Economics in action: VW crashes into regulation

September 25, 2015

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Volkswagen has crossed a line. The German carmaker has admitted to cheating on emissions tests, an offence which will cost the company billions of euros and has already cost the chief executive his job. The willingness to fit millions of cars with a “defeat device”, which de-activates emissions control technology while driving, is probably a sign of a faulty corporate culture, as my Reuters Breakingviews colleague Olaf Storbeck has suggested.

While VW has special problems, the issue is universal. All companies have to decide what to do about regulation. They mostly engage in what might be called arbitrage – finding the most favourable interpretation of the rules. Companies face the challenge of responding both as good citizens and as effective competitors to often thousands of pages of laws, rulings, detailed regulations and legally binding interpretations.

The VW mess is a reminder of how important regulation is in the modern economy. The best way to prevent a repeat is to make regulation work as well as possible. To do that, it is necessary to understand how the system is supposed to work.

Rule 1: regulation is important

Regulation largely does not appear in simple market-based models of the economy. In complex ones it is typically a cost or second-best solution. The inattention merely shows how unrealistic those models are. In fact, regulation is naturally at the centre of any modern economy.

Indeed, the rules set by government agencies or among industries themselves probably do more to shape the way we live than prices set in markets. Not that prices are irrelevant. Economist Friedrich Hayek thought in the mid-20th century that prices guided economic decisions in a more efficient and humane way than bureaucratic central planning.

That is fine and true, but prices simply cannot capture much highly relevant information. Sometimes there are not enough suppliers or buyers to haggle a fair price out. On other occasions, either the buyer or the seller is unfairly powerful.

But even a fair price cannot tell all. It can provide no direct information about how a product will work over the months and years of its life, how it will interact with other products and services, and how the product and the producer affect the natural environment and the human community. Price is also a crude tool for valuing such important factors as product safety or the research and development of new and improved products.

The need for non-price sources of information and guidance in the economy is often treated as a failure of the market. The negative tone is uncalled for. Economies aren’t, and have never been, guided solely by prices. Until the advent of the industrial age, prices played a minor role in determining who made what and who got what. Custom, power relationships and negotiations were far more important. They probably still are.

For VW and its carmaking rivals, regulations cover pretty much everything. From the headlights to the exhaust pipe, from the sound system to the seat covers, the producers must walk through a thicket of rules. They must also follow the numerous guidelines for workers, customers and shareholders. It is a daunting task. As VW has discovered, getting even one apparently small part of the regulatory mix wrong can be disastrous.

Rule 2: most diktats are helpful

Companies complain about rules, but they actually serve them very well. Executives and workers follow them because they want to be responsible and to be sure that rivals cannot gain an advantage by being irresponsible. There will always be rebels and chronic cheaters, but the system could not work unless the regulators and the regulated were basically on the same side. Indeed, dysfunctional regulatory systems are a major impediment to economic development. Countries stay poor as long as regulators can easily be bribed or ignored.

A common vision does not imply perfect harmony. Companies almost always try to stretch and twist the rules. They chafe especially at rules which they believe are pointless or excessive. In response, regulators sometimes look the other way, sometimes fight back and sometimes try to find more mutually acceptable goals.

Car companies fit right in. They have a long history of resisting or manipulating some regulations. They have been known to doctor cars to provide better figures on fuel efficiency and emissions. They have occasionally delayed reporting possible safety flaws. The VW trick, which involves using sensors to determine when a car was being tested, could only have been developed by engineers who took a certain pleasure in fooling the supervisors. And it is almost impossible that this company was vastly different from its peers.

Still, the regulatory friction and producers’ deceit should be kept in perspective. Compared to two decades ago, cars today are undoubtedly far safer, use much less fuel and pollute far less. There may be something of an attitude problem at VW and some of its peers, but there is still no fundamental conflict.

Rule 3: things could be better

Here are three suggestions. First, the car industry’s regulators need to reduce the scope for cheating. They should rely far more on testing cars on the road rather than in laboratories. That sounds simple enough technically, although all changes come with problems.

It might be harder politically. Regulators and manufacturers may well believe that some of the legal standards are technically unrealistic. In that case, maybe less ambitious but more achievable new standards are required. Politicians, who are the ultimate overseers, will have to be persuaded.

Second, VW and other car companies need to tweak their attitude. It is unacceptable for them to behave like clever students who usually work hard, but sometimes try to trick the teacher. Rules and regulations should be part of the spirit of the enterprise, engraved in heads and hearts.

Finally, everyone in the economy should be more appreciative of the role of regulation. Technical bureaucrats may not have the most exciting job descriptions, but they do more for the common good than, say, advertisers, financial traders and most lawyers. For the last few decades, it has been fashionable to follow Hayek in praising market forces, and to be a bit dismissive of the men and women who make markets possible by ensuring that products and producers serve society. Unless regulation gets more respect, VW will have many followers in the hall of shame.


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Everything technical “sounds simple enough technically” to an economist who probably needs assistance to install a new email program on his computer. However, testing cars for emission control standards on the road is a lot harder than pontificating about trickle-down pseudo-science or on how under-funded engineers and government regulators can magically catch sophisticated cheats like VW without any government or societal support.

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