How to Regulate Business without Getting Gamed

Posted on 2010 December 17

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We’ve been at this — regulating business — for over a hundred years, from the Interstate Commerce Commission to OSHA and the Environmental Protection Agency. Yet the fat cats are richer and more powerful than ever. What went wrong?

Two things. First: government agencies must fail. Second: agencies end up being controlled by the very companies they regulate.

Government agencies must fail?!? Yep. It’s amazing but true, almost a law of economics. Here’s how it happens:

If a business wants to grow, generally it must produce better goods or services at lower cost. That will improve its profits, which it can then plow back into the business, and it all gets bigger. But if a government department wants to grow — and department heads and legislative sponsors will gain greatly if it does — it must produce worse goods or services at higher cost. Why? Because if a bureaucrat manages his department so well that all its tasks are accomplished on time and below cost, at the next oversight hearing its budget will get slashed. But if the department makes a shambles of its mandate, the director will simply argue, “The people didn’t give us enough money to do the job properly!” And the legislature will nearly always increase the agency’s budget.

Strangely, this argument — “We didn’t get enough money!” — always works, year after year. The alternative would be to disband the department, at which point voters would start screaming, so legislators shrug and increase the budget. This is one reason government programs tend to grow out of all proportion to their original mandate.

The “failing upward” principle can occur in large institutional settings of all kinds. I spoke with the head nurse of a neonatal unit at a prominent Los Angeles hospital, and she told me that, at the end of each fiscal year, she always took any leftover cash in the unit’s account and spent it on extra folding tables or anything at all that might conceivably be useful to the unit. She did so because, as she explained, “They’d cut my budget if I didn’t spend all of it.” And she certainly didn’t want to find herself tethered to a smaller budget if the unit’s needs suddenly ballooned.

Now, most companies put a cap on bureaucratic waste with an overall budget. But the government — which can print extra money, raise taxes, and borrow endlessly — has no limit to its fiscal foolishness. Besides, it’s nearly impossible to fire a civil servant. And none of them have to earn the money their departments spend: it’s tax revenue, it just shows up, and there’s no need to use it wisely. There’s always more where it came from, so why bother to be careful with it?

All agencies end up controlled by the companies they regulate?!? This works as follows:

Once upon a time, a big company commits an egregious crime, and the public is outraged. Calls for a national regulatory agency lead to enabling legislation, and suddenly there are new inspectors in the marketplace.

Before long, corporate honchos with a knack for gaming the system appear in Washington, where they offer potloads of election-campaign dough to legislators who are willing to tweak the laws so that they penalize, not the fat cats, but their smaller competitors. Soon it’s too expensive for any but the wealthiest corporations to compete in that market. Now, some of the regulations are irritating to the big boys, but those same rules sweep away weaker companies, which makes it all worthwhile.

Then these gamers meet with the enforcement officials, who, after all, usually don’t understand the arcane workings of business and could make missteps that cause layoffs, reduced tax revenues, and increased unemployment costs. The honchos promise inspectors cushy, high-paying industry jobs when they leave public life if they look kindly on the businesses. Oh, they don’t say it directly — that would be against the rules — but after several drink-besotted luncheons paid for by corporate bigwigs, the civil servants get the idea.

The result is a system that, far from preventing bad companies from hurting us, in fact gives them more power than they could have amassed in the marketplace. They can charge more and offer less because pesky competitors have been wiped out by the new, expensive regulatory system. They get away with larcenies they would never have dared attempt in the past because the regulators are in their pockets and won’t call them out on their transgressions. So things are worse than before, not better.

This sort of corruption has been going on for decades, yet voters don’t rise up to demand that it all be dismantled. Why on earth do we put up with such a travesty year after year? Well, what’s the alternative? No government regulation? Are you kidding?!? There’d be chaos!

Not that there isn’t chaos already.

Most fiscal conservatives, nevertheless, insist that we “deregulate business!” But when deregulation fever strikes Washington, usually only a portion of the regulatory regime gets dismantled — no one dares remove the entire system — and this destabilizes the remaining apparatus, weakening it. This allows the bosses to act like freshman at a beer keg. For example, in 2004 the SEC, which otherwise has a strict hold on Wall Street, granted a margin waiver to the big investment banks, who promptly spent nearly all their safety cash on mortgage-backed securities. And you know what happened after that.

There’s a much better way to resolve this problem: decentralize regulation. But for this to work, we must call on four different types of institutions: insurance companies, rating agencies, private courts, and watchdog groups. Let’s look at the role of each in an improved regulatory system.

1. Insurance companies. These folks carry big clout with corporations because they can cripple scofflaw businesses with high premiums. And they will, because no insurance company can afford to shoulder huge lawsuit payouts unless its high-risk clients foot the bill. Meanwhile, corporations would find it extremely difficult to control all the individual insurance companies at once, the way they can control a single government agency. So actuarial standards would be relatively fraud-proof.

But insurers need to be free to operate anywhere in the country, lest certain fat cats hide behind convenient state borders. And the insurers themselves must also be weaned from their dependence on the sympathetic treatment of local regulators. A more independent and robust market for insurance will stimulate better underwriting, lower costs, and a closer watch over insured companies.

2. Ratings firms. The Feds, back in the early 1970s, essentially granted monopoly powers to three accreditation houses — Moody’s, Standard & Poor’s, and Fitch — which returned the favor by giving artificially high marks to the very investments that collapsed en masse in 2007. (Ironically, some of those ratings were justified: after all, the government did bail out many of the firms involved.) Aside from the fact that this ratings monopoly is yet another example of how regulators and the regulated work hand in paw, it also points up a critical need — namely, more competition among ratings firms.

Free to compete, there’d be dozens more of these companies, not to mention an increase in specialty raters such as Underwriters Laboratories, Good Housekeeping, and the Better Business Bureau (whose current efforts are overshadowed by government regulators). New and better standards would be invented and marketed, while companies would find themselves more accurately and strictly judged. This, in turn, would increase actuarial precision, which would improve insurers’ judgments about the reliability of the companies they underwrite. Finally, bad boys would find it nearly impossible to game such a system, as it would be spread out among dozens of companies no longer corralled by a central government department.

3. Watchdog groups. This includes newspapers, news wires, Consumer Reports, local civic groups, Internet bloggers, and so forth. This category is already the least fettered of the four we’re discussing, and already they have done much, if not most, of the work needed to bring recent scofflaws to heel. When Chinese companies exported tainted dog food to America, outraged pet owner associations, along with news media, got on the case weeks before the government roused itself from slumber. And when Mattel imported toys decorated with lead-based paints, similar groups forced the company to make quick amends — again, weeks ahead of the Feds’ appearance. And news reports made glaringly public the discovery of tainted spinach, along with its source and destination, way before before the government even filed a report.

The one thing large companies want least in the world is bad publicity. The independent, public nature of media and watchdogs help them combine to become the most powerful of the four types of regulator in a world without centralized monopoly government management.

4. Interlinked private courts. Many of today’s torts are heard in private courts presided over by judges hired for the purpose. Given free range, a much greater number of national private courts could arise to handle the cases brought to them by watchdogs, accreditors, and insurance companies. These courts would profit only if they established sterling reputations for fairness, rectitude, and efficiency, lest competition from other courts take away their clientele. (This is in contrast to the low quality, slow service, and arbitrary rulings of public courts.)

Most of the time, insurers would negogiate with each other about which courts to use for individual cases, or a court system could be chosen in advance by contract. Companies who refused to abide by the courts’ decisions would be unable to obtain insurance, and most would be hard pressed to self-insure, especially if they tended to attract claims against them like flies. And of course the ratings firms and the media and watchdogs would condemn corporate reprobates in public, which would damage their sales and squeeze their revenues.

Let’s review: competing casualty companies could keep sharp eyes on their client businesses, while ratings firms, watchdog groups and news outlets would dig constantly for any dirt they could find, and a system of competing private courts would dispense civil justice fairly to all. In fact, every one of these regulators, because they were privately held, would have to give good service or lose market share. And they would have no more ability to hide behind government agencies, in this new world, than the companies they now watched over.

The system would work for two reasons. First, these oversight companies would grow and prosper only by doing a good job at a good price in a highly competitive environment, instead of by becoming increasingly incompetent, expensive, and corrupted like a government agency. Second, these firms would be decentralized, numerous, and nearly impossible to corrupt as a group, unlike government agencies, which are centralized, have monopoly power, and are easy to push around.

Now that I’ve spoken vigorously for this concept, I’ll turn around and argue why it won’t be adopted. Most humans can’t wrap their heads around a system as diversified as the one just proposed. Something deep inside us craves the feeling of safety from a single, central authority. One boss is much easier to picture than hundreds of small authorities; the federal government may always look more appealing to our instincts than a bunch of companies spread out across the entire country. Besides, the idea of someone other than the government having regulatory power seems so, so … counter-intuitive. It’s easy to get the creeps just thinking about it. Businesses guarding other businesses? Forget it! It sounds corrupt! (Never mind that the august halls of Washington contain vastly more corruption than a decentralized private system ever could.) So don’t hold your breath.

On the other hand, there’s a useful lesson here for each of us. If we can learn to pay attention to the work already being accomplished by watchdogs and media … and if we plan carefully with our own insurers … and if we do business only with companies we trust … and if, in our business affairs, we can migrate our legal needs to the private courts already in operation … then we will begin to enjoy the fruits of this more sophisticated approach to regulation — whether the rest of the country decides to or not.

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POSTSCRIPT: For another approach to dispute resolution, check out the article, Imagine There’s No Law

UPDATE: On the Internet, everybody’s rating everybody: Yes, Uber Drivers Are Rating You

POSTSCRIPT: More government regulation just adds to the corruption: “Breaking Bad: Can Regulation Be Fixed?”

UPDATE: Online ratings give customers regulatory power

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Posted in: Politics