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Sunday, November 24, 2019

Not All Regulation Is Bad

By Howard Baetjer Jr. - November 24, 2019 at 06:00AM

City transport regulators have banned or hindered Uber and Lyft from operating, even though the public loves their convenience and drivers find the apps a good way to make money on their own terms. The Food and Drug Administration (FDA) prevents sick people from trying certain drugs that their doctors would like them to try and drug companies would like to sell them; many Americans who can afford it travel to other countries to get medicines the FDA denies them here. Banking regulation in America now prevents community bankers from making loans based on their judgment and knowledge of their would-be borrowers; the rules force lenders instead to follow formulas imposed by the regulators.

Government regulation is a problem. Through restrictions and mandates, it prohibits exchanges that peaceful people would like to make and requires transactions they do not wish to enter into. Thus it interferes with our liberty to interact as we choose.

But what do we do about it?

It won't do simply to say, "Let's deregulate," meaning to get rid of regulation altogether, because everybody wants what regulation is supposed to provide us: regularity and predictability in markets and assurance of quality and safety in the goods and services we buy.

When we get in a taxi or an Uber, we want to know that the driver is peaceable and responsible and that the car is in good condition. When we take a medicine, we want to know that it is safe and effective. When we put our money in a bank, we want to know that it has enough capital that we won't lose our savings if the institution has a run of bad luck. In short, we want goods and services to be well-regulated.

So it seems that we are stuck: Government regulation almost always denies liberty and usually causes economic harm, but we want the regularity, predictability, and quality assurance that regulation is supposed to provide. Does that mean the best we can do is to accept government regulation but try to rein it in, to limit it, to reduce the harm it does?

No. It is a semantic error to assume that regulation means government regulation. In fact, there is no such thing as an unregulated free market, because markets free of government regulation are very closely regulated by the choices and actions of market participants. And market forces regulate quality and safety better than government agencies can.

Regulation by Market

To regulate is to make regular and orderly, to hold to a standard, to control according to rule, as a thermostat regulates the temperature in a building.

Market forces do this constantly. Competing businesses offer what they hope will be a good value, then customers choose among the various offerings, then the competing businesses react to customers' and competitors' choices. That process is the market's regulator.

To take an example of market regulation so ubiquitous that many people don't even notice it, market forces regulate prices.

If the Giant supermarket near my home is charging $2 a pound for red peppers, the more upscale Eddie's Market will not be able to charge a whole lot more than that and still sell many red peppers. Neither will other grocery stores or the farm stands that open nearby in the summer. All will charge nearly the same price. There is strong regularity to the prices of red peppers at any place and time. This regulation is accomplished by each seller's response to the actions of his customers and competitors.

The same goes for quality. Consumers won't buy peppers that aren't fresh and firm if they think they can get better peppers at some other store. The grocers might wish they could sell last week's peppers that are getting soft on the shelf, but customers, along with the self-interested actions of other stores, won't let them. Their customers' choices and competitors' actions restrict the quality of produce they can sell. In this manner, market forces regulate quality.

The quality of red peppers can be directly observed. But what about goods and services whose quality and safety cannot be directly observed? We can't observe the criminal record of some taxi or Uber driver who comes to pick us up. We can't know by looking at it what side effects a medicine might cause. We can't observe the capital adequacy of a bank where we consider putting our savings.

In such cases we need somebody else who can give us assurances that the goods and services we consume are safe and of good quality. Enterprises in markets provide that kind of assurance all the time, in several ways.

Usually we don't just buy a product; we buy the product plus some assurance of its quality. Often, in fact, the quality assurance becomes a feature of the product.

One way is with branding. A brand like Sony or Black & Decker tells the customer, "You can trust this product." The company stakes its extremely valuable reputation on it. The same goes for franchises, which are brands of another kind. When we see the Holiday Inn sign, we know what to expect from a room there. It is not going to be great, but it will be clean and adequate.

While brands and franchises do give assurance of quality, the assurance is coming from the same company that wants to sell us the product. Such assurance is not always persuasive. Often we want assurance from some objective, outside, third-party assurer. The market provides these in abundance also.

There are third-party certifiers whose whole business is to provide reliable assurance of quality. Underwriters Laboratories is pre-eminent here. Manufacturers voluntarily pay that organization to assist in product design, to test their products, and to give them the famous U.L. seal of approval. Both customers and the manufacturers themselves want outside assurance that their products are safe and effective. (The manufacturer does not want to get sued.) Similarly, Good Housekeeping and the Better Business Bureau (BBB) give their seals of approval to, or withhold them from, various enterprises and their products. Credit-rating enterprises such as Moody's, Fitch, and S&P appraise financial instruments. (They did a bad job of this with mortgage-backed securities before the financial crisis, showing that they themselves were ineffectively regulated. But note that they are regulated by the Securities and Exchange Commission rather than by market forces.)

Then there are information providers, such as industry magazines and a variety of online quality-rating enterprises—among them PC Magazine's "Editors' Choice" awards, Angie's List, Carfax, Yelp, and Nextdoor. More recently there have arisen internet-based sharing and connecting services, such as Uber, Lyft, Airbnb, and Thumbtack, a website for sourcing and then reviewing local professionals of various kinds. With respect to quality assurance, these are particularly robust: Their customer ratings make every consumer an inspector.

I saw the significance of these third-party certifiers up close recently when I hired a paver for my driveway. His pitch on Thumbtack, where I found him, begins, "We are a licensed contractor." OK, that's government's regulation. But then he immediately adds, "and accredited by the BBB," a private-sector certifier. Then comes his main pitch: "We also have an excellent reputation on Angie's List, winning the Super Service Award every year since 2010!!!" This contractor relies on private accreditation more than on government licensing, and so did I.

Providers of goods and services typically have insurance. So insurance companies become still another source of quality assurance. They have a financial incentive to make sure their clients' products are safe and of good quality—by requiring U.L. certification, for example—because they don't want to write checks to people who sue their clients.

How effective are these market institutions at giving us the kind of regulation we want? More, I'll argue, than government institutions are. Indeed, since government regulation is top-down, with the public exerting control only indirectly through the political process, government regulation is itself nearly unregulated. This is a flaw that makes it unresponsive to the public's wants and needs. Regulation by market forces, by contrast, is bottom-up, with the public exerting control directly in the market. It is not perfect—nothing human is perfect—but it works pretty well, and it is very responsive to the public's wants and needs.

Government Failure

How do different localities regulate the safety and quality of ride services, such as taxis, Uber, and Lyft? They do so via an agency—a public service commission or a taxi commission, say—that imposes various restrictions and mandates on the service providers aimed at preventing bad outcomes and promoting good ones.

But suppose that agency does a bad job. What regulates the regulator? Suppose, for example, that the agency is in bed with existing taxi companies threatened by ride-sharing services and therefore bans the operation of Uber and Lyft. Agencies did this for a while in Austin, Texas, and in Buffalo, New York. Or suppose the agency merely obstructs the operation of ride-sharing companies, as the New York City Taxi and Limousine Commission did last December when it imposed minimum-wage rules on ride-sharing drivers. Such actions are directly against the interest of the public, who value these ride-sharing services. How is the regulatory agency's bad performance to be improved?

State or local legislatures are supposed to regulate the performance of their regulatory agencies. In some cases, they do. Several state legislatures, for example, have passed laws forbidding localities from interfering with ride sharing. But not all. Some legislatures are also in bed with the taxi companies and regulate in their interest rather than the public's.

When legislatures fail, who is supposed to regulate them? Members of the public, in their role as voters.

But the voters are not in a good position to affect the regulation of ride services or any other industry. Many people don't vote. Many who do vote are not interested in ride services. Most of those who are interested are what economists call "rationally ignorant." That is, it makes little sense for them to inform themselves about candidates' positions, because the chance that their vote will determine the outcome of an election is vanishingly small. So they vote without knowing what candidates think about ride-sharing regulation. They're also choosing among candidates who hold positions on many issues other than transportation, issues the voters may care about more. Accordingly, it is impossible for voters to weigh in on just the regulation of ride services. Plus, they vote only once every two years. This is a hopelessly indirect and attenuated way for the public to affect the regulation of ride sharing, or anything else.

A Lack-of-Knowledge Problem

Bank capital is a kind of cushion, a layer of cash a bank holds to keep it solvent if it should run into problems such as loans going bad. All banks need to hold some capital, but how much? Holding too much capital means not lending that money out for productive investment. Not holding enough means exposure to risk if the economy goes south. Who should decide what the right amount is, and how?

In the United States today, bank capital adequacy is regulated predominantly by the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC). These bodies restrict banks' freedom to operate as they choose in myriad ways, prohibiting certain kinds of investments, requiring others, and dictating how much capital of what kind must be held against each kind of asset.

Have these "regulations" (wouldn't "restrictions and mandates" be a more descriptive term?) worked well to keep financial institutions sound in the last dozen years? Clearly not, as many banks needed capital injections during the financial crisis. Among the problematic regulations were some declaring that the debt of sovereign nations, such as Greece, is risk-free and thereby requires no capital backing. Those rules are still in effect.

In criticizing government regulation of bank capital, I don't mean to imply that the regulators are corrupt or negligent. I believe most of them are competent professionals doing the best they can. But they face what's known as "the knowledge problem"—the fact that central planners cannot know all they need to know in order to plan effectively. Now, planning bank capital requirements is not comprehensive central planning of the whole economy. But bank regulators are still trying to plan the activities of an immensely large and complex sector, one that's intimately intertwined with most other sectors. It is just unrealistic to expect even the smartest and best-informed regulators to get it right. There is too much to know.

If the Fed and the FDIC do not do a good job of regulating bank capital, who is supposed to make them do it better? Congress is. But do its members have the necessary knowledge of monetary and banking history and theory to direct these agencies? Do they have the right incentives to make their decisions based on economics rather than politics? Have they tended to do a good job of regulating the financial regulators? The answers to those questions will differ for different members of Congress, but it seems clear that the majority are deeply ignorant of much of what they are asked to oversee.

If Congress does not regulate the Fed and the FDIC well, the system relies on the voters—rationally ignorant, voting on a package deal once every two or six years—to regulate Congress. As with government regulation of ride sharing, government regulation of bank capital is a deeply flawed process that fails to involve regular people in their role as customers. Better for regulation to be decentralized, distributed, and organic.

The story is similar with medicine. The FDA is charged with assuring quality. Its officials impose a variety of costly testing requirements on pharmaceutical companies and restrict the sale of any new drug or medical device for as long as they see fit. Their understandable but excessive caution has pushed the cost of getting a new drug from conception to market into the neighborhood of $1 billion. It has denied many patients access to drugs they and their doctors wish them to take, it has slowed the development of new therapies, and it has inhibited development of medicines for rare diseases.

If the FDA is misregulating through excessive caution, who is to regulate the FDA? Once again, Congress is, and voters are to regulate Congress if it fails in its task. Thus we face the same problems we saw above with government regulation of bank capital.

In contrast, let's consider how market processes regulate (or could regulate) the same three industries if they were free of government meddling.

Free Market Transportation

Regulation of quality and safety in ride services would be based on the choices not of bureaucrats but of the public, in the role of riders, not voters. They would choose among different offerings of taxi companies, ride-sharing companies, and any alternatives that might arise. In the absence of any government quality-assuring agency, the public would need to rely on quality-assuring enterprises.

Much of this assurance would come from brands. Taxi and ride-sharing companies seek to establish and maintain a reputation for good service. In a free market, they would set their own standards for background checks on drivers, inspection of vehicles, promptness of service, and the like, and then they would publicize those standards. Uber and Lyft do this now. Their background-checking procedures are more robust than those of many taxi commissions, and their driver rating process makes every customer an inspector. Additional assurance of taxi companies' quality would be provided by third-party certifiers such as Angie's List, Yelp, and the Better Business Bureau.

What assures the quality of the quality assurance offered by taxi companies, Uber, Lyft, Angie's List, Yelp, and others? Once again, it is the choices of the market participants involved, to which their competitors must respond. Consumers use Angie's List or Yelp (or both) to research taxi companies, and they reward those that provide the most useful and accurate information by returning to those sites. Taxi companies reward the best certifiers by displaying the certifications on their websites. Drivers reward Uber or Lyft (for good quality assurance, among other factors) by choosing to drive with one or the other. Anyone who lets quality slip, from the third-party certifiers to the taxi or ride-sharing companies to the individual drivers, tends to lose business.

This process of quality assurance is not perfect, but it is quick, fine-grained, and relentless. With respect to quality and safety, it makes taxi commissions at best an obsolete nuisance and at worst an impediment to progress.

Free Market Banking

The market process regulated bank capital until the Federal Reserve began central planning of the money supply in 1914. Until then, banks issued not only their own checking accounts but also their own banknotes.

To keep down the cost of exchanging these notes and checks with one another for payment, banks joined one or more clearinghouse associations. Each day the checks and notes for all the banks in the association were brought to the clearinghouse, where the mutual obligations were "cleared"—offsetting IOUs were canceled and the net obligations were paid.

Market-based bank capital regulation arose out of this system, because the banks in any clearinghouse association wanted assurance that their sister banks within the association were sound. Accordingly, they agreed, as a condition of membership in the association, to maintain the minimum capital requirements set by that association. They also agreed to periodic inspection of their accounts to make sure they were fulfilling their promises.

In this system, the quality-assuring entities—the capital adequacy regulators—were private-sector clearinghouse associations, not government agencies. What regulated their decisions? Market forces did: the choices of the market participants in the face of experience.

If a clearinghouse required its members to hold more capital than prudence required, those banks would not be able to make as many loans and would not prosper as they otherwise might have. Potential customers would take their business to banks in other clearinghouse associations with more appropriate capital requirements, and those banks would expand as a result.

Conversely, if a clearinghouse required less capital than the economic realities dictated, when an economic downturn occurred, some of its members would fail or have difficulties meeting their obligations to their partners in the clearinghouse. This problem would signal that the clearinghouse association needed to raise its capital requirements.

Note the way this process of bank capital regulation, and regulation of that regulation, takes into account the distributed knowledge and experience of different bankers in different times and places, and note how it provides the flexibility to adjust capital requirements in response to those differences. The knowledge and judgments of thousands go into the final rule. How different that is from top-down government regulation, in which decisions are made by bureaucrats based on their own limited knowledge and the political pressures of the time.

Market-based banking regulation was a constant work in progress, but it was still better than what we have had since. Remember that both the Great Depression and the financial crisis of 2008 happened on the Fed's watch.

Free Market Medicine

What of medicines? How would market forces, free of FDA interference, regulate their quality and safety? There would still be extensive testing of the safety and efficacy of different drugs, because everyone in the industry values such information. The testing would be done by the private sector—but then, so is the testing required by the FDA.

In addition to testing for FDA purposes, a tremendous amount of research is constantly being conducted by doctors and other researchers around the world, at medical schools and research hospitals and within pharmaceutical companies themselves. This research is presented at innumerable medical conferences and published in such journals as The LancetThe Journal of the American Medical Association, and The New England Journal of Medicine, among countless others.

These research institutions and publications are our primary source of information about the quality and safety of particular medicines for particular kinds of patients with particular illnesses. Even now, they are our main quality-assuring institutions. The difference in a market free of FDA restrictions is how that research would be evaluated and who would decide, based on the evidence, whether or not a medicine should be used in a particular case.

The average patient could not evaluate the research and choose therapies unaided. In a free market, patients would rely for help on still another layer of quality-assuring enterprises and individuals: their doctors, hospitals, pharmacies, and, indirectly, insurance companies. These would serve to regulate the safety and quality of pharmaceutical offerings. Doctors and pharmacists would make it their business to inform themselves about the safety and effectiveness of medicines. Hospitals, to protect their reputations and to protect themselves from lawsuits, would restrict the medicines that can be administered within their walls. Insurance companies, in their own financial interest, would require the providers they insure to prescribe only medicines that have been tested to standards the insurers deem prudent. All would learn from one another, by experience, what standards of quality and safety assurance are appropriate and which are overkill.

Most of this is true today. Federal officials do determine when drugs may go to market. But how they are used is regulated by market forces. Ultimately, by slowing the introduction of new treatments, the FDA reduces access to care.

Two Sorts of Regulation

With government regulation, the quality-assuring agency is a monopoly; with market regulation, quality-assuring enterprises must compete. With government, the quality-assuring agency is all but unregulated; with markets, quality-assuring enterprises are regulated by market forces. With government, the public votes in elections every few years; with markets, the public "votes" with dollars every day. With government, the public selects among candidates holding positions on many issues; with markets, the public makes a choice about the particular good or service in question.

With government, the regulating agency relies on bureaucrats' knowledge; with markets, the regulatory process draws on knowledge distributed throughout society. With government, bureaucrats face no competition from which to learn how to improve; with markets, enterprises are sharpened by their competitors. With government, the quality-assuring agency can ignore tradeoffs; with markets, quality-assuring enterprises have strong incentives to get the tradeoffs right. With government, there is no evolutionary selection of regulatory standards, methods, and quality assurers; with markets, there is. With government, regulators are vulnerable to "regulatory capture," in which an industry cozies up to the regulating agency and extracts favorable rules; with markets, there is no central authority to capture. Government regulation works by the restriction of choice. Market regulation works by the exercise of choice.

We need regulation of the quality and safety of the goods and services we buy. Because that regulation should be done as well as possible, it should be done by market forces, not by government.


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