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Regulation and Reality

February 14, 2002

Tags Booms and BustsU.S. EconomyBig GovernmentThe EnvironmentU.S. History

With Enron, Global Crossing, and other debacles in the news, the usual hue and cry for "more regulation" is hitting full steam.  In a recent New York Times column, Paul Krugman--always an apostle for expansion of the police powers of the state--says that the Enron collapse will have an even larger impact on the future of this country than the terrorist attacks of September 11, as he believes that the regulatory powers of government will now become much greater, a development that he welcomes.

Prophecies, of course, are cheap and usually wrong, but it is instructive for us to examine not only what went wrong at Enron, but to ask whether or not expansion of government regulation of business is the "appropriate" remedy.  As many of us have spoken out against the knee-jerk decision by Congress and President George W. Bush to make airport security officers federal employees, so we need to resist this attempt to expand the regulatory state.

At the same, we in the libertarian-classical liberal camps need to articulate why the "solution" of regulation is not a solution at all.  Furthermore, we also need to point out that behind the rhetoric is a set of statist agendas which, if enacted into law, will make our lives more difficult in many ways.  Let me begin.

The spectacular crash of Enron, just like the crash of numerous savings and loans more than a decade ago, makes for good theater, but it often produces more heat than light.  The typical thing we hear is this: "Business needs more government regulation.  We pulled back regulation because of ideological zealotry, and this is what happened."

This might sound good in newspaper editorial offices and in college classrooms, but it is far from realistic.  While ideology may play a role in the establishment or undoing of regulation, it generally takes a backseat to personal, business, and political agendas that truly drive the political system.  Of course, part of the entire charade that surrounds the implementation and enforcement of regulation is putting forth the notion that government regulation is a necessary entity that prevents corruption, business losses, and harm to consumers.

The myth is fashioned in the following way.  First, it is said that without regulation, markets will be chaotic and disorderly.  Thus, regulation works in much the same manner as a stoplight at a busy intersection.  Without this regulatory apparatus, drivers would be crashing into one another, and without the hand of the state to guide business operations, markets would crash and burn as well.

Second, regulation is a last-resort solution that is applied only when businesses abuse the freedom that the government has so graciously given them.  According to this supposed scenario, free markets result in chaos, corruption, and abuse of customers that ultimately becomes so bad that government must step in and clean up the mess.  Afterward, businesses are forced to behave in an orderly fashion, and people once again are able to gain confidence in government and the economy, as trustworthy, disinterested people who do not stand to game the system take control of the regulatory apparatus.

The problem with these explanations, of course, is that they are not true.  Let us take the "traffic signal" analogy first.  This explanation operates on the assumption that everyone who operates within a market system is essentially "flying blind," in the same way that those who support this "theory" assume that all drivers approach nonlighted intersections at full speed and wearing blinders.

Common sense tells us that this "theory" is bogus.  It is in the interest of market participants to gain as much information as they can when they engage in exchange and production.  Furthermore, the various signals sent by markets serve as regulating mechanisms.  For example, the Enron collapse did not come because regulators blew the whistle on the company's fraudulent operations, but rather because potential investors came to realize the company's shell games could no longer be hidden. The judgment of investors operating in the free market was swift and sudden: America's corporate darling was relegated to the abyss of penny stocks.

Businesses engage in numerous activities that include not only self-regulation but also various types of classifications as signals of quality.  For example, many certification organizations are privately run and require those who wish to join that profession to pass rigorous exams.  (The test for individuals to become certified public accountants, for example, is notorious for its difficulty.)

State-run licensing, on the other hand, while touted as a "signaling" mechanism, has been demonstrated time and again to be nothing more than a scheme to keep new entrants out of the market.  The regulation literature in economics is so complete and overwhelming in pointing out the real reason for much regulation that only those who are ideologically blinded will not recognize what is going on. (The chapter on regulation, "Who Protects the Consumer?" in Milton and Rose Friedman's Free to Choose is quite informative on this subject, but it is hardly the last word, as Austrians and non-Austrians alike have continually demonstrated the follies of regulation.)

Furthermore, the government regulatory process itself is often so confusing and disorganized that regulators are more out of touch than the people they supposedly regulate. Bruce Yandle, in his book The Political Limits of Environmental Regulation: Tracking the Unicorn, points out that the process simply breaks down under its own weight:

Federal air quality regulation was beginning to look more like a Unicorn. There were elaborate descriptions of details and behavior, but no one could really admit to having seen the real process in full operation. . . . Instead, those interested in environmental quality constantly pushed for more rules, as if rules alone were the goal, not improvements in the environment. (pp. 86-87)

Yandle was able to see the system at work from the inside from his position as an economist who served in a number of regulatory capacities in Washington. There was the perceived notion of how regulation was supposed to work, but in the end, reality always prevailed. This has not kept advocates of government regulation from continuing to proclaim the same tired message over and over again.

Advocates of regulation like to give the impression that business markets are a rendition of a Wild West show in which the participants are running amok until government shows them the way. For example, they say that, without regulation, fraud will be rampant.

Please understand that fraud is a crime under common law and was prosecuted as such long before the U.S. and state governments began to set up regulatory agencies in the late 1800s. Furthermore, the business deceptions that characterized much of Enron's behavior occurred in heavily regulated securities markets. (Krugman has been preaching from his New York Times perch that Enron was operating in an unregulated environment, something so far from the truth that only a Times editor or an Ivy League English professor could believe it.)

Government regulation did not keep Enron from defrauding its stockholders and employees. While its slide into bankruptcy has been spectacular, it could not have engaged in its financial shenanigans without the help of the Federal Reserve's 1990s policy of shoveling new credit willy-nilly into the economy. In fact, the very presence of heavy government regulation and intervention by the Fed into financial markets tends to create a false sense of assurance that "if the government is regulating it, everything must be okay."

There is also the quaint notion that government regulators are picked from a pool of scholarly, disinterested observers who (1) know how the regulated industry really works, (2) have no ties, financial or otherwise, to the industries being regulated, and (3) have the ability to provide the kind of leadership the regulated industries really need.

In truth, the "revolving door" between business and industry is the reality. As I noted in these pages several months ago, Joel Klein, who headed the U.S. Department of Justice's anti-Microsoft antitrust efforts, left his position to work in private industry as an antitrust lawyer. To put it another way, he was able to command hundreds of millions of dollars of tax dollars, in essence, to help prepare the way for him to go into private business and make millions of dollars per year.

Nor are the Joel Kleins the exception. As Friedman pointed out in Free to Choose, after the Interstate Commerce Commission was created in 1887 to regulate the railroads, railroad executives soon found that the ICC could be turned to their advantage. He writes:

As the campaign against the railroads mounted, some farsighted railroad men recognized that they could turn it to their advantage, that they could use the federal government to enforce their price-fixing and market-sharing agreements to protect themselves from state and local governments.

It was not long before the august body of railroad regulators was dominated by the railroads themselves--and this was the rule, not the exception, for industry regulation.  Economists from George Stigler to Murray Rothbard have pointed out that the pattern of regulation is for existing firms to use it as a government-enforced device to create and maintain cartels.  History demonstrates that regulation does not protect consumers; it protects producers.

Krugman and others who claim that the Enron scandal will be a watershed for regulation miss the point.  Government regulation already dominates our economic landscape.  Tossing on a few more rules might do damage, but it will not prevent fraud from occurring in the future.  For that matter, all of this new regulation that Krugman and others demand will not even prevent another Enron.  In truth, it might ensure that we have more Enrons down the road.


William Anderson, an adjunct scholar of the Mises Institute, teaches economics at Frostburg State University.  Send him MAIL.  See his Mises.org Articles Archive.


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