New demands, past experience, leading regulators to be more creative in how they regulate

Regulators and regulations are usually hijacked by influential industries and individuals they are meant to regulate and with damaging consequences. Now, that appears to be changing slowly

The paradox of the law is that it can be used to either extend or limit power. Like laws, regulations are subject to the same paradox. The complexity of modern technology and society requires expertise that no legislature, no lawmaker has the time to acquire. At some point the process has to be outsourced to bureaucrats, who have the responsibility of creating and enforcing regulations. How they do it has a direct impact on sustainable growth and a huge impact on investors. Whether they choose to extend their power to economic realms, or limit it to protect the people, will ultimately determine the economic efficiency of the system.
The first problem with regulations is the bureaucrats themselves. Like people everywhere, either for reasons of personal ambition, or for an understandable and laudable desire to protect the public, they have a tendency to expand their brief. The way they do so is to produce more regulations and hire more bureaucrats. The incentives of government encourage this jurisdiction creep. While any private business is limited by profit, bureaucrats as the preserve of patronage often are encouraged to grow.

Legislators and lawmakers don't help. Sadly, rulers everywhere believe that the solution to any problem can be found by passing a new law. These new laws are often generated by some special interest group with a particular grievance. Sometimes they are the result of a cataclysm and passed in haste. Old laws and regulations are rarely repealed. The result is an ever-increasing mass of regulations. For any new American lawyer the first introduction to an entire library wall of federal regulations can be a sobering experience.

Third, regulators and regulations are often hijacked, if not written by industries and individuals that they are meant to regulate. In Japan, the bureaucrats practiced amakudari, or descent from heaven. This is the practice of former bureaucrats dropping into high-paid private sector jobs after retirement. Toru Ishida, a powerful advocate for Japanese nuclear power and a director general of the Ministry of Economy, Trade and Industry, the agency overseeing nuclear power, was hired by TEPCO four months after he left his regulatory post. TEPCO is the owner of the crippled Fukushima Daiichi nuclear power station. The practice continued because it served the "Iron Triangle" of the Liberal Democratic Party, the civil service and Japan Inc very well.
It is not just the bureaucrats. As the great economist Mancur Olson pointed out in what is now known as the 'Free Rider' problem, small groups of interested parties have a far greater incentive to distort regulations in ways that benefit them rather than the general public at large. Often, even in the best of circumstances, the technical requirements of some forms of regulations require that bureaucrats either gain, or are closely connected to those interested parties.

Unless the regulation is not enforced, businesses and individuals will usually behave in conformity with that regulation. Conformity also will require investments. So business will view the status quo as a property interest and will fight tooth and nail to avoid any changes. A good example is broadcasting licences in the United States, which originally were supposed to be short term, but over time have become property. An even better example is the renminbi. The main beneficiary of a stronger renminbi would be ordinary Chinese citizens. But every time there is a suggestion that it should rise, there is intense lobbying to prevent it by the export industry, much of which is state owned.

The worst use of regulation has to do with attempts to manipulate markets. Frederic Neuman, an economist at HSBC, suggested four unintended consequences of attempts to use the regulations to control inflation. First and foremost, financial markets ultimately thrive on regulatory arbitrage. Second, adding more and more regulatory restrictions instead of hiking interest rates risks reducing transparency. Third, ad-hoc regulation distorts the price signals of private markets. Fourth, regulatory tightening in lieu of monetary tightening introduces uncertainties that will, over time, reduce overall investment in the economy. Of course the country that has depended most on these types of regulation to control inflation is China. The result is that the inflation problem in China will just get worse regardless of attempts to control it.

With these problems in mind, the regulators have in the past few years tried to be more creative in terms of how they regulate. One example is carbon emissions. Carbon emissions are a perfect example of the problem of the commons. Or as the English expression goes, if everyone owns it, no one owns it. Outright prohibition would encourage arbitrage, illegal activities, bribes, corruption, etc. So the European Union set up methods to buy and sell quotas to emit carbon dioxide. While far from perfect, the creation of synthetic markets, instead of regulation, holds the promise of a far more efficient regulatory environment, which not only achieves the aims of the regulations, but also cuts costs and creates more investment, not less.

(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected])

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