds is a very old one: the market.29 There are countless opportunities to improve regulatory policy by giving greater deference to the dispersed knowledge that is channeled through market forces. We should view with extreme skepticism regulatory proposals that are based on the assumption that individuals are irrational and depend on regulators to maximize their private welfare.30

As we lament the limitations of BCA, it is helpful to recall that the economic analyses that motivated regulatory reforms in the 1970s and 1980s were not primarily benefit‐​cost analyses. Instead, economists examined industry organization and barriers to competition, and pointed out the many ways that regulation was harmful. Consumers may not always recognize the advantages of deregulation, or capitalism, or laissez faire, or free markets; but they do seem to recognize that competitive markets work to their advantage. They like choice, and knowing that not only can they keep their doctor, they can fire their doctor — or their insurer — if they are not happy.

Greater economic growth and wellbeing are possible if our magic wand helps us focus on the benefits competitive markets bring, a greater reliance on the ability of market forces to regulate behavior, and a greater respect for the diversity of preferences. Policies should be designed in ways that encourage competition and allow for experimentation. Greater emphasis on federalism would allow regulators and market participants to learn from natural experiments on a smaller scale and modify policies accordingly. Less reliance on one‐​size‐​fits‐​all federal regulatory solutions would also encourage innovations at the state and local levels in ways that respect and reflect the diversity of conditions and preferences across the country.

1 The Interstate Commerce Act established the Interstate Commerce Commission in 1887 to regulate railroad rates.
2 Susan E. Dudley and Melinda Warren. 2015 Regulators’ Budget: Economic Forms of Regulation on the Rise, a joint report of the GW Regulatory Studies Center and the Weidenbaum Center at Washington University in St. Louis. July 9, 2014.Note that “agencies that primarily perform taxation, entitlement, procurement, subsidy, and credit functions are excluded from this report,” so these figures exclude staff developing and administering regulations in the Internal Revenue Service, the Centers for Medicaid and Medicare Services, etc.
3 A recent empirical analysis of the effect of regulations on economic growth reached the dramatic conclusion that “GDP at the end of 2011 would have been $53.9 trillion instead of $15.1 trillion if regulation had remained at its 1949 level.” John W. Dawson and John J. Seater, (2013). “Federal Regulation and Aggregate Economic Growth.” Journal of Economic Growth 18: 133–177.
4 World Bank 2003. Doing Business in 2004: Understanding Regulation. Washington, DC: World Bank Group.
5 George Stigler. “The Economic Theory of Regulation,” Bell Journal of Economics, 1971:3.
6 Adam Smith and Bruce Yandle. (2014). Bootleggers and Baptists. Washington, DC: Cato Institute.
7 James Buchanan, Robert Tollison and Gordon Tullock (eds.) (1980). Toward a Theory of the Rent‐​Seeking Society. College Station, Texas: Texas A&M Press.
8 Gordon Tullock, Arthur Seldon, and Gordon Brady. Government Failure: A Primer in Public Choice. P. 47. Cato Institute 2002.
9 Sofie E. Miller, “Crony Environmentalism,” Regulation, Vol. 36 Number 1, Spring 2013. Susan Dudley, “What is the Effect of Renewable Fuels Mandates?” Federalist Society. http://​exec​u​tive​branch​pro​ject​.com/​w​h​a​t​-​i​s​-​t​h​e​-​e​f​f​e​c​t​-​o​f​-​r​e​n​e​w​a​b​l​e​-​f​u​e​l​s​-​m​a​n​d​ates/
10 NBC recently ranked Des Moines, Iowa as the richest city in America.
11 Susan Dudley & Bruce Yandle. Is 9/11 a Crisis to be followed by a Leviathan? Mercatus Center at George Mason University (2002).
12 Michael Mandel & Diana Carew, Regulatory Improvement Commission:A Politically‐​Viable Approach to U.S. Regulatory Reform; Susan Dudley, A Retrospective Review of Retrospective Review, GW Regulatory Studies Center Regulatory Policy Commentary, May 07, 2013.
13 George Stigler, The Economic Theory of Regulation, Bell Journal of Economics, 1971:3.
14 Martha Derthick and Paul J. Quirk (1985). The Politics of Deregulation. Washington, DC: Brookings Institution Press.
15 Clifford Winston, “U.S. Industry Adjustment to Economic Deregulation”, Journal of Economic Perspectives, Volume 12, Number 3(Summer 1998), Pages 89–110.
16 Susan E. Dudley and Melinda Warren. (2014).
17 Sofie E. Miller, Public Interest Comment on the Department of Energy’s Direct Final Rule: Energy Conservation Standards for Residential Dishwashers, Docket I.D. EERE-2011-BT-STD-0060. September 14, 2012, Public Interest Comment on the Department of Energy’s Proposed Rule: Energy Conservation Standards for Commercial Refrigeration Equipment, Docket I.D. EERE-2010-BT-STD-0003, November 12, 2013, and Public Interest Comment on the Department of Energy’s Proposed Rule Energy Conservation Program: Energy Conservation Standards for Residential Furnace Fans, Docket I.D. EERE-2010-BT-STD-0011, December 18, 2013.
18 Susan E. Dudley, “OMB’s Reported Benefits of Regulation: Too Good to Be True?,” Regulation, Vol. 36, Number 2. Summer 2013.
20 Randolph May and Seth Cooper, Comments of the Free State Foundation to the Federal Communication Commission in the Matter of Protecting and Promoting the Open Internet, GN Docket No. 14–28. July 15, 2014.
21 Susan Dudley and George Gray, “Improving the Use of Science to Inform Environmental Regulation,” in Institutions and Incentives in Regulatory Science, Lexington Books, Jason Johnston ed. (2012).
22 Friedrich A. Hayek, The Use of Knowledge in Society, 35 Am. Econ. Rev. 519 (1945).
23 Cary Coglianese. “Looking Forward with Regulatory Lookback.” Yale Journal on Regulation 30: 57–66.
24 Susan Dudley “Regulatory Reform: Lessons Learned, Challenges Ahead,” Regulation, Vol. 32, Number 2, summer 2009.
25Executive Order No. 12866, 58 Federal Register 190 (Oct. 4, 1993).
26 Susan E. Dudley’s prepared statement before the Senate Homeland Security and Government Affairs Committee, July 2011.
27 For a short description of confirmation bias, see this.
28 Brian Mannix, “The Planner’s Paradox,” Regulation, Vol. 26 Number 2, Summer 2003.
29 John O. McGinnis, Accelerating Democracy: Transforming Governance through Technology. Princeton University Press, 2013.
30 Brian Mannix, “The Troubling Prospect of ‘Behavioral’ Regulation.” GW Regulatory Studies Center Regulatory Policy Commentary. April 19, 2010.

The opinions expressed here are solely those of the author and do not necessarily reflect the views of the Cato Institute. This essay was prepared as part of a special Cato online forum on reviving economic growth.

About the Author
Susan E. Dudley