The slow death of the regulatory state
At a time when public spending and deficits are ballooning on both sides of the Atlantic, taxes are rising and governments are enacting far-reaching reforms to financial regulation, healthcare and carbon emissions, it might seem strange to talk about the withering away of the state as an economic and industry regulator.
The past year has seen thousand-page bills on healthcare and banking reform and the greatest-ever increase in government spending outside wartime, prompting small-government conservatives to complain bitterly about over-reaching by the Obama administration and the resulting threat to individual freedom, enterprise and wealth creation.
Advocates for U.S. banks complain heightened capital requirements and compulsory clearing of derivatives will hamper their ability to extend credit and raise costs for customers. In the United Kingdom, retailers have fought a high-profile campaign against higher payroll taxes. Everywhere businesses groan about the burden of complying with an inexorably growing list of government regulations.
Free-market advocates at “The Economist” magazine have stressed the need to begin rolling back the state after a period of unprecedented peacetime expansion.
Adam Ridley, former director-general of the London Investment Banking Association, has an impassioned column in today’s “Financial Times” warning that “regulatory policymaking in Europe has become much harder to influence” because “the ideological and emotional context is no longer sympathetic”.
“Financiers have become public bogeymen, and the philosophy of liberalised global markets has become, in the eyes of many, the discredited Anglo-Saxon model. In Europe especially, the City’s traditional confidence is often seen as hubris”.
WEAKNESS NOT STRENGTH
But a closer look at the events of the last decade suggests it is not the over-mightiness of the state but its increasing weakness that lies at the root of a long list of catastrophic failures — from the mess in the U.S. mortgage market and banking industry, to the tragic mining accident at the Upper Big Branch mine in West Virginia and now the disastrous slick emanating from BP’s oil well in the Gulf of Mexico.
In each case, on paper, regulators (the Federal Reserve, Mine Safety Administration, and Minerals Management Service) wielded immense power to enforce rules on health and safety and risk-taking. But in practice they subcontracted enforcement and even the rule-writing to the firms they were supposed to be overseeing.
In Washington, the power of K Street lobbyists to influence, even write, whole sections of important bills has become notorious, under both Democratic and Republican administrations.
It is fuelling an outraged anti-incumbent populism that denounces both Washington and Wall Street alike, from both the political left (where insurgents have forced Arkansas Senator Blanche Lincoln into a run-off) and the right (where the “Tea Party” movement already toppled Senator Bob Bennett in Utah and is moving after other Republicans).
Much the same drift towards government by interest groups has been evident in the United Kingdom, where rules on financial supervision and markets published by the Treasury and the FSA often seem to have been largely written by industry groups.
Regulatory capture –where regulators come to share the interests and viewpoint of the industry they are supposed to be overseeing, rather than acting in the broader “public interest” — is nothing new. President Dwight Eisenhower warned about the power of the military-industrial complex in 1961.
But the scale of the capture across so many agencies, reaching into the heart of the regulatory state, under governments of all colours, is unprecedented in modern times.
It represents the largest “privatisation” of government since the Old Corruption of the 18th century (where government offices and laws were seen as an opportunity for private profit rather than a matter of “res publica” or the public interest).
CONFIDENCE AND CAPACITY
Industry groups whose interests will be most directly affected have strong reasons and a right to try to shape those decisions. They can also bring expertise and specialist understanding to discussions with regulators. But that expertise and understanding is never impartial and disinterested.
The proper role for regulators is to listen to representations and concerns from all the affected parties to a decision, assimilate them and then reach their own, independent and carefully thought through position. It is much like a judge in a law case. In fact much regulatory activity is described as “quasi-judicial”.
But in the past two decades regulators seem to have lost both the intellectual capacity and more importantly the self-confidence to perform this role. Rather than seeking input from companies and lobbying groups before forming their own independent position, they have increasingly contracted out the writing and enforcement to industry and professional advocates (lawyers, accountants, tax specialists and lobbyists).
Rather than the state as an overbearing Leviathan, a more accurate characterisation of modern regulatory agencies and legislatures is a hollowed out husk, thoroughly penetrated by the tentacles of private interest.
RETREAT FROM REGULATION
Several factors have contributed to the hollowing out of the regulatory state. But perhaps the most important has been the ascendance of an intellectual philosophy since the 1970s that markets and the private sector are inherently superior (more efficient, more responsive, more effective) to the public sector and regulators.
In the United States, this has been reinforced by a slow revolution in the courts that has sought to pare back regulators’ discretion. Everywhere from antitrust policy to health and safety regulations, the pro-business majority on the Supreme Court, and more importantly in the circuit and district courts, has sought to narrow the authority of regulators.
It is all part of regular historical swing of the pendulum between laissez-faire reliance on markets and private property rights and dirigiste intervention in the economy to redress imbalances and inefficiencies. In this case, the evisceration of the regulatory state represents the slow repudiation of the perceived excesses of the New Deal.
Part of the problem is also complexity. The skills and knowledge of regulators have not kept pace with the increasing sophistication and complexity of the industries they oversee.
THE FAILURE OF SELF-INTEREST
Proponents of this conservative “counter-revolution” insist self-interest and self-regulation can usually do a better job than state regulators. Investment banks talk about putting the client at the heart of everything they do, and being long-term greedy, to explain how they manage conflicts of interest. But it is not clear that such self-regulation can work in practice.
The foremost apostle of self-interested self-regulation, former Fed Chairman Alan Greenspan, admitted to the House Committee on Oversight and Government Reform in October 2008 “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief”.
Asked by Democratic Committee Chairman Henry Waxman: “Do you feel that your ideology pushed you to make a decision that you wish you had not made”, Greenspan replied: “Yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by the fact.”
Faith in self-interested self-regulation seems to have been at the root of the “dysfunctional” relationship between the regulators and industry over offshore drilling controls. It permitted no-income no-asset (ninja) home loans as well as the securitisation of vast quantities of poor quality credits and their sale to apparently witless investors.
I don’t want to suggest the state should account for an even larger share of economic activity, or try to regulate risk out of the system. Nor suggest there is not plenty of regulation around (thousands of pages of rules, guidance and interpretations continue to flood forth). But not very much of it is intelligent and effective, and for the most part that reflects the weakness of regulators, in terms of intellectual capacity and confidence, not their overbearing strength.