REGULATORY INSANITY:
THE "THING ITSELF,"
IN SIX MOVEMENTS
Michael Munger
Duke University PPE Program
IHS / Mercatus
January 26, 2013
FEDERAL TRADE
COMMISSION,
WASHINGTON, DC
THE PROBLEM IS STARK…WE HAVE TO DO
SOMETHING, RIGHT?
Many people readily concede many of our regulations are
insane, badly designed, and harmful.
The difference is that many people believe the problem is one
of structure, so all that is necessary is reform of the system. A
better halter, a better saddle, better tack.
Others believe the problem is "bad people," to which of course
the solution is "good people." If we can just elect better
leaders, and hire better bureaucrats, the (temporary) problem
will be permanently solved.
INTERESTING ANSWER: EDMUND BURKE
In vain you tell me that Artificial Government is good,
but that I fall out only with the Abuse. The Thing! the
Thing itself is the abuse! Observe, my Lord, I pray
you, that grand Error upon which all artificial legislative
power is founded. It was observed, that Men had
ungovernable Passions, which made it necessary to
guard against the Violence they might offer to each
other. They appointed governors over them for this
Reason; but a worse and more perplexing Difficulty
arises, how to be defended against the Governors?
Edmund Burke, A Vindication of Natural Society (1982 [1756];
emphasis added), pp. 64-65
THE RIGHT KIND OF NOTHING
WHY SOMETHING MAY BE WORSE THAN THE
RIGHT KIND OF NOTHING:
THE ANATOMY OF GOVERNMENT FAILURE
Market failure paradigm: Compare actual market performance to
hypothetical perfect market performance. It will fall short.
Then propose implementation of hypothetical perfect policy to fix market
failure.
Two problems:
1. Market failure defined with reference to an allocation that is, by
definition, not only unattainable but actually unknown.
2. Government failure may cause actual policy to fall short even of what is
possible, and knowable.
WHY SOMETHING MAY BE WORSE THAN THE RIGHT
KIND OF NOTHING: THE ANATOMY OF
GOVERNMENT FAILURE (THANKS TO F. BATOR, 1958)
•Collective action (Olson)
•Controlling Leviathan (Buchanan)
•Delegation (Niskanen and NcNollGast)
•Democratic coherence (Arrow, Black, and McKelvey)
•Knowledge problem (Coase, Downs, Hayek, Tullock)
•Rent-seeking (Krueger and Tullock)
1. COLLECTIVE ACTION
Judo move: NRA. No reason to expect that pressure
groups will correspond to "public interest."
Successful groups: small, concentrated benefits,
selective incentives
Answer: Don't give the state the power to control in the
first place. Because control will go astray. No necessary
connection between public action and public needs.
2. SCOPE (CONTROLLING LEVIATHAN)
Power doesn't stay put; it metastasizes. Clean Water Act 1972. What
does it apply to? All waters with a "significant nexus" to "navigable
waters."; however, the phrase "significant nexus" is unclear. The statute
frequently uses the term "navigable waters," but also defines the term as
"waters of the United States, including the territorial seas."
Scope Expansion #1: By 1985, the Supreme Court had decided what the
phrase "waters of the United States" actually meant. In particular, what
does "navigable" mean. Remember, the justification is interstate
commerce. United States v. Riverside Bayview, 474 U.S. 121 (1985).
"Those areas that are inundated or saturated by surface or ground water at
a frequency and duration sufficient to support, and that under normal
circumstances do support, a prevalence of vegetation typically adapted for
life in saturated soil conditions," and as such is subject to the Corps' permit
authority because the lands were characterized by those conditions, and
the property was adjacent to a body of navigable water."
These were puddles. They are not rivers; puddles.
Clearly not navigable, not even permanent. No flow.
But after 1985, they were regulated under the
interstate commerce justification.
Now, expanded from
"navigable waters" to
"puddles." Covered
under interstate
commerce. Because
water moves. And it
might move across
State boundaries.
SCOPE EXPANSION #2:
Larry Squires (veterinarian) owned land with alkaline sumps
(holes catch appreciable rainwater less than once per
century) in NM. Ideal for disposal of mining wastes because
bed is red clay. Water evaporates, and wastes safely
removed while in solid form. The sumps were so alkaline,
naturally, that they were extremely poisonous and could not
support any kind of life. Great Salt Lake life: not even those.
(These facts not in dispute).
In 1987 EPA ruled (under US v. Riverside Bayview) that the
lake not regulated by Clean Water Act, so brinewater
disposal was allowed. Squires created firm "Laguna Gatuna,
Inc.," invested in pipelines from the lake to nearby oil and
gas wells.
In 1992, the EPA monitored the sumps for water quality.
Saturated with salts and heavy metals. Noticed dead birds in
the area of the lake: EPA claimed Laguna Gatuna, Inc., had
violated Clean Water Act by "discharging" pollutants without the
EPA's permission. The EPA claimed the lake "provides a
significant nesting, feeding and loafing area for migrating birds,
including shorebirds, ducks, coots, grebes and raptors."
Natural rainwater accumulates in the sinkholes about once per
150 years, but bottom of holes impermeable. EPA claimed the
sump could be regulated by the Clean Water Act because….
Birds landing on these puddles "are engaged in
interstate commerce."
Did you get that? What moves? The water? Nope;
impermeable clay basin. Is this an endangered species
action? No. What moves? The birds. The birds are engaged
in interstate commerce.
The EPA issued a cease and desist order to Laguna Gatuna,
Inc., and threatened to impose a $125,000-a-day fine should
the company continue to dispose of production water on the
land. This was "pre-enforcement," pending an "actual"
regulatory decision.
But it was not "pre-enforcement" from the perspective of the
company, which had to shut down. It asked for compensation
for loss of property value, but U.S. Federal District Court in
NM / U.S. Court of Appeals said EPA orders under the Clean
Water Act are not open to judicial review.
So, Squires could not recover damages for loss of the use
of the land for its business purpose. No compensable
taking, under the 5th Amendment, given the regulatory
public interest. Squires tried continuously to get
compensation.
Then, in 2001, the Supreme Court struck down the
Migratory Bird Rule under the Clean Water Act in
SWANCC v. U.S. Army Corps of Engineers. Squires was
certain that he could get compensation now. The
response of the EPA is breath-taking. Guess?
Remember, it was a pre-enforcement ruling. It turned out, on review,
that the limits on operating the business were ultra vires (beyond the
power of the law.) Therefore, the EPA could not possibly have taken
the use of the land, because the law didn't allow it. It was all "preenforcement."
Thus, according to the EPA, Squires had a remedy: he could have
continued to operate the business, and pay the $125,000 per day, for
nine years. Just to be clear, that would have been cumulative fines of
more than $400 million dollars. The EPA said that they would have
refunded the fines in full, once the pre-enforcement process had been
completed. But since Squires had "voluntarily" settled, they had not
proceeded, and never discovered the action was ultra vires. So there
was no loss to Squires, and no compensable "taking" at all. It was not
a real decision, because it was all a pre-enforcement settlement.
Caused THIS reaction from the federal judge…
SETTLED
In September 2001, the U.S. Court of Federal
Claims ruled in his favor. The court found that the
Laguna Gatuna's numerous investments made in
anticipation of future company progress had been
destroyed by the EPA's regulatory order.
Consequently, the agency's action constituted a
"taking" that warranted compensation.
Squires received $2 million in compensation.
Almost all went to pay legal fees. He died a few
months later.
3. DELEGATION
TRANSANTIAGO: THE BUS SYSTEM REFORM-DELEGATE TO NATIONAL AGENCY
Problems with old system
• Danger from accidents
• Chaos at bus stops
• Pollution
• Congestion from too many buses/cars
• Profits (WTF?)
Social capital…passed money forward, change back.
TRANSANTIAGO
Two Problems: Greed and Danger
Greed: Profits of $60 m US per year
Danger: Accidents, because curb rights were common pool
TRANSANTIAGO
TIME MAG, 12-07: “THE MASS TRANSIT SYSTEM
FROM HELL”
Amid the apartment blocks and flyovers of the Chilean capital,
Monica Eyzaguirre joins the snaking line of people at a bus
stop, unfolds her newspaper & prepares for a long, long wait.
"I hate Transantiago with every bone in my body," she says of
the city's widely despised new transit system, watching a bus
heaving with passengers trundle towards her down a
congested road. "I used to take one bus to work and now I
have to take three. It's made the lives of millions of people
more difficult and more miserable.“
Read more: http://www.time.com/time/world/article/0,85991694607,00.html#ixzz13eemmlVA
NPR STORY, OCTOBER 2007
While a state-of-the art system installed in Chile has reduced pollution in
Santiago, a bungled adjustment has also left millions of passengers
reeling — and hundreds of others suing the government.
The new system may be generating less pollution, but it is also
generating mountains of complaints. What was once a 40-minute trip
can now take 2 hours. As a result, commuters are losing their jobs for
being late, or must change jobs because routes have changed.
So troubled is Santiago's new mass transit system, known as
Transantiago, that President Michele Bachelet made an unusual
admission just days after its disastrous roll-out. "It is not common for a
president to stand before the nation and say 'Things haven't gone well,"
Bachelet said in Spanish. "But that is exactly what I want to say in the
case of Transantiago. The inhabitants of Santiago, especially the
poorest," Bachelet said, "deserve an apology."
CITY FIX INTERVIEW (3/2010): PLANNERS’ ATTITUDE…
• TCF: Why did officials make the decision to open
Transantiago without any bus lanes?
• JCM: …There was a perception that the main goal of the
system was not to save time, but to reduce accidents,
prevent drivers from competing for passengers, and reduce
noise and pollution. All these objectives were met from the
beginning. But the system was performing so badly that the
users could not appreciate these benefits in the face of the
poor service they were experiencing.
(Juan Carlos Muñoz, PUC Planning/Transport)
WHAT WENT WRONG?
Remember, the problems had been greed,
pollution, and danger. Solution was to
make it public.
Routes
Incentives/Greed
Profits
Social Capital
SANTIAGO BUS ROUTE SYSTEMS
Old System: Redundancies,
Demand-driven
New System: Planned,
“Not to save time”
“I used to take one bus to work,
and now I have to take three”
4. DEMOCRATIC COHERENCE
Qualified by majority. "The" majority.
But there are many majorities. Two problems:
1. Agenda control
2. Actual incoherence
4. DEMOCRATIC COHERENCE
If there are three (or more) alternatives, and
there is disagreement, then democracy may
be radically indeterminate.
More simply, there is no correct answer to the
question, “What do the people want?”
In fact, some majority opposes every
alternative.
CHOICES: FOOD FOR ALL
Here is the problem:
1
2
3
A
C
B
Best
B
A
C
Middle
C
B
A
Worst
Majority preferences:
A>B>C>A
Endless, infinite cycling over alternatives. Not a tie, but a
literal perpetual motion machine
BUT THIS IS NONSENSE: MEETINGS END
That is what should terrify you: meetings end, and things get
decided. The point is that we are rarely presented with three or
more alternatives. We usually are presented with two. How are
those two chosen?
The “John Tomasi Revolution”: coalitions form, charismatic people
take power. Not the will of the people, but the force of will of
some demagogue or tyrant
If the rules matter to this extent, that means that procedures, not
preferences, determine outcomes. And elites control
procedures….
Real problem: A majority is opposed to every alternative.
NOT A TIE!
6. Law is the expression of the general will. Every citizen has a right to participate
personally, or through his representative, in its foundation. It must be the same for all,
whether it protects or punishes. All citizens, being equal in the eyes of the law, are
equally eligible to all dignities and to all public positions and occupations, according to
their abilities, and without distinction except that of their virtues and talents.
WHAT DOES DEMOCRACY LOOK LIKE?
5. KNOWLEDGE PROBLEM
How to act without prices?
Can we manipulate prices to affect how
people act?
HOUSING CRISIS: A TRAP SET BY THE US
GOVERNMENT, BAITED WITH 3 TASTY CHEESES.
"TASTY" BECAUSE SUPPRESSED PRICE INFORMATION
EFFECTIVE? UNFORTUNATELY… EACH TRAP
COULD CATCH MANY!
MANY TRAPS--THREE
KINDS OF CHEESE,
PRICES SET BY MAGIC!!!!!
1.Equity Purchase Subsidies
2.Artificially Low Interest Rates
3.Guarantee of Permanent Price
Increases
1. EQUITY PURCHASE
SUBSIDIES: HOMES
Home ownership policy of Bush, also Clinton: Pay low-income
people to make a risky investment that they would otherwise
rationally avoid.
Mortgage Agencies treated like “public utilities” (Bernanke,
Paulson).
Banks/financial entities both threatened, and bribed, to make
loans that could not possibly be paid back.
Community Development Block Grants: subsidize the down
payment.
"Qualifying" loans: A history
1. EQUITY PURCHASE
SUBSIDIES: HOMES
"New Agency Proposed to Oversee Freddie Mac and Fannie Mae,“ By
STEPHEN LABATON, September 11, 2003
The Bush administration today recommended the most significant
regulatory overhaul in the housing finance industry since the savings and
loan crisis a decade ago...The plan is an acknowledgment by the
administration that oversight of Fannie Mae and Freddie Mac -- which
together have issued more than $1.5 trillion in outstanding debt -- is
broken.... (Oxley): ''The current regulator does not have the tools, or the
mandate, to adequately regulate these enterprises. We have seen in
recent months that mismanagement and questionable accounting
practices went largely unnoticed by the Office of Federal Housing
Enterprise Oversight,'' the independent agency that now regulates the
companies….
1. EQUITY PURCHASE
SUBSIDIES: HOMES
Two New York Times Articles:
II. “New Agency Proposed to Oversee Freddie Mac and Fannie Mae,“
By STEPHEN LABATON, September 11, 2003
Among the groups denouncing the proposal today were the National
Association of Home Builders and Congressional Democrats who fear
that tighter regulation of the companies could sharply reduce their
commitment to financing low-income and affordable housing.
''These two entities -- Fannie Mae and Freddie Mac -- are not facing
any kind of financial crisis,'' said Representative Barney Frank of
Massachusetts, the ranking Democrat on the Financial Services
Committee. ''The more people exaggerate these problems, the more
pressure there is on these companies, the less we will see in terms
of affordable housing.''
Representative Melvin L. Watt, Democrat of North Carolina, agreed. ''I
don't see much other than a shell game going on here, moving
something from one agency to another and in the process
weakening the bargaining power of poorer families and their ability
to get affordable housing,'' Mr. Watt said.
2. ARTIFICIALLY LOW INTEREST RATES
ARTIFICIALLY LOW INTEREST RATES
Why would this matter? Reasons:
1. Subsidy to long term borrowing
2. Subsidize risk-taking, lender of last resort
3. ARMs and Balloons
Buy a house, zero down, 4 year lock-in of 4% ,
then balloon payment or ARM. If house was $200k,
and it appreciates at 5% per year, that’s more than
$40,000 capital gain. You can refinance, with $40,000
down payment and a standard fixed rate mortgage. It’s
all free! As long as housing prices go up forever…
The first rule of finance: Anything that will certainly
happen tomorrow actually already happened, yesterday.
3. GUARANTEE OF PERMANENT
PRICE INCREASES
Example: Interview with Henry Paulson (T-Sec,
2006-Jan 2009), in 2007:
Paulson: “I think what we’re doing is avoiding a market failure
that would have forced housing values down in a way that
was not in the investors’ interest, and in a way that the
market wasn’t intended to work.”
Interviewer: “How can you force values down? Why aren’t
values finding their natural level?”
Paulson: “The way values would go down is, as I’ve said, you’d
have market failure.” [After Treasury Department
intervention] “we won’t have housing prices driven down in
ways that distort the market.”
The Guarantee: Government SHOULD, and CAN, maintain
orderly permanent increases in housing prices.
BUT…HOW? HISTORY: 4 INFLUENCES
1. SECURITIZED DEBT
Fannie Mae (1938) and Freddy Mac (1970) set up to
“rationalize” the mortgage market—”Securitize.”
At first, worked pretty well. Repackaged and commoditized
mortgages, so that people with money could loan to people
who wanted to borrow money. Didn’t need banks, except
as intermediaries.
Home ownership is highly illiquid debt; more extensive loan
market, with reselling, allowed for increased liquidity
among both borrowers and lenders. Reduced transactions
costs, lower rates for borrowers, higher rates for lenders.
Problems: Risk status endogenous, increase asymmetric
information about repayment rates
HISTORY: 4 INFLUENCES
2. INCREASE HOME OWNERSHIP, CONFIDENCE IN
MANAGEMENT OF ECONOMY
It seemed home ownership was the stairway to the American
dream. Encourage home ownership through (a) tax
subsidies, (b) explicit subsidies, (c) pressure banks and
regulatory agencies to certify “subprime” loans as
“conforming.” Conforming loans require 20%
downpayment and 30% cap on monthly income. Both
relaxed by regulators, 1994-1997.
Problems: None, as long as home prices go up. But investors
either didn’t know, or didn’t care, that regulators were
expanding the definition of “conforming” loans. Appeared
to be good loans, certified by government agencies as
being investment grade assets.
US HOMEOWNERSHIP RATES
The new loan products are known as the combo / ballon loan,
and have lower down payment requirements. Combo loans are
the contract of choice for nearly 40% of new loans, explaining
much of the increase in homeownership rate since 1994.
At the same point in time, 1997, housing prices started to skyrocket in real terms.
Before, housing had been a hedge against inflation, but wealth was built through
accumulating equity. Now, with the new loan regime from the Congress and the
US HOMEOWNERSHIP
RATES
Clinton
administration, and Fred and
Fan helping, there was a huge rush of cash
chasing houses.
HISTORY: 4 INFLUENCES
3. COLLATERALIZED DEBT OBLIGATIONS
Collaterlized Debt Obligations (CDO)—90% repayment rate
means an accurate price for bundles, even if no one
security could be priced accurately.
Problems: 90% repayment rate is endogenous, assumed old
regulatory structure. And assumed steady increase in
home prices. When repayment rates plummeted, no idea
how to price these very complex assets. Imagine what the
bankers thought; they must have been incredulous! “We
can certify these lousy risks as investment grade, and then
we can sell them in bundles at full price to FM/FM, and
then bear NO responsibility for anything that happens
later? COOOOOL!”
HISTORY: 4 INFLUENCES
4. DERIVATIVES, especially Credit Default Swaps
Similar to other “hedging” derivatives. “Invented” by JP
Morgan analysts in 1997, in 2000 became exempt from
most regulation. (Pres. Clinton supported). Like insurance,
but NOT insurance. Needn’t own asset, not regulated, and
no requirements for reserves or structures of hedged risk
layoffs.
Problems: “Insurance” aspect of these derivatives meant that
no one cared about the underlying assets, and no one
investigated repayment rates. And AIG (with its physicists)
made huge amounts of money writing these contracts. But
like a one-sided betting shop: did not hedge the risk. For
many companies, their only assets were these swap
contracts after the primary assets defaulted.
PRICES ARE INFORMATION, NOT POLICY
No Regulation: You are on your own. No one knows if these assets are
risky, and if you lose money no one will bail you out.
Really, really bad regulation: Government caused the crisis, by
subsidizing housing prices, and using government prestige to
hoodwink small investors. Certified junk as conforming, allowed fast
resale at full price, facilitated by Freddy and Fanny. “Investment
houses” turned into “Animal Houses.” And firms that lost enough
money were made whole with public funds.
The dilemma: Bad regulation can be worse than no regulation. But
can't we "reform"? Wouldn't GOOD regulation be better? Test: When
you say, “Government should regulate markets,” take out the word
“Government” and substitute “Politicians I actually know.” You sure
you still believe that?
Confidence, Transparency, Liquidity required for
accurate pricing and functioning markets
6. RENT-SEEKING
Rent-seeking has a simple technical description: Two parts
1. All-pay auction
2. All the values of the bids are burned, or otherwise destroyed
Rent: return over and above opportunity cost return on effort or
asset value. Difference between "rent" and "profit": None from
the perspective of the entrepreneur.
Rent: artificial, created by legislation or accident
Profit: result of creating new net value
RENT-SEEKING
NBA? NHL?
Mortgage originators?
Solar panel manufacturers (Solyndra?)
Drug patents
Software patent trolls
One truly egregious example, combining a number of the
problems we have talked about…
DEEPWATER HORIZON
• Liability Cap: $75 million
• MMS takes over safety inspections:
Budget based on new wells
WHO SAID IT?
It is not sufficient to contrast the imperfect
adjustments of unfettered enterprise with the best
adjustment that economists in their studies can
imagine. For we cannot expect that any State
authority will attain, or even wholeheartedly seek,
that ideal. Such authorities are liable alike to
ignorance, to sectional pressure, and to personal
corruption by private interest. A loud-voiced part
of their constituents, if organized for votes, may
easily outweigh the whole. (p. 296).
ARTHUR CECIL PIGOU
18 November 1877 – 7 March
1959. “Credited” by Coase with
Pigovian tax scheme. But in fact
thought more organically. Quote is
from Economics of Welfare (1920),
p. 296
TRADITIONAL STATEMENT OF THE PROBLEM:
MARKETS VS. GOVERNMENT DIVIDING LINE
Here? Mostly
Socialism?
100%
Government
Here? A
Hybrid
System?
Here? Mostly
Laissez Faire?
100%
Markets
Properly, dispense with this continuum. A mechanism design
problem, not "more" or "less" regulation.
HOW TO DESIGN THE BEST GAME?
Too much government, always
arguing over the rules
Too little government
1.
2.
3.
How to design the best game?
The referee is not a player, but the referee is
powerful and in charge. Prevent metastasis.
Choose good rules, for an interesting game
that creates value for everyone. So problem
is NOT “is the referee too powerful?,” but
rather “are the rules the correct rules?”
“Rule of Law”: treat everyone equally, so that
they practice skills(invest in productive assets)
rather than arguing and lobbying for favorable
judgments from the referee. Marginality
condition: (a) invest in plant/
equipment/innovation, (b) invest in more
favorable rules