Ludwig von Mises Institute

Regulatory capture

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Regulatory capture is a theory associated with George Stigler, a Nobel laureate economist. It is the process by which regulatory agencies eventually come to be dominated by the very industries they were charged with regulating. Regulatory capture happens when a regulatory agency, formed to act in the public's interest, eventually acts in ways that benefit the industry it is supposed to be regulating, rather than the public.[1]

Analysis[edit]

According to the Chicago School economist George Stigler, "as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefits."[2] Under this theory of regulatory capture, an industry or some portions of an industry cultivate government to obtain laws and rules that favor the industry. The government trades favors for what it wants. Politicians gain political contributions, side payments, and votes for being seen to control the industry. The industry captures the regulators.

This analysis can be expanded. The first step of obtaining favors can be called "baiting the trap." But matters do not stop there. The trap is set when the industry becomes comfortable with its subsidy, tax break, tariff, exclusive position, license, or whatever. It then begins to extract monopoly rents and to lower product quality. This then leads to further steps such as public outcry and a government demand for the industry to police itself. Then come crisis, further regulatory intervention, and eventually a government stranglehold over the entire industry via a panoply of boards and price controls. This is when the trap is sprung. The market is replaced by government power and bureaucrats. Government, its aim being control, traps and captures the industry.

In the shorter term, the interest groups use the state against the public. In the longer term, the state and its bureaucrats rule the roost. In the end, the government bureaucracies expand. Paperwork and soft jobs rule the industry, innovation and competition are eclipsed, and the public suffers from poor product quality and high prices.[3]

The trap of regulation[edit]

1. "Baiting the Trap" - Extra-Market Benefits

The politicians enter an otherwise competitive market situation with an offer to promote certain industrial or professional programs. Taxpayers' money is used to finance this program, but it is rare for the potential short-run beneficiaries to reject the offer on these grounds. There are several possible forms in which the aid may come.

  • Industrial groups may receive tariff protection, which is a tax levied on consumers on both sides of a border. Consumers will pay higher prices. There can be no grants of government economic benefits without someone or some group bearing the costs. A tariff is a tax.
  • For professional groups, it is usually in the form of licensing, which is a grant of monopoly rents to those inside the protected profession. The profession elects representatives who sit on government boards, or who actually make up the whole board. They can police entry into the profession's ranks by unqualified competitors.
  • Another way to buy off almost any industry or professional association is by means of direct grants of money. The government may simply buy products from a company. It may establish government research grants. It may subsidize certain industries directly. In the case of the great railroads in the United States which were built in the 1860s and 1870s, the government offered millions of acres of land to the railroad companies as an incentive to begin and complete construction.
  • Perhaps the most popular form of subsidy is tax relief. In an era of growing taxation, this approach has been one of the most effective; the higher the tax level, the more advantageous is tax exemption. The American oil industry was the recipient of multiple tax breaks until quite recently, and they are still substantial.

2. "Setting the Trap" - Extra-Market Costs

The government is a political organization. Its justification is that it is an agency of the popular will, an agent of the public in its political capacity. The government cannot grant particular groups special favors randomly - unless it is in the public interest to do so. Once the grant has been made, the beneficiaries use it for their purposes. The money is spent. But expenditures are always difficult to reduce, especially in large, bureaucratic organizations. The firms become used to the higher income. The income becomes part of annual forecasts. Managers expect it to continue. The organization is hooked. It has become dependent on the continued favor of the state.

Inevitably, one firm or some individual begins to take advantage of his position. He exercises the monopoly grant of power which the state provided for him. He charges a bit too much. He starts running a "factory." Or the firm or individual cuts quality. In short, someone actually begins to milk the system.

Once the pattern of "exploitation" is detected by citizens or government officials, the response is politically inevitable. Someone calls for the government to do something about the unfair use which is being made of the government's trust. Some firm or some professional must be stopped, and stopped now. The industry or guild must be policed. The consumer must receive protection from the unscrupulous.

The industry leaders naturally resent this intrusion into the semi-free market. They resent the fact that someone is milking the system. That person, for one thing, is trying to get more than his "fair share" of the booty. Also, he is making the government angry. He is threatening the continuation of the subsidy. He is violating professional standards.

The government demands that the industry or professional group police itself. The market as a policeman has been compromised by the original grant of power or money. This compromised policeman β€” the consumers β€” cannot enforce its decisions inexpensively, given the government grant. So the government calls on the group to police itself, and it draws up certain standards that should be met. The "partnership" between government and professionals grows strained. So the industry or professional group elects (or more likely accepts) certain spokesmen who will "work with" the other partner. This supposedly will insure that the interests of the government and the favored group will mesh, and that the group will continue to receive its favors.

If government has the industry on a string, it need not have to resort to the policeman. All it needs to do is to cut off the subsidies, and the whole industry is put into a financial crisis. The existence of the subsidies calls forth the "industry's spokesmen."

The professional guild is perhaps the most vulnerable, since the very nature of the "bait," namely, a monopoly position based of guild-policed licensure, creates the very policing organization necessary for the government to impose its will at lowest cost. They can be appealed to on the basis of professional standards and the guild's responsibility to a vaguely defined public, irrespective of the individual professional's ability to satisfy the needs of specific members of the public.

3. "Springing the Trap" - Extra-Market Crisis

More cheaters are discovered. There are more examples of men or firms that have gouged the public, meaning people who are taking advantage of the very system that the government created. So the reports of cheating and fraud continue. The guild will still be under pressure to do something to stop the causes of the reports. Finally, new laws are called for to clean up the industry, since the industry is seemingly incapable of policing itself. The government wants to set all standards and enforce them.

To clean up the crisis, the government will alter the entire foundation of financing, policing, and pricing of the industry's services. The corruption will escalate, but now it will be a government problem, to be met by even more intervention. More laws can be passed, more penalties handed out, more regulations enforced: the government expands its control relentlessly. The trap has been sprung.

4. "Skinning the Victims" - Extra-Market Bankruptcy

There are any number of ways that the government can see to it that the former subsidies now become the straitjacket for the former beneficiaries. The most obvious method of control over professional groups is the establishment of government control boards that will enforce standards and price. The government begins to finance the guild more directly. The former monopoly grant now becomes direct payments. The government sets fees, allocates equipment, and assigns consumers (clients). The government directs the operation of the association through its captive agents, the profession's representatives. Members of the profession are told what they will be paid, the kind of service to be offered, and the quantity of service to be dispensed.

The government also establishes some sort of quality-control standards. These are enforced by quality-control boards made up of compliant members of the profession and representatives of the public (pressure groups) and the government (bureaucrats). These quality-control boards do exactly that: control quality. If quality, meaning cost, starts going up, then they step in and control it. They ration equipment. They set lower standards of care, especially in government hospitals or clinics. They make sure that costs are held down, since the government, not the consumer, is paying the bill. No matter what guild is involved, the government makes sure the "irresponsible quality" is avoided, meaning irresponsibly high quality.

The government forces industries to operate at a loss. The classic example in economic history is the American railroad system, created by government subsidy, controlled in the name of protecting the consumer. The Interstate Commerce Commission was the first Federal regulatory agency in the United States, established in 1887. It was established in the name of protecting the consumer, but the result was a freezing out of new competition, since the ICC established rate floors as well as ceilings. By the late 1950s, the passenger-carrying railroads were in trouble. By the early 1970s, they were bankrupt. (Long-haul freight railroads are still able to compete.) The government now owns and mismanages many of them (Amtrak, Conrail).

The incomes of the members of the industries and professions that are now directly financed and/or directly policed by the government necessarily fall. The public will not permit "profiteering." The politicians will not permit it. Prices, wages, and fees are controlled, and work loads increase. Regulatory agencies each claim a piece of the action, and the multiplication of paperwork is endless. The formerly independent producers, who answered directly to the formerly independent consumers, now answer to a multitude of bureaucrats and enraged customers who detect the collapse of productivity on the part of the now-controlled suppliers. Most suppliers lose, most consumers lose, and a real crisis is produced.[4]

Further effects[edit]

If the regulation and control by the state get bad enough, the market may find new ways to provide the same kinds of services. If the railroad industry is killed off, then trucking, buses, private autos, and air transport have incentives to replace rails. If medical practice declines, then home medical devices may spring up. Or the AMA may get competition from other kinds of doctors, domestic and foreign. The competition to meet needs will continue under new forms.

The government has an incentive to stop them or control them. It can do this by extending regulation to these new markets. The regulated industry will itself probably call for regulation of the new competitors so as to maintain its monopoly position. Hence, in the case of railroads, we can predict that truck, bus, and air transport will also come to be regulated. However, the regulators are usually behind the curve in technology and creativity. They are regulating last decade's model. The market leaps ahead at such times, and the public gets a reprieve.

Third, political reform or liberalization movements may occur. There are political profit opportunities for populist reformers who promise to reform an under-performing system. By promising that the state will loosen its grip on the industry, they may gain public support and win election. Privatization may occur, as under Thatcher in England. Within the seemingly monolithic Communist systems of the Soviet Union and China, rival factions competed for control. Even Castro's Cuba has seen a loosening trend because he could not kill the patient altogether. And there are more moderate and more statist factions in Iran.

Fourth, while such reform movements go deep enough to be noticeable, they hardly ever go all the way back to a high degree of freedom. And after a while, enthusiasm peters out and the counter-liberal forces begin to regroup and reassert their dominance. This occurs partly because reform movements are often not radical enough. If they retain large vestiges of the earlier regulatory systems, then they will be blamed when things go badly. And things often do go badly unless a complete deregulation occurs. Statists have had a field day in California because of the botched and partial de-regulation in the electricity industry.

Fifth, the government does not find that all industries are equal prey. It has an incentive to control those industries (a) that can't escape as easily from the country and (b) for which there are fewer substitutes. At the time the US government began to control the railroads, autos and airplanes didn't exist. And the large fixed capital investments of the railroads within the continental United States made them good fixed targets. Similarly, medical services have to be delivered to individuals on the spot within the country's borders, and home medical devices like those today were not widespread in 1910 β€” although there have always been home remedies.

Sixth, when over-regulation occurs and the trap is sprung, the industry may try to escape overseas if it can or the customers will take their business overseas if they can. They will search for lower-cost places to do business. Many clear examples occur under financial regulation because many elements of financial dealings can be transacted overseas. Ceilings on interest rates paid on deposits led at one time to dollars fleeing overseas, whereupon a eurodollar market grew up. Sarbanes-Oxley regulation leads to overseas listings or even incorporation. Excessive regulations of exchanges leads to lower cost trading venues in London, or else trading shifts to over-the-counter formats.

Seventh, if business escapes the country as in the case of some financial services, the government may again respond in order to maintain its control. One method of control is to form a political cartel with other governments. It is usually called "harmonization." The most heavily regulating government will try to get the other governments to "improve" their regulation, that is, to copy that of the heavy regulator. This occurs in the guise of labor, safety, and environmental standards, for example.

It's worth pointing out that state and local governments can also play the same regulation game. But they can't control those industries that can easily flee the state and do business in another state. This is why states focus on more locally oriented interests like barbers, beauticians, and construction trades, etc. Even so, they face the ultimate threat of depopulation of the state or locality. A small locality, however, such as a university town, can impose rent controls since it can count on the university remaining in the area, and students may not wish to travel or find that travel time and costs are high.[3]

References[edit]

  1. ↑ "Regulatory Capture Definition", Investopedia, referenced 2012-12-08.
  2. ↑ George J. Stigler. "The theory of economic regulation" (pdf), The Universityof Chicago, referenced 2010-07-21.
  3. ↑ 3.0 3.1 Michael Rozeff. "Who Captures Whom? The Case of Regulation", Mises Daily, September 28, 2006. Referenced 2010-07-21.
  4. ↑ Gary North. "The Snare of Government Subsidies", Mises Daily, August 31, 2006. Referenced 2010-07-21.

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